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Negotiable Financial Instruments > This page

Bonds

(Source: Encyclopedia of Banking and Finance)

Introduction 
Bond Market
 
Bond Ratings 
(Member section)
Corporate Bond Ratings  
(Member section)
Municipal Bond Analysis 
(Member section)

Introduction
An interest-bearing certificate of debt, being one of a series constituting a loan made to, and an obligation of, a government or business corporation;  a formal promise by the borrower to pay to the lender a certain sum of money at a fixed future day with or without security, and signed and sealed by the maker (borrower);  a promise to pay a principal amount on a stated future date and a series of interest payments, usually semiannually until the stated future date;  "all subdivided interest-bearing contracts for the future payment of money that are drawn with formality whether they are secured or unsecured, whether the interest is imperative under all conditions, or not, as in the case of income bonds" (L. Chamberlain, The Principles of Bond Investment).

The difference between a bond and promissory note is aptly explained by F.A. Cleveland (Funds and Their Uses) as follows:

The only way that a bond is distinguished from an ordinary promissory note is by the fact that it is issued as part of a series of like tenor and amount, and, in most cases, under a common security.  By rule of common law the bond is also more formal in its execution.  The note is a simple promise (in any form, so long as a definite promise for the payment of money appears upon its face), signed by the party bound, without any formality as to witnesses or seal.  The bond, on the other hand, in its old common-law form, required a seal and had to be witnessed in the same manner as a deed or other formal conveyance of property, and though assignable was not negotiable.  This is still the rule with many jurisdictions.

A bond differs from an investment note only in the time which it has to run before maturity.  Ordinarily the deviding line is five years;  if the term of the funded debt exceeds this period, the issue is called bonds;  if within this period, notes.
A bond differs from a share of stock in that the former is a contract to pay a certain sum of money with definite stipulations as to amount and maturity of interest payments, maturity of principal, and other recitals as to the rights of the holder in case of default, sinking fund provisions, etc.  A stock contains no promise to repay the purchase price or any amount whatsoever.  The shareholder is an owner;  a bondholder is a creditor.  The bondholder has a claim against the assets and earnings of a corporation prior to that of the stockholder, and while the bondholder is an investor, the stockholder speculates on the success of the enterprise.  The former's claim is a definite contractual one;  the latter's claim is contingent upon earnings.
Numerous classifications of bonds are possible.  The following classifications have been selected as the most important and useful:

Character of obligor
Civil bonds.  Examples:  government bonds, state bonds, municipal bonds.
Corporation bonds.  Examples:  railroad bonds, public utility bonds, industrial bonds.

Purpose of issue.  Examples:  equipment bonds, improvement bonds, school bonds, terminal bonds, refunding bonds, adjustment bonds.

Character of security
Unsecured.  Examples:  civil bonds, corporate debentures.
Secured.
Personal security.  Examples:  endorsed bonds, guaranteed bonds.
Lien security.  Examples:  first mortgage bonds, general mortgage bonds, consolidated mortgage bonds, collateral trust bonds, chattel mortgage bonds.

Terms of payment of principal.  Examples:  straight maturity bonds, callable bonds, perpetual bonds, sinking fund bonds, serial bonds.

Terms of payment of interest.
Fixed interest as a fixed charge.
Contingent interest (payable if earned, in income bonds).
Zero-interest bonds (such bonds pay no interest, but provide accretion of discount by being issued at discount but by paying full principal of bond at maturity).  The Internal Revenue Service, however, as of 1982 ruled that the zero-interest bondholder must pay income tax each year on the effective annual yield, a negative tax impact.

Evidence of ownership and transfer.  Examples:  coupon bonds, registered bonds, registered coupon bonds.

Bonds may also be classified according to tax exemption, convertibility, eligibility for investment by savings banks, insurance companies and trust funds, eligibility for securing government deposits, etc.

Bonds may also be classified as domestic or foreign bonds, the latter including Eurobonds and bonds payable as to principal and/or interest in specified choice of foreign currency as well as currency of the country of issuance.
Specific kinds of bonds are described under separate titles, e.g. adjustment bonds, bearer bonds, collateral trust bonds, debenture bonds, extended bond, first mortgage bonds, general mortgage bonds.

