A bond is a type of interest-bearing security issued by an organization that needs funds. The issuer—a corporation, governmental agency, or municipality—compensates the bondholders by paying interest for the life of the bond. At maturity, the bondholder will be repaid for the funds lent. Maturity dates vary, but bonds are most commonly used for long-term debt. The discussion here will focus primarily on such long-term bonds. Corporate bonds and government bonds from the perspective of issuers will be introduced first. Investing in bonds from the point of view of individuals will be discussed later.
Corporate Bonds
Most corporate bonds are sold in $1,000 denominations. This $1,000 is the par (or face) value of the bond. When bonds are issued, the actual price paid by the bondholder may be the par value (face value) or an amount below (referred to as issued at a discount) or above (referred to as issued at a premium) par value. Regardless of the amount received when they are issued, at maturity the corporation will pay the par value (or $1,000 per bond) to the bondholders. While the bonds are held by the bondholders, the corporation will pay the holders interest at a rate specified on the bond. Interest payments are usually made semi-annually. As an example, a corporation issues fifteen-year, 6 percent $1,000 bonds with a total par value of $300,000,000 on November 1, Year 1. If the bonds sell at par, the corporation would receive $300,000,000 at issuance (less the cost of underwriting). Over the fifteen years, the corporation would pay its bondholders $9,000,000 ($300,000,000 × 6% × ½ year) every six months on May 1 and on November 1, for total interest of $270,000,000 over the fifteen years. At maturity on November 1, Year 16, it would also return the $300,000,000 par value to the bondholders.
When corporations issue bonds, they generally do not sell directly to the public; rather, they sell their entire issues to underwriters, which act as "middlemen" for the corporation and the bondholders. The underwriter, in turn, will sell the bonds to the bondholders. As compensation for its services, the underwriter sells the bonds to the bondholders for slightly more than what it paid the corporation. Once the bonds are sold, the underwriter is no longer involved with the bond issue.
The stated (also called the coupon or nominal) rate of interest relative to the market (sometimes referred to as the real or effective) rate determines whether a bond will sell for an amount equal to its par value, at a discount, or at a premium. When purchasing a corporate bond, the investor knows the stated rate of interest, the rate that determines the periodic interest payment. This stated rate is fixed during the life of the bond. The market rate of interest (i.e., the interest rate demanded by investors in the market), however, fluctuates, usually on a daily basis in the secondary market. This fluctuation is due to a number of factors, some of which are federal monetary policy, investors' perception of growth and strength of the economy, and investors' increasing or decreasing fear regarding inflation. When the stated rate equals the market rate, the bonds sell at par value. If, however, the stated rate is less than the market rate, investors are unwilling to pay the par value of the bonds; thus the bonds would sell at a discount. As an example, a bond has a stated rate of interest of 6 percent, but the current market rate of return for bonds of similar quality is 7 percent. In order to induce the investor to buy the bonds, the bonds will sell for an amount less than par that provides the investor a 7 percent return, the market rate. The opposite relationship can also exist: that is where the stated rate of the bonds is greater than the market rate. In that situation, the bonds would sell for a premium. When the bonds are sold, the issuer will "lock in" the market rate of interest that existed on that date. This will be the real interest rate for the issuer over the life of the bond. Similarly, an investor will "lock in" that same market rate and will earn that return for the time he or she holds the bonds, possibly until the bonds mature.
If bonds sell at par, they are said to sell for 100, meaning they are selling for 100 percent of their par value. If bonds sold for 98½, they would have sold at a discount, in this case for 98½ percent of their par value. Bonds sold at a premium sell at an amount greater than 100 such as 101¼. As bond prices fall—that is sell for less than par value—the rate of return rises for the reasons stated above. Conversely, as bond prices rise, rate of return falls.
Bonds are registered in the name of the person who purchased them. The registered owner receives the interest on the interest payment date. With the use of electronic processing, however, most bonds are book entry, meaning there is no certificate or document issued. The bondholder holds a "virtual" bond, and the corporation's computer files merely contain the names and addresses of those to whom interest checks will be sent on the appropriate dates. Additionally, with the ability to transfer funds electronically, corporations are able to deposit interest payments directly into their bondholders' bank accounts.
