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BOND BASICS
A bond is just an IOU issued by a corporation or a government, that is, a promise to repay a sum of money at a certain interest rate and over a certain period of time. In other words, a bond is a debt instrument that sets out the agreed terms and conditions between the lender and the borrower. Most bonds pay a fixed rate of interest (variable rate bonds are slowly coming into more use though) for a fixed period of time.
As the buyer of a bond, you are lending money to the borrower, also known as the issuer. For example, when you buy a $5,000 bond maturing in five years, you are extending the borrower the use of that money for five years. In return, the borrower issues you a certificate that acts as an IOU. In the bond indenture (the trust agreement between the lender and borrower) on the back of the certificate, the terms of the loan and its payments and ultimate repayment are laid out.
Here's how this works. With almost any loan, the borrower pays interest to the lender. This interest can be paid in several different ways:
In a home mortgage, the monthly payment consists of part principal and part interest. Usually payment in the early years of the mortgage are mostly interest.
Interest can also be paid in installments over the term of the loan. For example, conventional bonds make two interest payments a year until maturity, at which time the issuer repays the entire principal amount to the borrower.
Interest can also be deducted from the principal up front. This format is used by zero coupon bonds and some government savings bonds. In this type of bond, the principal of the loan (the face amount on the bond) is actually a fixed amount such as $5,000. Instead of sending out semiannual checks, however, the issuer simply deducts what it would have to pay in interest payments at the beginning of the term. Depending on the length of time remaining until maturity, the buyer pays a discounted amount to purchase the bond at the beginning of the term. For example, a $5,000 face amount bond with five years to go until maturity might sell for $2500 today. This type of debt instrument is said to be "discounted."
Since bonds are intended to be bought and sold, all the certificates of a particular bond issue contain a master loan agreement called the "bond indenture" or "deed of trust". This agreement between the issuer and investor (or creditor and lender), contains all the information you'd expect to see in any loan agreement, including the following:
Amount of the loan: The "face amount," "par value," or "principal" is the amount of the loan - the amount that the bond issuer agrees to repay at the bond's maturity. In the U.S., corporate bonds are often issued in units of $1,000. When municipalities issue bonds, they are usually in units of $5,000.
Rate of Interest: Bonds are issue with a specified "coupon" or "nominal" rate, which is determined largely by market conditions at the time the bond is originally issued. Once determined, it is set contractually for the life of the bond. The dollar amount of the interest payment can be easily calculated by multiplying the rate of interest (or coupon) by the face value of the bond. For example, a bond with a face amount of $1,000 and a coupon of 8% pays the bondholder $80 a year ($1,000 times .08).
Schedule or Form of Interest Payments: Interest is paid on most bonds at six-month intervals, usually on either the first or the fifteenth of the month. If the annual interest payment on the bond was $80, it would probably be paid in two installments of $40 each spaced six months apart.
Terms: A bond's "maturity," or the length of time remaining until the principal is repaid, varies greatly. A bond with a maturity of less than two years is generally considered a short-term instrument (also known as a short-term note). A medium-term note is a bond with a maturity between two and ten years. And of course, a long-term note would be one with a maturity longer than ten years. A long term bond typically matures in from 20 to 40 years.
Call Feature (if any): A "call feature," if specified in the bond indenture, allows the bond issuer to "call in" the bonds and repay the bond holder (investor) at a predetermined price before maturity. Bond issuers (the borrowers) use this feature to protect themselves from paying m9re interest than they have to for the money they are borrowing. Companies call in bonds when general interest rates are lower than the coupon rate on the bond, thereby retiring expensive debt and refinancing it at a lover rate, much as a homeowner will refinance his mortgage if interest rates have fallen significantly below his old mortgage rate. Many times the borrower will issue new, lower interest bonds and use the proceeds to call in the older, higher interest bonds. Some bonds offer "call protection" during the earlier years of their issuance. This protection usually prohibits the bonds from being called during a stated period of time after issuance, typically five to ten years. Call features can affect the value of a bond, in effect setting a ceiling on the bond value, since informed buyers are unwilling to pay more than the call price for a bond which is subject to being called at any time.
Collateral: If the loan is secured by collateral, the indenture will specify the nature.
Organizations issue bonds for a variety of reasons. Let's say a corporation needs to build a new office building, or needs to purchase manufacturing equipment, or needs to purchase aircraft. Or maybe a city government needs to construct a new school, repair streets, or renovate the sewers. Whatever the need, a large sum of money will be needed to get the job done.