Corporate bonds are usually issued in denominations of $1,000.  The amount shown on the bond is the face value, maturity value, or principal of the bond.  Bond prices are usually quoted as a percentage of face value.  For example, a $1,000 bond priced to sell at$980 would be quoted at 98, which means that the bond is selling at 98% of $1,000.
The nominal or coupon interest rate on a bond is the rate the issuer agrees to pay and is also shown on the bond or in the bond agreement.  Interest payments, usually made semiannually, are based on the face value of the bond and not on the issuance price.  The effective or market interest rate is the nominal rate adjusted for the premium or discount on the purchase and indicates the actual yield on the bond.  Bonds that have a single-fixed maturity date are term bonds.  Serial bonds provide for the repayment of principal in a series of periodic installments.
If bonds are sold above face value, they are said to be sold at a premium.  If bonds are sold at a premium, the effective interest rate is less than the nominal rate because the issuers received more than the face amount of the bond but are required to pay interest on only the face amount.  If bonds are sold below face value, they are said to be sold at a discount.  If bonds are sold at a discount, the effective interest rate paid is more than the nominal rate since the issuer received less than the face amount of the bonds but are required to pay interest on the face amount.
Callable bonds are bonds that can be redeemed by the issuer at specific prices, usually at a premium, prior to their maturity.  Convertible bonds are bonds that at the option of the bondholder can be exchanged for other securities, usually equity securities of the corporation issuing the bonds during a specific time at a determined or determinable conversion rate.  The conversion price is the price at which convertible securities can be converted into common stock.  The conversion ratio is the number of shares of common stock or other securities that may be obtained by converting one convertible bond.
Secured bonds are bonds that have a specific claim against assets of the issuing corporation.  If the corporation fails to make interest payments or the maturity payment, the pledged assets can be seized by the bondholders or his/her representative.  Real estate mortgage bonds have a specific claim against certain real property of the issuer, such as land and building.  A chattel mortgage bond has a claim against personal property, such as the securities owned by the bond issuer, such as stocks or bonds.  Guaranteed bonds are bonds on which the payment of interest and/or principal is guaranteed by another party.  Income bonds are bonds on which interest payments are made only from operating income of the issuing entity.  Unsecured bonds, or debentures, are bonds the holder of which has no claim against any specific asset(s) of the issuer or others but relies on the general creditworthiness of the issuer for security.
Senior securities are securities that have claims that must be satisfied before payments can be made against junior securities.  Junior securities have a lower-priority claim to asset(s) and income of the issuer than senior securities.
Registered bonds are issued in the name of the owner and are recorded in the owner's name on the records of the issuer.  Coupon bonds are bearer bonds that can be transferred from one investor to another by delivery.  Interest coupons are attached to the bonds.  On interest payment dates, the coupons are detached and submitted for payment to the issuer or an agent.  Sinking fund bonds are bonds for which a fund is established into which periodic cash deposits are made for redeeming outstanding bonds.
Bonds may be sold by the issuing company directly to investors or to an investment banker who markets the bonds.  The investment banker might underwrite the issue, which guarantees the issuer a specific amount, or sell the bonds on a commission (best efforts basis for the issuer).

The price of bonds can be determined either by a mathematical computation or from a Bond Values Table.  When mathematics is used, the price of a bond can be computed using present value table.  The price of a bond is:
the present value at the effective rate of a series of interest payments (that is, an annuity) and
the present value of the maturity value of the bond.

To determine the price of a $1,000 four-year bond having a 7% nominal interest rate with interest payable semiannual purchased to yield 6%, use the following procedure:
Present value of maturity value at effective rate (3%) for 8 periods:
$1,000 x .7894909 (= present value of 1 at 3% when the number of periods is 8)           $789.41

Present value of an annuity of 8 interest receipts of $35 each at effective interest rate of 3%: 
$35 x 7.01969 (= present value of an annuity of 1 at 3% for 8 periods)                           $245.69

Price of the bond                   1,035.10


The carrying value (or book value) of the bond issue at any time is the face value plus any amortized premium or minus any unamortized discount.  The periodic write-off of a bond toward the bond's face value.  Amortization of the discount increases the amount of interest expense while the amortization of a premium decreases the amount of interest expense while the amortization of a premium decreases the amount of interest expense reported.

Credit rating agencies, such as Standard & Poor's, Moody, and others, report on the quality of corporate and municipal bond issues.  The reports of these agencies serve as a basis for evaluating the risks, profitability, and probability of default on bond issues.  Bond ratings are based on various factors, including the issuer's existing debt level;  the issuer's previous record of payment;  the safety of the assets or revenues committed to paying off principal and interest;  the mortgage provisions in the bond indenture, the existence of a sinking fund, and others.  Symbols such as AAA or Aaa (referred to as triple A) refer to the highest-quality rating.  Other symbols are used to refer to high-quality bonds, investment grade bonds, substandard bonds, speculative bonds, and bonds in default.

Once established, the rating on a particular issue of corporate or municipal debt is reviewed periodically by the rating agencies.  When rating changes occur, they almost always have a substantial effect on the market price of the securities.  Usually, when a company announces a large new public debt issue, the rating agencies review the ratings on all of the company's outstanding securities.  To avoid triggering such an overall rating review, companies have sometimes turned to bank financing in the expectation of postponing a rating review until their financial condition improves.

Bibliography
Bond Buyer.
Bond Guide.
Bond Week.  Weekly.
Credit Markets.  Weekly.
Darst, D.M.  The Handbook of the Bond and Money Markets.  McGraw-Hill Book Company, New York, NY, 1981.
The Complete Bond Book.  McGraw-Hill Book Company, New York, NY, 1975.
Donoghue, W.E. "High-Risk Investments"  Executive Female, November/December, 1988.

Bond Market
Although the various stock exchanges list bonds, the principal markets for bonds U.S. Government, federal agency, international and foreign, state and municipal, and corporate are the over-the-counter markets, with markets made and trading carried on by bond houses tending to specialize in trading as well as underwriting in one or more of these sectors.  Commercial banks of larger size are also found in this field as bank dealers, underwriting and trading U.S. Government and general obligation state and municipal securities.

The bond market is predominantly institutional, with commercial banks particularly heavy investors in state and local government issues.

The above trends reflect the restriction of savings institutions largely to the bond market by statutes and administrative regulations and, on the other hand, their low motivation because of light taxability to invest in state and municipal issues, which are exempt (as to their interest income) from the federal income tax.  Commercial banks however, are subject to federal income taxes, and thus have found the tax exempts to be attractive in recent years in view of higher volume of time and savings deposits and the higher interest rates paid on such deposits.

By contrast, pension funds, investment companies, and individuals in recent years have shown relatively light increases in ownership of straight bonds, reflecting their investing preferences for convertible bonds and debentures and for common stocks directly.

Bibliography
Corporate Bond Ratings:  An Overview.  Standard & Poor's Corporation, New York, NY. Periodic updates.

Bond Ratings
Measures or yardsticks of investment quality ...........

More information is provided in the Member Area

Recommended further reading:
Historical Bonds: Names you should know
The world's top 50 banks
Corporate Bonds
Type of Instruments

Books on Financial Instruments


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