Some corporate bonds are issued with a call provision. This allows the issuing corporation to "call" the bonds—that is, buy them back from the bondholders—before their maturity date. This call provision is likely to be exercised by the corporation if the market interest rates have fallen since the bonds were issued. This allows bonds with a high interest rate to be retired and replaced by lower-interest bonds.
Another feature of some bonds allows the bondholders to convert bonds into shares of common stock of the issuing company. These are referred to as convertible bonds. This is often an attractive feature to bondholders who want to switch from being a creditor of the corporation to an owner if the company's stock begins to appreciate in value. The conversion ratio (e.g., 40 shares of common stock for each $1000 bond) would be specified.
The bond market is dominated by institutional investors, such as insurance companies, mutual funds, and pension funds, but bonds can be purchased by individual investors as well. Bonds are traded in the both the primary market and the secondary market. The primary market refers to the initial sale of bonds by the underwriters. The secondary market refers to the sale of bonds subsequent to their original sale by issuer or underwriter.
Bonds are one of the primary ways corporations raise large amounts of capital. A corporation can sell previously unissued shares of stock (equity) to shareholders, or it can borrow the money by issuing bonds (debt). There are advantages and disadvantages to both.
By issuing equity, the corporation does not increase debt, thus avoiding paying interest to bondholders. This method of raising capital, however, causes a dilution of ownership to existing shareholders and, thus, may not be favored by the current owners. If the corporation issues bonds, it will be required to pay interest, but there will be no change in the ownership structure of the company. Furthermore, the corporation's management hopes—and expects—that they will earn a greater return than the interest they are paying on the bonds. As an example, if the cost of borrowing on bonds is 6 percent, but the corporation is able to earn 10 percent on the money it has borrowed from the bondholders, the 4 percent difference earned above the cost of borrowing accrues to the existing shareholders. Thus, shareholders earn a 4 percent return on funds borrowed from bondholders.
An important consideration for a corporation deciding whether to issue stocks or bonds is the tax deductibility of the bond interest. Interest paid on bonds is a tax-deductible expense on a corporation's income tax return, meaning their taxable income will be reduced by the amount of interest paid. Their after-tax cost of borrowing is, as a result, less than the interest paid on the bonds. As an example, if a corporation issues 6 percent bonds and has an average tax rate is 40 percent, the after-tax interest rate on the bonds is3.6 percent [(6% (1 tax rate)].
Government Bonds
The U.S. federal government borrows large amounts of money. Since the late 1970s, the federal government has consistently spent more money than it has collected in taxes. (In the late 1990s, that trend began to reverse.) In order to have adequate money to pay for its expenditures, the United States borrows money. Bonds issued by the federal government have different names depending on their maturity date. Those which have a maturity date of less than a year are called "Treasury bills" (or "T-bills" for short). Debt instruments with maturities from one to ten years are called notes; those with maturities exceeding ten years are called bonds. Collectively all are referred to as Treasuries.
Federal bonds are auctioned according to a schedule, for example, thirteen-week T-bills are auctioned every Monday and two-year treasury notes on the last Wednesday of every month. The results of these auctions, including market interest rates, are reported in the financial press. These rates not only reflect the interest the bondholder will earn; they also influence interest rates for debts such as mortgages, car loans, and credit cards.
State and local governments also borrow money by selling municipal bonds (frequently referred to as "munis"). Municipal bonds are either general obligation or revenue bonds. General obligation bonds (also known as "GOs") will be paid off by money received from taxes and possibly by user fees. The costs of building schools and sewers are paid for through general obligation bonds. A revenue bond is one that is issued by an enterprise that serves a public function. Examples include airports, utility companies, toll roads, universities, and hospitals. The money to pay the bond interest and the bonds at maturity will be generated by these enterprises' revenue-generating activities.
While interest on corporate bonds is fully taxable to the bondholder, interest on Treasuries is exempt from state (but not federal) income tax. Interest on municipal bonds is exempt from federal income tax. If the municipal bond is issued by the jurisdiction in which the bondholder resides, the interest is tax-exempt by both the federal government and the state government. If there is a local income tax, the interest is tax-exempt at this level, too. Thus in some instances the bondholder has a triple exemption. Because of the tax-exempt nature of municipal bonds, their rates are usually one-to two-percentage points lower than that of comparable taxable corporate bond, for which there is no tax exemption.
