When you prepared for the SIE exam, you learned that a bond is a specific type of loan. Corporations and governments borrow money continually and often in very large amounts. For example, Apple borrowed $6.5 billion in 2021 through a long-term bond issuance.
It would be difficult for Apple to borrow that amount from a single bank because of the risk involved. Even though Apple is one of the largest companies in the world, a default (the inability to pay back borrowed funds) on a loan that large could bankrupt many banks. And even if Apple could find a bank willing to lend $6.5 billion, the bank would likely demand a high interest rate to compensate for the risk. The more interest a company pays, the less profit it keeps from its business operations.
Issuing bonds spreads that risk across thousands (or even millions) of investors. The $6.5 billion Apple bond offering is equivalent to 6.5 million $1,000 par bonds. If 6.5 million different investors each bought one $1,000 par bond, each investor would face the risk of losing $1,000. Losing $1,000 is painful, but it typically won’t bankrupt an investor. By spreading risk, Apple was able to borrow a large sum and pay a relatively low interest rate (yielding less than 1% above Treasuries).
Whether a bond investor is an individual or an institution, the investor takes the role of a bank when a bond is issued: the investor lends money, and the issuer borrows it. Issuers often initially offer bonds at their face value, also called par. Over the life of the bond, the issuer (borrower) pays the investor (lender; creditor) interest, typically in semi-annual (twice-a-year) payments. At the end of the bond’s life, called its maturity, the issuer makes one final interest payment and repays the face (par) value.
That’s how the typical bond works, although there are exceptions. In the following chapters, you’ll learn about specific types of bonds and how they function.
The par value for bonds is typically $1,000, although you may see questions with higher par values. The bond’s interest rate, also called its coupon or nominal rate, is based on par. For example:
$1,000 par, 5% bond
This bond pays two $25 interest payments per year, totaling $50 of annual interest. No matter who owns the bond or what price was paid for it, it always pays this amount of interest. The par value and the interest rate do not change over the life of the bond.
Unlike dividends, interest payments can’t be skipped. If an issuer skips an interest payment, bondholders can sue and force the issuer into bankruptcy court. In other words, bond issuers must make their interest payments. If they don’t, it’s a default, similar to a person declaring bankruptcy because they can’t pay outstanding loans.
The term “coupon” has a historical origin. Before the 1980s, bonds were commonly sold as paper certificates.
Bruce C. Cooper Collection/Wikimedia Commons/"San Francisco Pacific Railroad Bond WPRR 1865"/Public domain
As you can see in the picture above, bond certificates were divided into two sections. Most of the certificate represented the principal (par value) of the bond. The coupons were at the bottom (in grey). When an interest payment was due, the bondholder clipped the appropriate coupon and mailed it to the issuer. Each coupon showed a date telling the investor when it should be clipped and mailed. After receiving the coupon, the issuer sent the bondholder a check for the interest owed. That’s where the term “coupon” comes from.
When bonds were issued this way, they were issued in bearer form. That’s another way of saying “whoever bears (holds) this bond is the owner.” Cash works the same way. If you have a $20 bill in your pocket, it’s yours. If you drop it and someone else picks it up, it’s now theirs. Bearer bonds worked the same way.
In 1982, Congress outlawed the issuance of bearer bonds because they were difficult to track and easy to use for illegal purposes. Some older movies (e.g., Heat) involve criminals stealing bearer bonds because authorities couldn’t easily trace them and each certificate could represent a large amount of money. Bearer bonds still exist outside the United States, but they are no longer issued within the U.S.
Today, it’s much harder to steal bonds because of how they’re issued. Bonds are now issued in book entry form, meaning there is no paper certificate and ownership is tracked digitally. When you buy a bond, your ownership is recorded by the transfer agent. There’s no need to clip coupons or safeguard certificates. When interest and/or principal is due, it’s credited to the investor’s account.
The longer a bond’s maturity, the more risk is involved. Because of that, a one-month bond typically offers a much lower rate of return than a 30-year bond. Over a short period, fewer things can change, and investors can often make reasonable expectations about the bond market over the next several weeks. Even if something drastic changes with the issuer or the market, the bond will mature soon.
A 30-year bond has much more time for uncertainty to show up. Over 30 years, we could see major interest rate swings, economic downturns, and fundamental market changes. To compensate investors for these risks, longer-maturity bonds are generally issued with higher interest rates.
