The Bond: A Loan You Can Trade, and What the Issuer Has Promised

A bond is a loan written as a security that can be sold on. The issuer promises stated amounts on stated dates: interest at a contracted rate on a stated face amount, and the face amount itself at a stated final date. The holder has a claim to those dated payments and nothing more, and may hand that claim to somebody else, who then holds it instead.

Why read the promise before the price?

The instrument itself starts neither with a price nor with a market. A loan is an obligation before it is anything else. One party has agreed to pay another particular amounts on particular days, and that single sentence is the whole of what has happened. Everything said about a bond after that, what it is worth, how much its worth swings about, what a riskier borrower has to pay, how a collection of them is managed, is a statement about that set of amounts and days.

A price is something a buyer offers for a schedule of payments, so the schedule has to exist and be settled before anybody can offer anything for it. The order is a fact about how the two things come into existence rather than a matter of presentation. No price can be computed for a promise that has not yet been written down, and the arithmetic that turns a written schedule into a price is covered separately.

A familiar version of this arrives without ever being called finance. A household borrows Rs 40,000/- from a neighbour for a wedding. Somebody writes on a slip of paper how much comes back and on which days, both parties keep a copy, and the thing is done. The slip is a bond written in fewer words. The slip names who owes, how much, and when. Add one property to it, that the neighbour may pass the slip to somebody else and be paid out today rather than waiting, and that is the whole idea of a bond.

What has the issuer actually agreed to do?

Three things, and this is the complete list. First, pay interest at a contracted rate struck on a stated face amount. Second, pay that face amount back on a stated final date. Third, keep the other terms written into the document that carries the obligation, whatever those terms happen to say. That is it. There is no fourth item hiding somewhere, and there is no implied undertaking that a reasonable person would expect to find.

The list is closed, and reading anything extra into it is how a holder ends up surprised by something the document never contained. The closed list does more work than it looks. An issuer has not agreed to keep its business healthy. The issuer has not agreed to warn the holder before things go wrong. Nor has it agreed that the claim will be easy to sell, or that anybody will want it at a sensible number on the day the holder needs the money. Every one of those sounds like something a decent borrower would obviously do, and not one of them is on the list.

The closed-list idea shows up outside finance in about ten seconds. A carpenter agrees to build a wardrobe by the fifteenth for Rs 22,000/-. The wardrobe, the date and the price are the agreement. The carpenter has not agreed to sweep the room afterwards, to advise on the paint, or to come back in a year and tighten the hinges. All three might happen and any of them would be pleasant. None of them is owed, and a customer who has quietly assumed one of them into the deal carries the disappointment rather than the carpenter answering for it.

The first of the three commitments is the only one carrying arithmetic, and the arithmetic is a single multiplication. The contracted rate is struck on the face amount, and on nothing else. Not on what the holder paid for the claim, not on what the claim would fetch today, not on what the issuer earned that year. The face amount is the base, and naming the base is what stops the multiplication being run against the wrong number.

Put the invented instrument through it. The ten year 8.50 per cent bond has a face amount of Rs 1,000/- and a contracted coupon rate of 8.50 per cent a year, on annual compoundingThe counting convention where a year of interest is settled once a year and any discounting is done once a year too. Say it out loud beside a rate, because the same number counted twice a year is a different rate.. So one coupon is 8.50 per cent of Rs 1,000/-, which is Rs 85.00/-. The base was the face amount and nothing else, and that is why the answer is Rs 85.00/- rather than some other number that a different base would have produced.

Which four terms fix the promise?

An obligation is settled by four questions, and every bond is an answer to all four. Who owes the money. How much is owed. At what contracted rate. On which dates. Answered, those four specify the instrument completely; leave one unanswered and nothing has been specified at all.

The four terms are not a description of a bond, they are the bond, so changing any one of them produces a different obligation rather than a variation on the same one. Change the borrower and it is a different obligation. Change the dates and it is a different obligation. Run it the other way and the same rule holds with more force: two instruments that agree on all four are the same obligation, whatever either of them is called, whichever route each was issued through, and however differently the two documents are laid out.

