What is a Bond?

A bond is a valuable security issued by an issuer to raise funds, paying a certain percentage of interest at agreed times, and repaying the principal upon maturity. In other words, a bond is a means for the issuer to finance, with the returns also being predetermined.

Classification of Bonds

There are many ways to classify bonds, and a single bond can belong to many categories. For example, a government bond 998 can be classified as a government bond, it is also a coupon bond, it is a long-term bond, a listed bond, and finally, it can also be classified as an unsecured bond and a public offering bond. Therefore, we should have a concept of bond classification, and it is not necessary for you to remember all the content, but at least you should be aware that there are such classifications to avoid being completely ignorant when investing in bonds. Get your neurons moving now!

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Classification by Issuing Entity

Government bonds are bonds issued by the government to raise funds. They mainly include national bonds and local government bonds, with the most important being national bonds. National bonds are also known as "gilt-edged bonds" due to their good credit, favorable interest rates, and low risk. The interest on government bonds is tax-exempt, while bonds issued by companies or financial institutions, which are guaranteed by the government, do not enjoy the tax-exempt treatment of the interest on central and local government bonds. Bonds issued by the central government are also known as public bonds or treasury bonds, and their purpose is to cover fiscal deficits or invest in large-scale construction projects. Bonds issued by local government institutions such as cities, counties, and towns are called local government bonds, and their purpose is mainly to raise funds for local construction, hence they are bonds with longer terms. There is also a category of bonds called government-guaranteed bonds, which are mainly issued by enterprises directly related to the government to raise funds for the construction of municipal projects and public facilities.

Financial bonds are bonds issued by banks and non-bank financial institutions. In China, financial bonds are currently mainly issued by policy banks such as the China Development Bank and the Export-Import Bank. Corporate bonds are bonds issued by enterprises according to legal procedures, with an agreement to repay the principal and pay interest within a certain period. The purpose of issuing financial bonds is generally to raise long-term funds, and their interest rates are generally higher than the interest rates on bank deposits of the same period, and bondholders can transfer the bonds at any time when they need funds.

The issuing entity of corporate bonds is a joint-stock company, but it can also be a company that is not a joint-stock company. Therefore, when classifying, corporate bonds and bonds issued by enterprises are combined and can be directly referred to as corporate (enterprise) bonds. The purpose of issuing is to raise long-term construction funds, and there are generally specific uses. According to relevant regulations, enterprises must participate in credit ratings before issuing bonds, and only those that meet certain standards can issue. Because the credit level of enterprises is not comparable to that of financial institutions and the government, the risk of corporate bonds is relatively higher, and therefore their interest rates are generally higher as well.Classified by Repayment Period:

Long-term bonds are generally considered to be those with a repayment period of over 10 years. Medium-term bonds have a term of 1 year or more, but less than 10 years (including 10 years). Short-term bonds are those with a repayment period of less than 1 year. Note: The classification of corporate bond terms in our country differs from the above standards. Short-term corporate bonds in our country have a repayment period of less than 1 year, medium-term corporate bonds have a repayment period of more than 1 year but less than 5 years, and long-term corporate bonds have a repayment period of more than 5 years.

Classified by Interest Rate Determination Method:

Fixed-rate bonds are bonds where the interest rate is set at issuance and remains unchanged throughout the repayment period. Floating-rate bonds are the counterpart to fixed-rate bonds; they are bonds where the interest rate is set to fluctuate periodically with market interest rates at issuance. The interest rate is typically determined based on a market benchmark rate plus a certain spread. Floating-rate bonds are often medium to long-term bonds. Since the interest rate can float with market interest rates, using floating-rate bonds can effectively hedge interest rate risk.

Classified by Interest Payment Method:

Fixed-interest bonds are bonds where the interest rate is set at issuance and remains unchanged throughout the repayment period. Floating-interest bonds are bonds where the interest rate is set to fluctuate periodically with market interest rates at issuance, meaning the bond interest rate can be adjusted during the repayment period. Zero-coupon bonds are issued at a discount and are bought back at par by the issuer upon maturity. Based on convertibility, convertible bonds are bonds that can be converted into other financial instruments under certain conditions, while non-convertible bonds are those that cannot be transformed into other financial instruments. Convertible bonds generally refer to convertible corporate bonds, where the holder can convert the held bonds into stocks according to certain conditions at their discretion.

Classified by Coupon Payment Method:

Discount bonds, zero-coupon bonds, interest-bearing bonds, fixed-rate bonds, and floating-rate bonds.

Classified by Interest Calculation Method:

Simple interest bonds, compound interest bonds, and progressive interest rate bonds.

Classified by Bond Form:

Physical bonds (bearer bonds), certificate bonds, and book-entry bonds.

Classified by Fundraising Method:

Public offering bonds and private placement bonds.

Classified by Guarantee Nature:

Secured bonds, unsecured bonds, and pledged bonds.Why Do We Need Bonds When We Have Stocks?

Since financing can be achieved through the issuance of stocks in the financial market, why is there a need for the financial instrument of bonds? It is evident that bonds have their specific advantages that justify their existence.

Not Wanting Investors to Participate in Corporate Management and Profit Distribution

The purchasers of bonds are known as creditors. Stocks and bonds represent two different methods of financing. Issuing stocks is akin to selling the ownership of a company; stockholders can demand participation in the management and profit distribution of the enterprise. Issuing bonds, on the other hand, is like borrowing money from others, with only the obligation to repay the principal and interest; creditors have no right to participate in the management and profit distribution of the company. Therefore, bond issuance is a more secure and straightforward financing method compared to stock issuance.

