Debt Instrument

A bond is a long-term debt instrument.  When a prospective homeowner borrows money to finance the purchase of the home, it is called a mortgage.  A home mortgage is a mortgage bond wherein the interest rate, the repayment date, and other terms are stipulated.  Similarly, corporations and governments issue (sell) bonds to raise money to finance their operations.  They are the borrowers, and the individuals or other entities that purchase the bonds are the lenders.

Bond terminology

Most corporate and government bonds have a maturity date (i.e., repayment date) that is 10 or more years from the date of issue.  The maturity date is the date on which the bondholder (lender) will receive the face value, also called the par value or the maturity value, of the bond.  The face value of the majority of domestic bonds is $1,000.  In contrast to a home mortgage, wherein the regular payments that the borrower makes include both interest and a partial repayment of the loan, most corporate and government bonds are structured such that only interest payments are made prior to the bond’s maturity.  The annual dollar interest paid on a bond is called its coupon, and the annual interest rate is referred to as the coupon rate.  This said, the bonds issued by most domestic corporations and governments pay interest every six months, or semiannually.  For example, if a 20-year $1,000 bond has a 6% coupon rate, with semiannual payments, the bondholder will receive $30 every six months until the maturity date, at which time the bondholder will receive the last interest payment of $30 along with the $1,000 face value of the bond.  Most bonds have a fixed coupon rate; that is, the interest rate paid does not change during the life of the bond.  There are, however, a few variable rate, or floating rate, bonds.  The interest rate on these bonds will change with a change in some benchmark rate, such as the Fed Funds rate, which is the rate that banks charge each other for overnight loans.

But maybe you don’t want to have to hold the bond for 20 years in order to receive the $1,000 face value.  You’re in luck; you can sell your bond to another investor prior to maturity, just as a financial institution that originates a home mortgage often sells the mortgage to another investor.  Most bonds are bought and sold via dealers in the over-the-counter market—in fact, all government bonds are traded only in the over-the-counter market—however, some corporate bonds are also listed on the New York Stock Exchange’s bond market.

Bond Prices 

Bonds may sell for their face values, or they may sell for more or less than their face values.  A bond selling for its face value is said to be selling at par.  A bond that is selling for more than its face value is said to be selling at a premium, and a bond that is selling for less than its face value is said to be selling at a discount.  The coupon rate on most bonds is set so that the bond will sell at par when it is first issued.  This is accomplished by stipulating a coupon rate that is the same as the yield that investors are getting on investments of similar risk.  In this instance, the entire yield that the investor will receive if he or she holds the bond to maturity is equal to the coupon rate.  If a 7%, $1,000 bond issued by XYZ Corporation is selling for $1,000, an investor who buys the bond and holds it to maturity will receive $70 in interest each year ($35 every 6 months) and $1,000 when it matures.

However, as interest rates in the economy change, so do bond prices.  Bond prices vary  inversely with interest rates.  That is, if interest rates increase, the prices of existing bonds fall, and vice versa.  To continue with the example above, let’s suppose that interest rates increase so that a new bond issued by the ABC Corporation that is similar in risk to the XYZ bond is offering a 9% coupon rate.  If XYZ’s bond were to continue selling for $1,000, no one would buy it.  Thus, market forces will drive the price of the bond down until the XYZ bond also offers a 9% yield—part of which will be the 7% coupon, with the additional 2% coming in the form of capital gains since the investor will be paying less for the bond than he or she will receive when the bond matures.  

If, on the other hand, interest rates in the economy are falling, the price of existing bonds will rise.  If the MNO Corporation issues a new 5% bond that is considered to be of similar risk to that of the XYZ bond, everyone will want the XYZ bond since it is offering a higher rate of interest than the market demands.  This will cause the price of the XYZ bond to be bid up to the point that it, too, will only be yielding only 5%.  While the investors will still get $70 in interest annually, they will have paid more than face value for the bond and will have a capital loss when the bond matures.