Depending on maturity, certain terms apply. For example, debt securities with one year or less until maturity are referred to as money markets. You’ll learn more about different types of bonds when we discuss specific versions of U.S. government, municipal, and corporate bonds.
When a bond is created and sold to investors, the issuer sets the schedule for interest payments. These schedules are often written in a shorthand sometimes called “finance language.” Here are two common examples:
J&J 1
F&A 15
Each pair of dates is six months apart. When an interest payment is made, the issuer is paying bondholders for the previous six months of ownership. For example, when a J&J 1 bond pays interest on July 1st, it’s paying the bondholder for owning the bond from January 1st through June 30th.
Zero coupon bonds are exactly what they sound like: bonds with a 0% interest rate. They’re unusual because most bonds have interest rates above 0%.
While “normal” bonds pay interest semi-annually throughout the life of the bond, zero coupon bonds pay their return at maturity. Investors earn money based on the price they originally paid. Issuers sell zero coupon bonds at discounts, and they mature at par. The longer the maturity, the deeper the discount tends to be.
For example, assume you purchase a $1,000 par, 20-year zero coupon bond issued at $600. You won’t receive ongoing interest, but you’ll earn $400 over 20 years. Unlike most bonds, zero coupon bonds aren’t designed for investors seeking consistent income. In this example, you wouldn’t receive any return for 20 years.
Zero coupon bonds generate phantom income, because interest is treated as earned income for tax purposes as it accrues, even though no cash is received until maturity. The taxes owed on that phantom income are often referred to as a phantom tax, because investors must pay them out of pocket before receiving any cash.
Even though zero coupon bonds don’t have an interest rate, their market values still respond to interest rate changes. Like other bonds, their market prices rise when interest rates fall, and vice versa. In fact, long-term zero coupon bonds can experience some of the most volatile price changes when interest rates move.
Longer-term zero coupon bonds are often used for long-term goals, such as saving for a young child’s college or retirement. The idea is simple: invest today, and the bond pays out at maturity.
When a loan is obtained, it will either be secured or full faith and credit. This applies to everything from bonds to mortgages to car loans to student loans. If a bond is secured, it’s backed by something of value. If a bond is full faith and credit, it’s backed only by the borrower’s promise to repay.
A bond is collateralized if it is secured, meaning there is collateral backing the loan. Mortgages are secured loans; if you fail to make mortgage payments, the bank can take your home. Similarly, if a bond has collateral backing it, it is secured in the same way. If the issuer fails to pay bondholders interest and/or principal, the collateral can be liquidated (sold) and the proceeds passed on to bondholders. Examples of collateral pledged by bond issuers include real estate, equipment, and subsidiaries.
If a bond is full faith and credit, also known as unsecured, it is backed only by the issuer’s promise to repay. If the issuer fails to make the required payments, bondholders can still sue. However, there is no collateral backing the bond. If the issuer has little-to-no capital (money) left, bondholders could lose their entire investment.
Secured bonds are generally safer and therefore are typically issued with lower interest rates and trade at lower yields. To compensate investors for additional risk, unsecured bonds are issued with higher interest rates and trade at higher yields.
We first learned about call features in the preferred stock chapter. Bonds work the same way. If a bond is callable, the issuer can repay the principal (par) value before maturity and end the bond early. When a bond is called, the issuer must pay accrued interest, its par value, and any call premium (discussed below) to bondholders. After the bond is called, the issuer stops paying interest and the bond ceases to exist.
Calling a bond is similar to paying off a loan early. The borrower repays principal and no longer makes interest payments. That’s good for the borrower, but the lender may lose years of expected interest income. Callable bonds create the same trade-off.
There are a few reasons an issuer might call a bond. The most common is to refinance. Assume an issuer has a $100 million 7% bond outstanding, so it pays $7 million of interest annually. If interest rates fall to 3%, the issuer could sell a new bond with a 3% coupon and use the proceeds to call the older 7% bond. That reduces annual interest cost by $4 million (from $7 million to $3 million). This is the same basic idea as refinancing a personal loan.
An issuer could also call a bond simply because it has the cash available. It’s similar to paying off a credit card balance because there’s money in the bank.
Callable bonds are issuer-friendly and generally unfavorable for bondholders. Bonds are often called when interest rates fall. If you owned the 7% bond above and it was called, it would be difficult to find another 7% bond in a 3% interest rate environment without taking on much more risk. This is an example of call risk.