Providing Financing for Institutions That Cannot Issue Stocks

Some institutions are unable to raise funds through the issuance of stocks, such as governments and non-public companies. Governments need financial support to maintain their functions in managing the country, ensuring the normal operation of various government departments. If government expenditures exceed tax revenues and other sources of income, a fiscal deficit will arise, and the government must borrow additional funds. This is an important reason for the issuance of government bonds. Additionally, some companies that have not gone public may also raise funds for development. For example, Huawei registered and issued two series of medium-term notes totaling 6 billion yuan in 2019, marking its first domestic bond issuance for financing. With the financial instrument of bonds, institutions that have potential but have not issued stocks can raise funds and continue to develop smoothly.

Treasury Bonds as an Important Tool for Macroeconomic Regulation

Treasury bonds can connect fiscal policy with monetary policy. Central banks can engage in "open market operations" by buying and selling government bonds to absorb or release base money, adjust the reserve positions of commercial banks, and influence their credit capacity, thereby regulating the money supply and interest rate levels in service of monetary policy. In many instances when central banks adjust monetary policy, they do so through the purchase and sale of government bonds, such as the Federal Reserve selling government bonds to achieve the effect of raising interest rates.

What is the Relationship Between Bond Yield and Price?

First, understand a few concepts:The face value of a bond refers to the set nominal value, representing the amount that the issuer commits to repay to the bondholder on a specific future date, and this value remains constant.

The issue price of a bond is the price used by the issuing company (or its underwriters, agents) when issuing bonds, which is the actual price paid by investors when they subscribe to the bonds issued by the company. The issue price and the face value of the bond are usually equal, but there are also cases where they are not equal. When the bond issue price is the same as the face value, it is called par value issuance; when the bond issue price is higher than the face value, it is called premium issuance; when the bond issue price is lower than the bond's face value, it is called discount issuance.

The trading price is the price at which bonds are bought and sold after they are issued and before they mature. In reality, due to various considerations of the issuer or the supply and demand relationship in the money market, changes in interest rates, the market price of bonds often deviates from its face value, sometimes higher and sometimes lower. That is to say, the face value of a bond is fixed, but its price is constantly changing. The issuer calculates interest and repays the principal based on the face value of the bond, not its price.

The coupon rate is the interest rate stipulated to be paid when the bond is issued and is directly printed on the bond's face. It represents the ratio of the annual interest payable to the bond's face value. The level of the coupon rate directly affects the financing cost of the security issuer and the investment returns of the investor, and is generally determined by the security issuer based on the situation of the bond itself and an analysis of market conditions. The interest payment method of a bond refers to the way the issuer pays interest to the bondholders in installments during the validity period of the bond, and the interest payment method also affects the investor's returns.

Yield to Maturity (YTM), also known as the full term yield or maturity yield, is not a contractual interest rate but a measure of return calculated through complex calculations. It refers to the internal rate of return calculated on the purchase price when an investor holds a bond or other fixed-income security until its maturity date, assuming that the principal and interest are paid on time. [1] The present value obtained by discounting all future cash flows (including interest and principal) of the bond at the YTM is equal to the purchase price, that is, it satisfies the following equation:

\[ C \times \frac{1 - (1 + r)^{-n}}{r} + F \times (1 + r)^{-n} = Pv \]

where \( C \) is the annual interest paid at the coupon rate, \( r \) is the YTM, \( Pv \) is the current market price of the bond, \( n \) is the number of years to maturity, and \( F \) is the face value of the bond. For example: If a two-year bond with a face amount of 1000 yuan pays 60 yuan in interest in the first year and 50 yuan in interest in the second year, and the current market price is 950 yuan, what is the YTM of this bond?

YTM is an indicator to measure the quality of two bonds. Generally speaking, the higher the YTM, the higher the bond's returns.

What affects bond prices?

When bonds are traded in the market, their prices will definitely fluctuate. What factors affect the trading price of bonds? The first is the market interest rate. When interest rates rise, the trading price of bonds will fall because when interest rates rise, the returns on newly issued bonds of the same specification will increase, leading to a decrease in demand for already issued bonds. Since everyone stops buying already issued bonds, the price of already issued bonds will decrease until it reaches a level where the returns are equal to the returns of newly issued bonds. The second is a decrease in bond credit. If there are credit issues with the bond issuer, such as a default or the possibility of a default, the purchasing power of this bond will decrease, and the price will naturally fall.

Bond yield inversionThe inversion of bond yield refers to the phenomenon where long-term interest rates are lower than medium and short-term interest rates (under normal circumstances, long-term interest rates are higher than medium and short-term rates), and this signal is often considered the best predictor of future economic recessions. Research by the Federal Reserve Bank of San Francisco shows that in the past 60 years, every time before an economic recession in the United States, the yield curve has inverted.

Conclusion

Since the reform and opening up, especially entering the new century, China's securities market has achieved tremendous development. The number of issuers has continuously increased, the market size has expanded, and the types of bonds have become more diverse, becoming an important part of China's financial market system. It has played a significant role in promoting the development of the entire financial market and financial system, increasing the proportion of direct financing, and serving the development of the real economy. However, compared with the needs of economic and financial development, there is still a significant gap in the development of China's bond market, and many issues need to be studied and resolved. The bond market still needs to be vigorously developed.