What are bonds?

Think of it this way: a friend wants a loan and promises to repay the full amount at maturity. In the meantime, there are moments when you receive interest at predefined intervals. And you can transfer their debt to someone else – maybe someone values the interest more and is willing to cover your initial investment plus something extra.

Now imagine that your friend – the issuer – could be a country, a supranational entity, or a corporation. The loan would be called a bond, maturity would still be maturity, the dates when you receive interest would be called coupon dates, and transferring the loan would be the moment when you trade bonds on the stock exchange.

Let’s go into more detail.

Bonds have a fixed par value to which the coupon rate is applied in order to calculate interest. However, the price received by the issuer at issuance may be lower or higher than par value, in which case the bond is said to be issued at a discount or at a premium.

Similarly, the issuer may redeem an amount higher or lower than the par value, in which case redemption is said to occur at a premium or at a discount.

When traded on the exchange, bonds can be sold easily before maturity, and the price you receive varies depending on market supply and demand. We have selected several key factors that may influence interest: the associated credit risk of the issuer, reference interest rates, macroeconomic outlook, and the remaining time to maturity.

The first three are subjective: each investor may assess them differently depending on the available information.

We cannot predict the future, but we can make projections regarding the general future state of the economy, from growth rates to how specific sectors – especially that of the bond issuer – may evolve.

When it comes to trading, there is an important particularity: in addition to the market-estimated price for the present value of all future payments (called the clean price), the buyer pays and the seller receives a component automatically calculated by the exchange called “accrued interest”.

This represents the interest owed to the seller for the holding period since the last coupon date (or since purchase, if no coupon was received during that period). When added to the clean price, the result is the actual price received by the seller (and paid by the buyer), known as the “dirty” price.

So, how do we classify bonds and what should we know when choosing? First of all, they are divided into several types based on a series of criteria, the most important being: issuer type, coupon type, level of collateral, and attached options.

Depending on the issuer, bonds can be classified as government bonds, supranational bonds (such as those issued by the World Bank), municipal bonds (issued by local authorities), or corporate bonds (which in Romania can only be issued by joint-stock companies).

Not every government-issued debt instrument qualifies as a bond. In Romania, for a government security to be considered a security and treated as a bond, it must have a maturity of at least one year at issuance.

Since bonds are loans and all loans involve risk, which bonds will let you sleep at night? Government and supranational bonds are generally considered the safest, followed by municipal and corporate bonds. However, every rule has exceptions: German federal bonds are considered safer than Greek ones, and Romanian government bonds may be riskier than Apple bonds.

Let’s also talk about the coupon, because interest is probably what matters most to you. Depending on its type, bonds may have fixed or floating coupons.

In the first case, the rate does not change from issuance until maturity. In the case of floating-rate bonds, the rate may vary according to a formula defined in the issuance documents – the prospectus or the offering document.

Typically, the rate is linked to a public national or international interest rate index (ROBOR, EURIBOR, LIBOR, etc.), published regularly by an entity independent of the issuer.

There are also exceptions: zero-coupon bonds, which do not pay interest but are issued at a discount, making the redemption value higher than the invested amount, or bonds whose coupon rate is periodically adjusted based on inflation.

When you lend money, you often feel the need for a safety net – the assurance that you will recover your money at the agreed date. This brings us to the level of collateral, which refers to what happens if the issuer enters liquidation or defaults.

In other words, it defines the order in which debts are paid and where bonds stand in that hierarchy, as well as any assets or rights dedicated exclusively to repaying bond-related debt.

The classification is as follows: secured bonds, senior unsecured bonds, and subordinated (junior) bonds. Depending on national legislation, seniority may mean different things, but generally senior bonds rank alongside other unsecured liabilities, while subordinated bonds rank below them, except for equity.

There is also a special category of subordinated bank bonds, designed as a buffer against potential losses caused by economic crises or poor management. In the EU, these instruments are restricted, and investors must qualify in order to assume the additional risk.

Anything valuable deserves collateral. If a footballer can insure their leg, it is natural that bonds may also be collateralized – with mortgages, intellectual property, financial instruments, inventories, receivables, other issuer assets, or even assets belonging to third parties.

These third parties commit to covering payments from their own assets if the issuer is unable or unwilling to do so.

For exchange-listed bonds, the existence of a collateral agent is required to monitor and, if necessary, enforce collateral on behalf of bondholders.

If you encounter the term attached options, it refers to special clauses included in the prospectus or final offering document that grant the issuer or the investor the right to take a specific action once certain conditions are met.

The other party is obliged to comply if those conditions are fulfilled. Examples include call and put options on bonds, which allow the issuer (call) or the investor (put) to request early redemption – something not normally permitted without attached options.

Another important feature is the conversion option, allowing bonds to be converted into other securities – typically shares or bonds – at a predefined conversion rate, once the agreed conditions are met.

As with any financial explanation, you may want to read, reread, and learn more. But if you had to explain bonds to your mother in just two minutes, you could say that anyone – from countries to corporations – can borrow money, that you can lend to them and receive compensation called a coupon (interest), that not all borrowers offer the same level of safety, that collateral can matter, and that sometimes even governments can owe you something.

Variable (from low to high, depending on issuer, collateral, and maturity)

Generally, short-term bonds are less risky than long-term bonds. Government bonds are less risky than municipal bonds, which in turn are less risky than corporate bonds, and corporate bonds are usually considered less risky than equities.

However, according to rating agencies, Apple bonds are less risky than Philippine government bonds, while Transelectrica shares are less risky than a start-up’s bonds when insolvency risk is considered. As with all spot market instruments, an important thing to remember is that you cannot lose more than the amount invested.