What is a bond?
In practice, the debenture is another name for bonds - both terms can be used synonymously. Because of its simplicity, "bond" is used more often. You certainly know the principle of a bond: The debtor (issuer of the bond) issues a bond that is bought by the creditor (investor). The investor receives a fixed or variable interest rate on the capital invested for the duration of the bond. At the end of the term, the creditor also receives back the so-called nominal amount of the bond. This is the amount that the issuer borrows from its creditors (per bond).
Bonds can be issued by banks but also by companies as an alternative to going public in order to raise fresh capital. Bonds always securitise a so-called creditor's right, which is why they represent debt capital (compared to shares) from a legal point of view.
Important note: In this article we focus on bearer bonds. Another type - the so-called registered bond - can also be classified as equity.
Claims on the part of creditors
By purchasing a bond, creditors are entitled - on the basis of the creditor's right - to repayment of the capital invested at a defined point in time. This is independent of where the bond was purchased - whether on the stock exchange or on a private market. The issuer of the bond is therefore also the debtor in relation to the investor.
In comparison to shares, creditors do not receive any participation in the company and therefore also no co-determination rights. This is particularly advantageous for companies that want to determine the further development of the company independently. Investors receive an interest rate that is either fixed or linked to the company's performance (profits). In the latter case, the interest rate is variable.
A fixed interest rate has the advantage that investors have a certain form of predictability when purchasing the bond. The returns from the investment are clearly defined. However, there are risks if the creditworthiness of the issuer is at risk - more on this in a moment.
We note that there are two types of bonds. In the case of fixed interest, a certain interest rate is guaranteed by the issuer for the entire term and cannot be adjusted. The character is similar to that of a classic loan at the bank. In the case of variable interest, the interest rate is linked to a dynamic component.
In practice, this is often done by linking it to a key interest rate, e.g. Euribor . However, the linkage can also be tied to other variables - e.g. profits (or losses) from the business. In this case, the bond has an owner-like character.
What debt securities are there?
There are a number of different forms of debt securities. In this article, we do not yet go into the specific characteristics of the respective debenture.
As an investor, you will have heard of some of the following bonds:
- Government bonds
- Corporate bonds
- Convertible bonds
- Warrant bonds
- Currency bonds
- Redemption bonds
- and bearer bonds
Maturities and risks
There are no predefined maturities for debt securities. The maturities range from one year to 30 years. In principle, any period is conceivable. As an investor, you should think carefully about the period over which you want to tie up your capital, especially in the case of unlisted bonds. If you cannot sell them early, there is a risk that you will not be able to convert the investment into cash in an emergency. Always check the maturity and tradability of bonds before investing.
What people tend to overlook, especially with fixed-income asset classes, are the major risks that come with them. Just because a certain repayment is guaranteed does not mean that the company will be able to meet its obligations. If there is a financial bottleneck, you as an investor will lose your invested capital in the worst case. Depending on the structure of the bond, there are other risks besides the risk of total default. In the case of government bonds, the interest rate risk is of great importance. If the key interest rates change, the price of the bond changes.
With variable interest rates, you also bear the risk that your investment will not pay interest if, for example, it is linked to the profits of the company. If the company makes a loss, you will not receive a return on your capital.
Conclusion
Debt securities offer companies an interesting alternative for corporate financing. Compared to an IPO or a private equity investment, the creditors (investors) do not receive any co-determination rights and therefore cannot influence the company's development.
For investors, this results in an interesting addition to volatile portfolio components - especially in the case of fixed interest rates. Nevertheless, you should always be aware of the risks. Issuers of a bond can become insolvent if the company develops adversely. In this case, even the total loss of the investment is quite possible.