Because callable bonds expose investors to call risk, they are typically issued with higher interest rates than similar non-callable bonds. In the market, callable bonds also tend to trade at lower prices, which results in higher overall rates of return (yields) for investors.
We already learned about call protection and call risk in the preferred stock chapter. As a reminder, call protection is the number of years before a security can be called. A call premium is any amount above par ($1,000) that an issuer must pay to call a bond.
Here’s a video breakdown of a question involving both call protection and call premiums:
Even if a bond isn’t callable, an issuer can still try to reduce its debt before maturity by buying bonds back in the market. The issuer could also make a tender offer to current bondholders. A tender offer is a formal offer to buy back securities, typically at a premium to market value.
A put feature is similar to a call feature, except the bondholder controls it. If a bond is puttable, it allows the bondholder to sell the bond back to the issuer for its par value before maturity. Puttable bonds are attractive to investors, especially if interest rates rise.
When interest rates rise, bond values fall because the coupon is fixed. If newly issued bonds offer higher interest rates than older bonds trading in the secondary market, those older bonds must trade at a discount to be competitive. However, puttable bonds should not trade at discounts. If you own a puttable bond, why sell it for less than $1,000 in the market when you can put it back to the issuer for $1,000?
Investors tend to put their bonds when interest rates rise so they can reinvest at higher rates. If you hold a puttable 4% bond and interest rates rise to 8%, you would put your bond. The issuer pays you $1,000 par, and you can use that money to buy a newly issued bond with similar features yielding 8%.
When a bond offering occurs, an issuer typically sells thousands (or millions) of individual $1,000 par bonds. Sometimes all of the bonds have the same issue date and maturity, but not always. Here are the main bond issuance formats:
Term
Serial
Series
Bonds are structured in different formats depending on the issuer and the purpose of the borrowing. Most corporate and US government bonds are issued in term format. Many municipal (city and state government) bonds are sold in serial format. Bonds funding construction-related projects are commonly offered in series format. These are general patterns, and you’ll see exceptions later.
We’ll also learn how bonds are quoted in future chapters.
You won’t need to know why bonds are quoted in different ways; just remember that some bonds are quoted with prices and some are quoted with yields. Here are two examples:
Price quote example
Yield quote example
You’ll learn how to translate each quote, but you can already see the difference. One refers to price (95 = 95% of par, or $950), while the other refers to yield (the overall rate of return on a bond).
Bonds issued in certain formats are often quoted in specific ways. Term bonds are most often quoted in price form. Price quotes may also be called percentage of par quotes. As discussed above, a quote of 95 means the bond is trading at 95% of par. Price quotes may also be referred to as dollar quotes or term quotes.
Serial bonds are most often quoted in yield form. Yield quotes are also referred to as serial quotes and basis quotes. You may have heard of a basis point, which equals 0.01%. In practice, basis points are often used when discussing performance. For example:
“The company’s revenues exceeded expectations by 50 basis points.”
That means the company exceeded revenue expectations by 0.50%. You may encounter basis points on the exam. Here are two key conversions:
If basis points are mentioned in reference to a bond quote, they’re referring to a bond’s yield. That’s why yield quotes are sometimes called basis quotes.
Underwriters market securities to the investing public on behalf of issuers. Issuers pay underwriters significant fees to help raise capital (money) by selling securities. For example, the underwriters for Uber’s IPO in 2019 collected over $100 million in fees. Many factors affect underwriting fees, and the underwriter’s commitment is a major one.
Underwriting commitments can be firm or best efforts. The key difference is who ends up with any unsold securities. For example, if an underwriter tries to sell $100 million of bonds but sells only $75 million, who keeps the remaining $25 million?
If a bond is sold on a firm commitment basis, the underwriter keeps the unsold securities. This is an example of a principal transaction, where the underwriter buys the securities from the issuer, holds them in inventory, and sells them to investors from that inventory. In this setup, the underwriter pays the issuer close to $100 million for the entire issue and tries to profit on resale (selling the bonds for more than it paid). If any bonds go unsold, the underwriter is stuck with them.
If a bond is sold on a best efforts basis, the issuer keeps the unsold securities. This is an example of an agency transaction, where the underwriter tries to sell as many securities as possible on behalf of the issuer but does not buy the securities into inventory. The underwriter earns a fee for each security sold but does not have to keep unsold shares or bonds.
Firm commitments are riskier for underwriters, so they typically come with higher underwriting fees than best efforts commitments.
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