The everyday version is a building with ten tenants. Every one of them hands over Rs 18,000/- on the fifth of the month, on identical terms, into the same account. The building does not carry one obligation with ten payers. Who owes the money is one of the four terms and it differs in every single one of the ten, so the building carries ten separate obligations that happen to agree on the other three. When one tenant stops paying, the other nine are unaffected, and the reason they are unaffected is exactly that the fourth term was never shared.

What does the holder actually own?

A claim to dated payments from one borrower. The answer is short and it is complete. The exclusions are what a reader arriving from shares gets wrong, so they are worth listing item by item.

No share of profit. No vote on anything. No say in how the issuer spends the money once it has it. No entitlement that grows when the issuer has a good year, and none that shrinks when it has a bad one either, right up until the point where the issuer cannot pay at all. A holder is a lender with a schedule, and a lender's best possible outcome is being paid exactly what was promised, on the days it was promised.

The capped best outcome is the part to keep. A shareholder's best outcome is not written down anywhere, because it is whatever is left over after everybody else has been paid, and there is no ceiling on what is left over. A lender's best outcome is written down on the day the loan is made and never moves after that. The two are not two points on one scale of risk. The lender's claim and the owner's claim are opposite shapes, and mixing them up produces every mistake in what follows.

Why can it be traded at all?

An ordinary loan sits between the two parties who made it. A neighbour lends the money, that neighbour is owed the money, and the arrangement has exactly two ends. A bond is written so that one of those ends can be handed to somebody else. The new person then stands exactly where the first holder stood, with the same claim to the same amounts on the same days.

The property that makes this work is that the obligation does not change when the owner of the claim changes. The issuer still owes Rs 85.00/- on each date and Rs 1,000/- at the end. The issuer owes them to whoever holds the claim on the day each payment falls due, and it has no interest in who that is. Nothing about the promise was ever tied to the identity of the person on the receiving end, which is precisely why that person can be replaced without touching the promise.

Transferability of that kind is unusual. Most agreements made in an ordinary week cannot survive one side being swapped out. A tailor who has agreed to alter a particular customer's jacket has agreed to alter that jacket. A tutor who takes one family's child on Tuesdays has not agreed to take somebody else's child on Tuesdays. In both cases the identity of the other party is part of what was agreed. A bond takes that out, and taking it out is the whole of what tradable means.

One consequence lands immediately and it saves confusion later. If the claim changes hands ten times over ten years, the issuer's total obligation is still exactly what it was on day one. Nothing was created by the trading and nothing was consumed by it. The payments were simply directed to a different account each time. The amounts the various buyers and sellers paid each other along the way are a separate story, and a story about price rather than about the promise.

What does the promise look like written out?

A description of a schedule is a poor substitute for the schedule, so now write the promise out rather than describing it. The ten year 8.50 per cent bond, on annual compounding, produces this and only this.

The schedule is not an illustration of the bond, it is the bond written out. Nine dates carrying Rs 85.00/- each, which is Rs 765.00/- between them, and a tenth date carrying the last interest payment and the face amount together, which is Rs 1,085.00/- landing on one day. Add the two and the issuer has promised Rs 1,850.00/- in total, against a face amount of Rs 1,000/-, so everything promised is 1.85 times the amount originally borrowed.

The shape of it matters before anything else. The final payment of Rs 1,085.00/- is 12.76 times the size of any ordinary coupon date. The lopsidedness is not a quirk of this instrument; it is the standard shape of a plain bond, and once seen it is recognisable in every schedule afterwards. Nearly all of the money arrives on one day at the end, and the nine dates before it are comparatively slight.

How much of what is promised is interest?

Split the Rs 1,850.00/- and something quietly surprising falls out. Rs 1,000/- of it is the face amount coming home. The other Rs 850.00/- is interest, and that interest is 45.95 per cent of everything promised, against 54.05 per cent for the face amount itself. The two shares print to exactly 100.00 per cent.

