Bonds

Bonds are long-term debt instruments used by both the private and public sectors to raise funds. They are liabilities for the issuer and can be excellent INVESTMENT opportunities. In the private sector, corporate bonds are most common. In the public sector there are Treasury bonds and U.S. Savings Bonds issued by the federal government and municipal bonds issued by local governments and municipalities. With the exception of bonds issued by the federal government, all bonds have some risk of DEFAULT. Moody’s and Standard and Poor are the two major firms that rate bonds, both public and private sector, according to their default risk. Both organizations use two broad classifications of risk. Those bonds with ratings of “BBB” or “Baa” and higher are termed investment grade or investment quality bonds. These are the bonds with minimal default risk. Bonds with ratings less than BBB or Baa are termed speculations because of their considerable risk of default. The more common name for these speculative bonds is junk bonds. All bonds have a maturity date and a face value, the amount that is paid to the bondholder on the maturity date. Most bonds, especially corporate bonds, also have a coupon-interest rate. The interest that a coupon bond pays is determined by multiplying the coupon-interest rate by the face value of the bond. Bonds may pay coupon interest annually, semiannually, or quarterly, depending on what is stipulated on the face of the bond. The object of the bond issuer who is trying to raise CAPITAL is to get as much money for each bond as is possible while at the same time trying to minimize the interest expense associated with the bond. To accomplish this, the issuer sets the coupon-interest rate at the going rate of interest in the market at the time the bonds are issued. This helps to ensure that the bonds will sell “at par”—that is, for their face value. (If one looks in the newspaper at the reporting for the bond exchanges, one notices that there are many bonds outstanding, all with different coupon-interest rates. This is because there are bonds issued every day, and the various coupon-interest rates reflect the going rates of interest when the bonds were issued.) A bond with a coupon-interest rate lower than the going rate of interest in the market, ceteris paribus (other things being equal), will not be viewed as an attractive INVESTMENT. Why should one purchase this bond when most any other investment in the market will yield a higher return? In order for the return on this bond to be more attractive, investors would only be willing to buy this bond at a discount (i.e., below its face value). This would add a CAPITAL GAIN to the bond’s comparatively low interest yield. (At maturity, a bond will pay its face value, regardless of what was initially paid for it.) Thus, for organizations in need of funds, it makes no sense to issue bonds with coupon rates that are lower than current market rates. A bond with a coupon-interest rate higher than the going rate of interest in the market, ceteris paribus, will be viewed as a very attractive investment. Investors will clamor to purchase such a bond, causing it to sell at a premium, or for more than its face value. Organizations in need of funds will not offer such high coupon-interest rates because this increases the interest expense they must pay on the borrowed funds. Coupon-interest rates are also determined, in part, by default risk. Rational investors are risk-averse, and they demand to be compensated for assuming risk. Thus the higher the degree of default risk, the higher the bond’s coupon interest rate, ceteris paribus. Occasionally, a firm finds that it needs to raise funds during a period of high interest rates in the economy. In order for the bonds it issues to sell at par, the coupon-interest rate will be set at the current market interest rate. However, the bonds will most probably be callable. A BCALLABLE BOND is one that will be called in by the issuer for redemption before the bond reaches it maturity date. The call period is normally stated on the face of the bond, and investors who own callable bonds expect not to be able to hold such an attractive bond until its maturity. The call provision allows firms to escape the costly interest expense of the high coupon interest rates by allowing the bonds to remain outstanding only until their call dates. Often firms will use the funds obtained from newer, lower coupon-interest rate bonds to call in and redeem their callable bonds. Some bonds are convertible bonds, which may be converted to shares of COMMON STOCK (as a fixed price) at the option of the bondholder. Because they offer the potential for a capital gain when the stocks are eventually sold, convertible bonds normally carry lower coupon-interest rates than bonds that are not convertible. Some bonds have no coupon-interest rates. These are known as zero-coupon (or deep discount) bonds. When issued, they always sell at a discount. The return from investing in such bonds is a capital gain, because the face value received at maturity is more than the purchase price of the bond. Treasury bills and U.S. Savings Bonds are examples of zero-coupon bonds issued by the federal government. Bonds may be secured or unsecured. Secured bonds have collateral or pledged ASSETS backing them, minimizing their risk. Unsecured bonds have no such backing and are known as debentures. Ceteris paribus, secured bonds are less risky than debentures and, thus, offer lower interest yields than debentures. Local governments and municipalities often sell bonds to finance INFRASTRUCTURE and to build schools. The interest earned on a municipal bond, called a muni, is exempt from federal taxation. Because the interest earnings on munis are not federally taxable, this allows local and municipal governments to issue their bonds at lower coupon-interest rates than other similar bonds, with the savings accruing to the local taxpayers. The largest issuer of bonds is the federal government, selling Treasury securities and savings bonds. When there is a budget deficit, the federal government is forced to make up the shortfall by borrowing from the private sector. It does this by selling Treasury securities: Treasury bills with maturities up to one year; Treasury notes with one to five-year maturities; and Treasury bonds with five to thirty years. With the national debt at approximately $6 trillion, this is roughly the amount of money the federal government has borrowed (bonds outstanding) as a result of spending in excess of tax revenues in past years.
See also BRADY BONDS; STOCK MARKET, BOND MARKET.