Investing in Bonds
There is no centralized market for corporate bonds excepted for those listed on exchanges. An investor who wishes to buy or sell bonds must contact a broker or dealer who might carry that particular bond in inventory. A dealer who does not have that bond would contact another dealer who did. Because of the transaction costs involved in buying and selling corporate bonds in the secondary market, they may not be an attractive investment for investors. Treasuries may be purchased directly from the government. They are also much more easily obtained in the secondary market from brokers because they are generally available.
Bonds typically earn a return greater than that offered by a bank on its savings account or certificates of deposit (CDs), which are among the safest of investments since they are currently guaranteed up to a value of $100,000 in insured banks.
Bonds are considered relatively safe for several reasons. When buying a bond, the bondholder knows how much interest will be paid periodically from the issuing corporation (or government). Thus, there is little uncertainty regarding the return.
Bonds are also considered relatively safe because the issuers of bonds most likely will be evaluated by one of the credit-rating agencies— Moody's, Standard & Poor's (S & P), or Fitch. These agencies evaluate the creditworthiness of corporations and of state and local governments.
Although bonds are among the safer investments, there are several risks associated with them. Probably the biggest risk to the investor is market risk. This is the risk an investor faces should interest rates rise after the bonds have been purchased. As mentioned above, when interest rates rise, the price of bonds falls (and vice versa). If an investor bought bonds that were yielding 6 percent, the return is 6 percent as long as the bonds are held, possibly until maturity. If interest rates rise above 6 percent, however, the bonds are no longer paying the market rate of interest. Furthermore, if the investors were to sell the bonds, they would sell for less than what was paid for them. All bonds—corporate, Treasuries, and munis—are subject to market risk.
Another risk associated with investing in corporate and municipal bonds (but not Treasuries) is the credit risk (or credit-rating risk) of the issuer. Since a bond is a loan, a bondholder has to assess the likelihood that the issuer will be able to pay the periodic interest payments and the bond's par value at maturity. Credit rating agencies are well respected and widely used to help an investor assess the credit risk of corporate and municipal bonds. Although the ratings the agencies use and how they determine them vary slightly, they generally rate the bonds from extremely safe investments to wildly speculative ones. With Treasury bonds, there is virtually no credit risk since most investors see them as having the full faith of the U.S. government behind them. Because of this perceived absence of default, investors typically use the rate offered on Treasuries as the benchmark against which other investments are evaluated. Another risk associated with investing in bonds is call risk. As mentioned previously, some bonds are callable at the discretion of the issuer. This means that the issuer may retire the bonds, paying the bondholder the par value (and usually a small "call premium" as well) and any accrued interest since the last interest payment date. The issuer returns the money to the investor. A corporation (or municipal government) usually calls bonds only when interest rates have fallen. If bonds are called, the investor now would be back in the market buying bonds yielding a lower re turn. Furthermore, if the investor had originally purchased the bonds at a premium, it is likely that the original purchase price would not be realized when the bond is called. Corporate and municipal bonds may be callable. U.S. Treasuries are not.
In spite of the risks mentioned, bonds are still considered an attractive investment for many in vestors. Prices of bonds are much less volatile when compared to prices of stocks. Defaults on bonds are also quite rare. Furthermore, even if a corporation faces liquidation because of financial distress, bondholders would be among the first to receive corporate assets, since they are creditors of the corporation. According to conventional wisdom, bonds strike an acceptable compromise between risk and return.
(See also: Capital markets; Finance; Financial institutions)
Bibliography
Bodie, Zvi, Kane, Alex, and Marcus Alan J., (1999). Investments. Boston: Irwin/McGraw-Hill.
Emery, Douglas R., Finnerty, John D., and Stowe, John D. (1998). Principles of Financial Management. Upper Saddle River, NJ: Prentice-Hall.
Levy, Haim, and Alderson, Michael J. (1998). Principles of Corporate Finance. Cincinnati, OH: South-Western College Publishing.
Mahony, Stephen. (1996). Mastering Government Securities. London: Pitman.
Ross, Stephen A., Westerfield, Randolph W., and Jaffe, Jeffrey. (1999). Corporate Finance. Boston: Irwin/McGraw-Hill.
[Article by: ALLIE F. MILLER]