Bond features

Bonds may be secured or unsecured.  Secured bonds are backed by one or more assets owned by the firm.  If the issuer fails to make the promised payments, the bondholders can sell the assets to get the money owed them. Similar to a home mortgage, a corporation may issue a mortgage bond that is backed by real estate owned by the firm. Equipment trust receipts are bonds backed by specific equipment owned by the firm.  Railroads often issue these, using railroad cars as the security. Unsecured long-term bonds are also called debentures.

Bonds may be convertible, callable, or putable.  A convertible bond allows the bondholder to exchange the bond for shares of the stock of the corporation.  If the firm is doing particularly well, the bondholder may choose to do so in order to enjoy the unlimited profits associated with stock ownership. A callable bond enables the issuer—i.e., the borrowing firm—to buy the bond back from the bondholder prior to its maturity date at a pre-specified price.  A firm may choose to do so if interest rates have fallen since it can then issue a new bond with the lower coupon rate.  A putable bond gives the bondholder the right to force the borrowing firm to buy the bond back at a pre-specified price.  This feature is less common than the preceding two features.  Putable bonds are more popular in times of volatile interest rates.

All of these features, if applicable, along with the face value, the coupon rate, the maturity value, and other features a bond might have are spelled out in detail in a document called the bond indenture.

Credit rating

You may have noticed that the words “similar risk” were used in the discussion on bond prices.  Not all bonds have the same risk.  Bond rating agencies, such as Standard & Poor’s ( S&P), Moody’s, and Fitch, assess the default risk—i.e., the risk that the promised payments will not be made-of the majority of bonds issued.  The highest rating is a “triple A” rating, which is indicated as AAA by S&P and Fitch and Aaa by Moody’s.  Bonds with this rating have an extremely low default risk.  This said, any bond with a “triple B” rating (designated as BBB by S&P and Fitch and Baa by Moody’s) or better is considered to be investment grade, with a very low risk of default.  Ratings below triple B are considered junk, and the lower the rating, the less likely the bondholders are to receive the payments promised.  An abbreviated table is provided below.  S&P and Fitch also assign a D rating to some bonds, and all three agencies also assign ratings of “+” or “-“ within each category.  For example, S&P and Fitch may rate a bond as AA+, AA, or AA- while Moody’s uses the designations Aa1, Aa2, and Aa3 to mean something similar.



Standard & Poor’s Moody’s Fitch



So, why would anyone invest in a junk bond?  It’s a matter of risk and return.  Because they are much riskier—and the investor may end up with little or nothing—they must offer a much higher return to incite investors to take the risk.  And some junk bonds do end up paying off big time.

Bond issuers

As noted earlier, bonds are not only issued by corporations, but also by governments.  Bonds issued by the U.S. government are called Treasury bonds.  These are considered default-risk free since they are backed by the full faith and credit (i.e., taxing power) of the U.S. government.  Federal government agencies, such as the U.S. Postal Service and the Small Business Administration (SBA), issue bonds to obtain money to support their operations.  Some, but not all, government agency bonds are backed by the full faith and credit of the U.S. government, but most bond traders believe that the federal government would not allow a bond of one of its agencies to go into default.  

Bonds are also issued by state and local governments.  These are called municipal bonds, or munis.  They have a unique feature in that you don’t have to pay federal income tax on the interest you earn on them.  Moreover, the interest is not subject to the state or local income tax of the issuing government.  For example, if you purchase a bond issued by Orange County, California and you happen to live in that county, you will not have to pay federal income tax on the interest you earn on that bond, nor will the interest be subject to taxation by the state of California or by Orange County.  However, if you happen to be a resident of Texas, while you will not have to pay federal income tax on the interest income you earn, you will have to pay income tax to the state of Texas on the interest earned, as well as to any local government that levies an income tax.  Texas has no desire to encourage you to lend another state money.

Final words

All else equal, bonds are less risky investments than stocks.  For one thing, most bonds pay a fixed rate of interest, and if the issuer fails to make the payments as scheduled, the bondholders can force the firm into bankruptcy.  The stockholders of a firm are not guaranteed any income from their investment.  Companies are not obligated to pay dividends.  And if the firm is forced into bankruptcy, the bondholders will be paid before the stockholders can receive anything.  Moreover, bond prices are not as volatile as stock prices can be.  All of these differences make bonds attractive investments to consider when constructing a diversified portfolio.

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