A reader who thinks of a bond as a way of getting a thousand rupees back has just been shown that nearly half the promised money is not the thousand rupees. The interest share is worth stopping on, and it reorders what deserves attention. If interest is that large a share of the whole, then the number of dates is not a detail of the arrangement, it is most of the arrangement. And every one of those dates is a separate occasion on which the issuer has to actually have the money.

One bond on its own teaches a number and two bonds together teach the mechanism, so now hold that result up against a second invented instrument. Palash Cements Limited has a five year bond at 9.10 per cent a year struck on Rs 1,000/- of face amount, on the same annual compounding. One coupon is 9.10 per cent of Rs 1,000/-, which is Rs 91.00/-. Five of those is Rs 455.00/- of interest, and with the face amount back at the end the whole promise is Rs 1,455.00/-.

Work the interest share and the result runs against expectation. Rs 455.00/- of Rs 1,455.00/- is 31.27 per cent, against 68.73 per cent for the face amount. The Palash Cements bond carries the higher contracted rate and the smaller interest share, because the number of dates moves the share far harder than the rate does. Ten dates at 8.50 per cent put 45.95 per cent of the promise into interest; five dates at 9.10 per cent put only 31.27 per cent there. A guess from the rates alone would have gone the wrong way round.

Two other schedule shapes are worth naming so that they are recognisable when they turn up. A zero coupon bond has a coupon amount of Rs 0.00/- on every date before the end, so its entire schedule collapses onto a single payment on a single day. An amortisingDescribes a repayment shape in which the amount owed is paid down in slices across the life of the obligation rather than all in one go at the end. variant hands the face amount back in slices along the way rather than in one lump. Both answer all four fixing terms, so both are bonds, and both are taken up elsewhere.

What is deliberately not in the promise?

Four absences, and each of them is deliberate rather than an oversight. No share of profit. No vote. No protection against the issuer being unable to pay. No statement whatsoever about what the claim can be sold for tomorrow.

The absences matter as much as the three commitments, because a reader who thinks the missing items are implied will misread everything that comes after. The reason is that every later idea in this subject area is about one of the things the promise leaves open. The sale value tomorrow is the whole of pricing. Whether the issuer can pay is the whole of credit. How far the sale value swings when rates move is the whole of interest rate risk. To a reader who believes the promise already covers those, the later material reads as fussing over problems that were solved on day one; they were not solved on day one, they were left open on day one, on purpose.

The third absence deserves a sentence of its own because it is the one that costs money. The issuer has promised to pay. The issuer has not promised that it will be able to pay. The two sentences are different and only the first one is in the document. A promise to pay is not a guarantee of payment, and the gap between the two is what a lender is exposed to for the whole life of the instrument. The cost of that gap, how it is priced and how it is judged are all covered separately. The gap itself is there from the first day, whatever any of that turns out to say.

What kind of rate is this?

Four different objects get called a rate around a bond, and only one of them is written into the contract. The labelling rule sorts the four, and it is used throughout the subject, so it is worth thirty seconds of proper attention rather than a skim.

A contracted coupon rate is a term of the obligation. The contracted rate is struck on the face amount, it produces a rupee payment, and it is not a discount rate at all. On the ten year bond that rate is 8.50 per cent a year and it produces Rs 85.00/-.

A spot rateA rate attached to one single future date and to nothing else. A request for the spot rate has to be met with a question about which date, because there is a different one for every date. is the rate for one single future date. The five year government spot rate on the invented curve behind these figures is 6.90 per cent a year, and the word spot travels with it everywhere it goes.

A yieldThe one annual rate that, applied to every payment a particular bond promises, arrives back at one particular price for it. It belongs to a bond and a price together and never to a bond on its own. is the single annual rate that discounts one bond's promised payments to one price. A yield needs a price before it can exist, so a bond on its own has no yield at all. Yields are covered separately.

