Bonds

Bonds are a relatively old form of financing. Formalized debt arrangements long preceded corporate structure and the idea of equity (stock) as we know it. Venice issued the first known government bonds of the modern era in 1157, while private bonds are cited in British records going back to the thirteenth century (Adams, 1921).

Bonds

In addition to financing government projects, bonds are used by corporations to capitalize growth. Bonds are also a legal arrangement and, as such, are subject to various 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. Table 14.1.1 lists the descriptive terms for basic bond features.

Basic Bond Features

Bond Term	Meaning
Issuer	Borrower
Investor	Lender or Creditor
Principal, Face Value, Par Value	Amount Borrowed
Coupon Rate	Interest Rate
Coupon	Interest Payment
Maturity	Due Date
Term	Time until Maturity
Yield to Maturity	Annualized Return on Bond Investment
Market Value	Current Price

Table 14.1.1

The coupon is usually paid to the investor twice yearly. It is calculated as a percentage of the face value – the 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 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. A registered coupon bond is registered for principal only and not for interest. A registered bond is issued by the issuing company and is registered in the owner's name. A bearer bond does not register the bond in the investor's name. 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. In other words, a debenture "is a bond that is backed only by the reputation of the issuing corporation." Most bonds are issued as debentures. The First Nations Finance Authority "is a not-for-profit finance authority formed in 1995 to provide member First Nations with the opportunity to use debentures to access long-term affordable financing. Its primary purpose is to raise long-term private capital at preferred rates for public works, such as roads, water and sewer, and buildings." These debentures are secured through property taxes or long-term revenue sources.

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. In case of bankruptcy, senior debt will be paid first and subordinate debt second.

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, and
• 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 Canadian government issues two types of bonds: marketable bonds and T-Bills.

Canada Treasury bills, also known as T-Bills, are investments fully guaranteed by the Government of Canada, which means the principal and rate of interest are guaranteed. T-Bills are considered the safest Canadian investment you can hold with a term of one year or less. They are offered for terms of one month to one year. Interest is paid at maturity. T-Bills can be purchased from most financial institutions and can be sold at market value at any time. The minimum investment for a T-Bill, which has a term of three months to one year, is $5,000. The minimum investment for a T-Bill having a term of one or two months is $25,000.

Marketable bonds not only have a specific maturity date and interest rate, but they are also transferable and can thus be traded in the bond market. All Canadian-dollar marketable bonds are non-callable, which means they cannot be called in by the government to be redeemed before maturity. Marketable bonds also pay a fixed rate of interest semi-annually.

Real Return Bonds are Canadian government bonds that pay a fixed rate of interest semi-annually that is adjusted by inflation. This ensures your purchasing power remains constant regardless of the future inflation rate.

The sale of Canada Savings Bonds ended November 1, 2017. It was the third type of bond issued by the Canadian government.

Provincial and municipal governments issue bonds to raise funds for program spending and to fund deficits. Provincial bonds or debentures are primarily used by provincial governments and are secured by the province through its ability to levy taxes. A general obligation bond is a bond backed by a municipal government. Canadian municipalities often issue two forms of general obligation debt: the serial bond, in which the principal and interest mature on different dates or are paid in installments, and the bullet bond, in which the entire principal is repaid on the bond's maturity date while regular interest payments are made on the investors' shares during the term of the fund. Municipal bullet bonds are often offset by sinking funds "to which annual or semi-annual deposits are made for the purpose of redeeming a bond issue." 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. Revenue bonds are not common in Canada and are currently only used in Toronto.

Foreign corporations and governments also 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.

Bond Markets

The volume of capital traded in the bond markets is far greater than what is traded in the stock markets. All sorts of borrowers issue bonds: corporations; national, provincial, and municipal governments. Even small towns issue bonds to finance capital expenditures such as schools, fire stations, and roads. Each kind of bond has its own market.

Private placement refers to bonds that are issued in a private sale rather than through the public markets. The investors in privately placed bonds are institutional investors such as insurance companies, endowments, and pension funds.

Corporate bonds are traded in over-the-counter transactions through brokers and dealers. Because the details of each bond issue may vary – maturity, coupon rate, callability, convertibility, covenants, and so on – it is hard to directly compare bond values the way stock values are compared. As a result, the corporate bond markets are less transparent to the individual investor.

To provide guidance, rating agencies provide bond ratings; that is, they "grade" individual bond issues based on the likelihood of default and, thus, the risk to the investor.

 Rating agencies are comprised of independent agents that base their ratings on the financial stability of the company, its business strategy, competitive environment, and its outlook for the industry and the economy – any factors that may affect the company's ability to meet coupon obligations and pay back debt at maturity.

Rating agencies such as DBRS, Fitch Ratings, A. M. Best, Moody's, and Standard & Poor's are hired by large borrowers to analyze the company and rate its debt. Moody's also rates government debt. Rating agencies use an alphabetical system to grade bonds (shown in Table 14.1.2) based on the highest-to-lowest rankings of two well-known agencies.

Bond Ratings

Standard & Poor's	Moody's	Grade	Meaning
AAA	Aaa	Investment	Risk is almost zero
AA	Aa	Investment	Low risk
A	A	Investment	Risk if the economy declines
BBB	Baa	Investment	Some risk, more if the economy declines
BB	Ba	Speculative	Risky
B	B	Speculative	Risky; expected to get worse
CCC	Caa	Speculative	Probable bankruptcy
C	Ca	Speculative	Probable bankruptcy
C	C	Speculative	In bankruptcy or default
D		Speculative	In bankruptcy or default

Table 14.1.2

A plus sign (+) following a rating indicates that it is likely to be upgraded, while a minus sign (−) following a rating indicates that it is likely to be downgraded.

Bonds rated BBB or Baa and above are considered 

investment-grade bonds: relatively low risk and "safe" for both individual and institutional investors. Bonds rated below BBB or Baa are speculative in that they carry some default risk. These are called speculative-grade bonds, junk bonds, or high-yield bonds. Because they are riskier, speculative-grade bonds need to offer investors a higher return or yield in order to be "priced to sell."

Although the term "junk bonds" sounds derogatory, not all speculative-grade bonds are "worthless" or are issued by "bad" companies. Bonds may receive a speculative rating if their issuers are young companies, in a highly competitive market, or capital intensive, requiring lots of operating capital. Any of those features would make it harder for a company to meet its bond obligations, thus earning its bonds a speculative rating. In the 1980s, for example, companies such as CNN and MCI Communications issued high-yield bonds, which became lucrative investments as the companies grew into successful corporations.

Default risk is the risk that a company won't have enough cash to meet its interest payments and principal payments at maturity. That risk depends, in turn, on the company's ability to generate cash, profit, and grow to remain competitive. Bond-rating agencies analyze an issuer's default risk by studying its economic, industry, and firm-specific environments to estimate its current and future ability to satisfy its debts. The default risk analysis is similar to equity analysis, but bondholders are more concerned with cash flows – cash to pay back the bondholders – and profits rather than profits alone.

Bond ratings can determine the coupon rate the issuer must offer investors to compensate them for default risk: the higher the risk, the higher the coupon must be. Rating agencies have been criticized recently for not being objective enough in their ratings of the corporations that hire them. Nevertheless, over the years, bond ratings have proven to be a reliable guide for bond investors.

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Source: Bettina Schneider, https://ecampusontario.pressbooks.pub/financialempowerment/chapter/chapter-14-owning-bonds-and-investing-in-mutual-funds/
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