One way is to arrange for banks or others to lend the money. But a generally less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date).
Corporate bonds are issued by companies of all sizes. Bondholders are not owners of the corporation. But if the company gets in financial trouble and needs to dissolve, bondholders must be paid off in full before stockholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy.
Municipal bonds are issued by cities, states, and other local agencies and may or may not be as safe as corporate bonds. Some municipal bonds are backed by the taxing authority of the state or town, while others rely on earning income to pay the bond interest and principal. Municipal bonds are not taxable by the federal government (some might be subject to Alternative Minimum Tax) and so don't have to pay as much interest as equivalent corporate bonds.
U.S. Bonds are issued by the Treasury Department and other government agencies and are considered to be safer than corporate bonds, so they pay less interest than similar term corporate bonds. Treasury bonds are not taxable by the state and some states do not tax bonds of other government agencies. Shorter term Treasury bonds are called notes and much shorter term bonds (a year or less) are called bills, and these have different minimum purchase amounts.
DIFFERENT TYPES OF YIELDS AND BOND PRICING
Although the bond indenture describes the terms of the loan, it says nothing about the value of the security. The price of a bond is a function of prevailing interest rates. As rates go up, the price of the bond goes down, because that particular bond becomes less attractive (i.e., pays less interest) when compared to current offerings. As rates go down, the price of the bond goes up, because that particular bond becomes more attractive (i.e., pays more interest) when compared to current offerings. The price also fluctuates in response to the risk perceived for the debt of the particular organization. For example, if a company is in bankruptcy, the price of that company's bonds will be low because there may be considerable doubt that the company will ever be able to redeem the bonds. To understand the value of a particular bond, you must understand the three basic types of yield.
Coupon (Nominal) Yield: If a bond has a face value of $1,000 and pays interest at a rate of 8%, the coupon (or nominal) yield is 8%. This means the bond pays $80 a year ($1,000 times .08). Since the coupon percentage rate and principal don't change for the term of the loan, the coupon yield doesn't change either.
Current Yield: If you could buy an 8%, $1,000 bond for $800, you are still entitled to the $80 annual interest. Yet the $80 in annual interest received represents a higher percentage on the $800 that you actually paid than it does on the $1000 face value. Your current yield would be 10% ($80 divided by $800).
Because the bond is selling for less than it's face value, it is said to be selling at a "discount." The discounted bond mentioned above would be quoted at "80," which means $800. To convert the quoted price into a dollar price, simply multiply it by $10. A quote of 80 1/2 means the bond is priced at $805 (80.5 times $10). Bonds actually are quoted in eighths, with one eighth equal to $1.25 as shown in the table below:
| 1/8 |
$1.25 |
1/4 |
$2.50 |
3/8 |
$3.75 |
1/2 |
$5.00 |
5/8 |
$6.25 |
3/4 |
$7.50 |
7/8 |
$8.75 |
Conversely, a bond selling for more than it's face value is said to be trading at a "premium." When bonds trade at a premium, the current yield is less than the coupon rate.
Yield to Maturity: Current yield does not take into account the difference between the purchase price of the bond and the principal repayment at maturity. In the discounted bond discussed above, the purchaser of the bond paid $800 for the bond but will receive $1,000 in principal repayment when the bond matures. This extra $200 is also considered yield, and is included in the calculation of yield to maturity (YTM). To include the $200 discount in the yield calculation, divide the $200 by the number of years remaining to maturity.
RISKS OF BONDS
The bond market is typically less risky than the stock market, although there have been times when bonds are just as risky and volatile as stocks.
| Bond Ratings: |
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Ratings of the two major rating services are similar but there are minor differences. |
Moody's |
Standard and Poor's |
What the Ratings Mean |
Aaa |
AAA |
Best quality, with the smallest amount of risk. Issuers are extremely stable and dependable. |
Aa |
AA |
High quality, with a slightly higher degree of long-term risk. |
A |
A |
High to medium quality, with many strong attributes but with some risk exposure to changing economic conditions. |
Baa |
BBB |
Medium quality, currently adequate but with significant risk possible over the long term. |
Ba |
BB |
Some speculative element, with moderate security but not well safeguarded for the long haul. |
B |
B |
Able to pay now but with a significant risk of default in the future. |
Caa |
CCC |
Poor quality with a clear danger of default. |
Ca |
CC |
High speculative nature, often in or near default. |
C |
C |
Lowest rated, poor prospects of payment going forward but may be current in payments. |
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D |
In default. |
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