Bonds

In addition to financing government projects, bonds are used by corporations to capitalize growth. Bonds are also a legal arrangement, couched in conditions, obligations, and consequences. As a result of their legal and financial roles, bonds carry a quaint and particular vocabulary. Bonds come in all shapes and sizes to suit the needs of the borrowers and the demands of lenders. Figure 16.1 "Basic Bond Features" lists the descriptive terms for basic bond features.

Figure 16.1 Basic Bond Features



The coupon is usually paid to the investor twice yearly. It is calculated as a percentage of the face value - amount borrowed - so that the annual coupon = coupon rate × face value. By convention, each individual bond has a face value of $1,000. A corporation issuing a bond to raise $100 million would have to issue 100,000 individual bonds (100,000,000 divided by 1,000). If those bonds pay a 4 percent coupon, a bondholder who owns one of those bonds would receive a coupon of $40 per year (1,000 × 4%), or $20 every six months.

The coupon rate of interest on the bond may be fixed or floating and may change. A floating rate is usually based on another interest benchmark, such as the U.S. prime rate, a widely recognized benchmark of prevailing interest rates.

A zero-coupon bond has a coupon rate of zero: it pays no interest and repays only the principal at maturity. A "zero" may be attractive to investors, however, because it can be purchased for much less than its face value. There are deferred coupon bonds (also called split-coupon bonds and issued below par), which pay no interest for a specified period, followed by higher-than-normal interest payments until maturity. There are also step-up bonds that have coupons that increase over time.

The face value, the principal amount borrowed, is paid back at maturity. If the bond is callable, it may be redeemed after a specified date but before maturity. A borrower typically "calls" its bonds after prevailing interest rates have fallen, making lower-cost debt available. Borrowers can borrow new, cheaper debt and pay off the older, more expensive debt. As an investor (lender), you would be paid back early, which sounds great, but because interest rates have fallen, you would have trouble finding another bond investment that would pay as high a rate of return.

A convertible bond is a corporate bond that may be converted into common equity at maturity or after some specified time. If a bond were converted into stock, the bondholder would become a shareholder, assuming more of the company's risk.

The bond may be secured by collateral, such as property or equipment, sometimes called a mortgage bond. If unsecured, or secured only by the "full faith and credit" of the borrower (the borrower's unconditional commitment to pay principal and interest on the debt), the bond is a debenture. Most bonds are issued as debentures.

A bond specifies if the borrower has more than one bond issue outstanding or more than one set of lenders to repay, which establishes the bond's seniority in relation to previously issued debt. This "pecking order" determines which lenders will be paid back first in case of default on the debt or bankruptcy. Thus, when the borrower does not meet its coupon obligations, investors holding senior debt as opposed to subordinated debt have less risk of default.

Bonds may also come with covenants or conditions on the borrower. Covenants are usually attached to corporate bonds and require the company to maintain certain performance goals during the term of the loan. Those goals are designed to lower default risk for the lender. Examples of typical covenants are

  • dividend limits,
  • debt limits,
  • limits on sales of assets,
  • maintenance of certain liquidity ratios or minimum cash balances.

Corporations issue corporate bonds, usually with maturities of ten, twenty, or thirty years. Corporate bonds tend to be the most "customized," with features such as callability, conversion, and covenants.

The U.S. government issues Treasury bills for short-term borrowing, Treasury notes for intermediate-term borrowing (longer than one year but less than ten years), and Treasury bonds for long-term borrowing for more than ten years. The federal government also issues Treasury Inflation-Protected Securities (TIPS). TIPS pay a fixed coupon, but the principal adjusts with inflation. At maturity, you are repaid either the original principal or the inflation-adjusted principal, whichever is greater.

State and municipal governments issue revenue bonds or general obligation bonds. A revenue bond is repaid out of the revenue generated by the project that the debt is financing. For example, toll revenue may secure a debt that finances a highway. A general obligation bond is backed by the state or municipal government, just as a corporate debenture is backed by the corporation.

Interest from state and municipal bonds (also called "munis") may not be subject to federal income taxes. Also, if you live in that state or municipality, the interest may not be subject to state and local taxes. The tax exemption differs from bond to bond, so you should be sure to check before you invest. Even if the interest is not taxable, however, any gain (or loss) from the sale of the bond is taxed, so you should not think of munis as "tax-free" bonds.

Foreign corporations and governments issue bonds. You should keep in mind, however, that foreign government defaults are not uncommon. Mexico in 1994, Russia in 1998, and Argentina in 2001 are all recent examples. Foreign corporate or sovereign debt also exposes the bondholder to currency risk, as coupons and principal will be paid in the foreign currency. Figure 16.2 "Bond Issuers and Terms" shows a summary of bonds and their issuers.

Figure 16.2 Bond Issuers and Terms