A forward rateA rate covering a stretch of time that starts later, worked out from two spot rates rather than observed anywhere. Nobody quotes it; somebody builds it. is a fourth object, derived from two spot rates rather than observed. A forward rate stated without the two spot rates behind it teaches nothing at all, so the pair matters more than the number derived from it.

The labels are worth the ink because on any smooth curve a forward rate can land within a few basis pointsOne hundredth of a percentage point. Twenty five of them is a quarter of a point, and the unit exists because rates move in slices too thin to say comfortably in decimals. of a spot rate for a different date, and a reader who meets the two of them without labels will quietly merge two completely different things. The merging is not a hypothetical risk; it is the ordinary behaviour of a well behaved curve. How a curve is built and what it says are covered separately, and the labelling habit is what makes that material readable.

One more reason to keep the labels attached uses figures already given. The Palash Cements five year bond carries 9.10 per cent a year and the five year government spot rate is 6.90 per cent a year. Both are quoted per cent a year, both cover five years, and subtracting them gives 2.20 percentage points, which is 220 basis points. The coupon rate and the spot rate are different objects doing different jobs, the gap between them has a name and a meaning, and the whole of that is covered separately. The question is visible at all only because each rate arrived carrying its label.

Which counting convention are these numbers on?

Every rate in this sequence is annual and the compounding is annual: one payment a year, discounted once a year. A rate travels with its convention or it travels wrong, so the convention belongs beside the rate rather than in a note at the foot.

The same coupon on the same dates at the same quoted rate, counted on a semi-annual convention instead, produces a different price, so an account that leaves the convention out gives a figure that cannot be reproduced and cannot be checked. The convention is part of the quote in exactly the way the unit is part of a weight. Two kilograms and two pounds are both written as a two, and nobody would accept the two on its own; a rate without its convention is the same defect wearing better clothes.

The labelling rule and the convention rule travel together for the same reason. A rate arriving with neither its kind nor its convention is not a slightly incomplete number; it is a number nothing can be done with. A bare number cannot be checked, it cannot be compared against the one printed beside it, and whatever was computed from it cannot be reproduced. Insisting on both, every time, makes the rest of this subject area noticeably easier to read.

Where does the price come in?

The promise is fixed on the day it is written. The amount somebody will pay for it is not, and never was, and was never meant to be.

The schedule is a contract term and the price is an opinion about that contract, formed by whoever happens to be buying, and the two never swap sides. The split between a contract term and an opinion is the hinge of the whole subject area, so it is worth stating in both directions. The face amount of Rs 1,000/-, the contracted coupon rate of 8.50 per cent a year and the ten dates are settled facts about a document; nobody's opinion moves any of them. The number a buyer offers for that document is a judgement; no document fixes it.

Turning the schedule into a price is arithmetic, and it is covered separately. How far the opinion moves afterwards, and how fast, is covered separately again. The promise is where the line falls. A reader who has the promise clear will find the pricing arithmetic almost easy, and a reader who does not will find it impossible.

Who sets the rules around the instrument?

Six separate questions surround a bond without being answered by it. Who may issue one and on what terms. How an issue is offered and through which route. The form a bond is held in and where the holding is recorded. How a trade is settled and on what cycle. The disclosures that must be made when a bond is offered. Which categories of investor may hold which bonds.

All six belong to the Reserve Bank of India for government securities and the money market, and to SEBI for corporate debt. All six move. The current text of each is published by the body that sets it: the Reserve Bank of India at rbi.org.in and SEBI at sebi.gov.in.

Where the arrangement touches tax, the tax authority is the Income Tax Department at incometaxindia.gov.in. The roles around an issue, the trusteeA party appointed to hold and enforce the lenders' rights collectively, so a hundred separate holders do not each have to chase the borrower on their own., the arranger, the registrar and the paying agent, appear by role only and are never named, and what each of them must do is set elsewhere too.