What are bonds?
Bonds are a form of debt. The borrower is the issuer of the bond and the lender is the investor who buys the bond. Distinctively, unlike other forms of lending, the investor is free to sell their investment to another investor.
The conditions that issuers, and the banks that trade in bonds must satisfy are set by securities regulators, such as the Financial Conduct Authority in the UK, and these rules are similar to those governing shares issued by companies and traded by investment banks on a stock market. Thus a better name for a bond is a debt security: it is a tradable instrument with the characteristics of debt.
The ability to sell bonds is the key to their popularity, both as an investment and a means of borrowing. When a borrower issues a bond they know that they have secured the funds from investors for the life of the bond. The lender knows that if their circumstances change, then they can sell the bond to another investor and recoup some or all of their investment. These features reduce the risks and uncertainties for both parties and are an important factor in making the bond market a popular means of borrowing.
Like a mortgage loan or a credit card agreement, the issuer must agree to the investors’ conditions before the funds are advanced. As with other forms of borrowing, bond investors expect to be paid interest on the amount they have lent to the issuer of the bond and to have the amount borrowed repaid by an agreed date. The conditions that the issuer of a bond must meet, such as the timing and scale of payments to be made, are set out in a document, which is usually referred to as the prospectus, before the bond is first issued. The terms in this prospectus constitute a binding contract (hence the term “bond”) between the issuer and all investors. As bond investors’ entitlement to income is ‘fixed’ at the point of issue and may not be varied without the consent of both issuer and bondholders, bonds are also called fixed income securities.
The contractual nature of a bond, which is similar to that of other forms of borrowing, has important implications for all parties. If the issuer breaches any term of the prospectus and does not remedy the breach within a set period of time, then the issuer is deemed to have defaulted. While this is undesirable for all parties, it creates the legal basis on which the investors can seek to recover their investment from the issuer. This is important because, while the issuer continues to meet all the conditions of the prospectus, bond investors have no influence on the strategy or policies of the issuer. This changes if the issuer defaults on their prospectus with investors, and it is essential that it does to protect the interests of the investors.
In summary, bonds are a form of debt, which are tradable and therefore subject to regulation by securities regulators. Bonds entitle investors to an income that is fixed in a prospectus along with other binding conditions that the issuer must meet before the bonds are issued. The fixed but tradable nature of bonds means that they are also called fixed income securities.