According to Wikipedia, a bond is:

… a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the “coupon“) and/or to repay the principal at a later date, termed the maturity.

Interest is usually payable at fixed intervals (semiannual, annual, sometimes monthly). Very often the bond is “negotiable“, i.e. it can be sold to another.

Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Certificates of deposit (CDs) or short term commercial paper are considered to be money market instruments and not bonds: the main difference is in the length of the term of the instrument.

The Climate Bonds Initiative divides bonds into three broad categories:

1. Organisation-guaranteed bonds. These are also called “general obligation bonds” – the organisation is asking you to trust it to pay the bond from it’s various sources of revenue and assets. The credit worthiness of the organisation is the key to the interest rate the bonds will pay. Issuing organisations include:

  • Government. These are largely national governments (Sovereign or Treasury bonds), but State Governments and municipalities also issue bonds in some countries. In the US, thanks to significant tax credits, the muni bond market is valued at $2.9 trillion.International financial institutional (IFI) bonds. Such institution range from the World Bank to the International Monetary Funds. These entities are supported by credit guarantees from various governments.
  • Corporate bonds. As above, but issued by private or listed companies.

The bulk of these, like Government bonds, are simple promises by the company to pay interest for the life of the bond at a pre-agreed rate  - these are called “vanilla bonds“.

A different approach is the convertible bond, which allows investors to convert their bonds to an equity stake in an entity (in other words, become shareholders in a company), at agreed points. A recent example is in the banking sector, where regulators have encourage the issuance of bonds that convert to (higher risk) shares if capital adequacy ratios fall below a certain point.

  • One form of climate bond is a Government, IFI or corporate bonds linked to qualifying assets. In this case investors can see what the organisation has used funds for, but the creditworthiness of the bond is tied only to the organisation.

2. Asset-backed securities or secured bonds. These are bonds where the coupon and thus creditworthiness are tied directly to cash flows from specified assets, such as wind energy farms or loans to solar project. Typically these assets are placed in a “special purpose entity“, a corporate structure set up just to hold those assets. As there is no guaranteeing established company, the creditworthiness of the bond is essentially tied to the asset’s expected performance.

Project bonds are a form of secured bond, where the security is a project yet to be completed.

3. A variation on asset-backed is the hybrid “dual recourse” bond. This is where the investor has recourse to both company and the specified assets. If a company goes bankrupt it’s the investor who owns the assets, not the bankruptcy administrator.

The most common dual recourse bond is the “covered bond“. This is backed by cash flows from loans, most commonly housing mortgages. The assets usually remain on the issuer’s balance sheet, but are separated into a “cover pool” so the investor knows what they’re getting as security. In most countries the covered bonds market is highly regulated. Covered bonds are also called Pfandbriefe in Germany and Scandinavia, Obligations Foncières in France, and Cédulas Hipotecarias in Spain.

Different models of calculating interest rates 
Bond interest (the coupon) can be calculated in a variety of ways:

  • The most common approach is to use fixed interest or a floating rate, linked to a money market reference rate, like LIBOR or the federal funds rate - plus an extra (a.k.a. “spread” or “quoted margin”).
  • Some bonds are “zero-coupon”, which means that they don’t pay any interest until the end of the bond’s life, whether 10, 20 or 30 years in the future. These are most suitable when new technology needs to be developed, embryonic technology needs to be scaled up, or existing technology has to be invested in high-risk countries. An “enabling institution” converts high-risk projects into low risk investments for institutions by acting as incubators until companies and technologies become large enough or low risk enough to sell off.
  • Climate Bonds Advisory Panel member Michael Mainelli has proposed a bond where the interest rate payable goes up if the carbon price does not meet stated targets. This allows renewable energy investors to hedge their bets by buying such bonds as insurance — if the carbon price targets they base their investment plans on are not met, they can claw some of the loss back by getting a higher rate of return on these bonds.
  • Islamic bonds – Sharia-compliant bonds - would have no interest payable; payments would be in other modes, such as fixed periodic payments, equivalent to a lease. Green Sukuk is the term for sharia-compliant bonds related the climate change investments.
  • A range of small bonds have been issued that have exotic coupons paid – where all or part of the interest paid is tied to something other than the financial performance of the underlying asset.  In the climate change space, for example, the World Bank has issued modestly sized bonds in Japan that have coupons linked to carbon or eco-company indices. These have remained niche issues, however, and are generally eschewed by institutional investors.
  • Recent years have seen the development of social return bonds or various sorts, where investors gain all or part of their reward in a manner tied to social performance of the project being funded. These are still very few in number – in R&D effectively.

Global bond market is $78 trillion

The global bond market was estimated (by the Bank of International Settlements) to be worth $78 trillion at the end of December 2012 [1]. Domestic bonds accounted for 70% of the total and international bonds for the remainder. The US was the largest market with 33% of the total followed by Japan (14%).

As a proportion of global GDP, the bond market increased to over 140% in 2011 from 119% in 2008 and 80% a decade earlier. The considerable growth means that in March 2012 it was much larger than the global equity market which had a market capitalisation of around $53 trillion. Growth of the market since the start of the economic slowdown was largely a result of an increase in issuance by governments.

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[1] Prior to December 2012 the Bank of International Settlements (BIS) had said the bond market was worth $100 trillion. However, in Dec 2012 they published a paper saying they’d uncovered problems in their methodology that had led to double-counting, and revised the global figure down some $20 trillion!