Review
When you prepared for the SIE exam, you learned how a bond is a unique form of a loan. Organizations like corporations and governments borrow money continually and in large amounts. For example, Apple borrowed $6.5 billion in 2021 through a long-term bond issuance.
It would be difficult for Apple to find a bank to borrow this amount of money from due to the risk involved. Although Apple is one of the largest and most powerful companies in the world, a default (the inability to pay back borrowed funds) would bankrupt most banks. Even if Apple could find a bank willing to lend $6.5 billion, a high interest rate is virtually guaranteed due to the significant risk a loan of that size presents. The more interest a company pays, the less profit it keeps from its business operations.
Issuing bonds spreads the risk among thousands, if not millions of investors. The $6.5 billion Apple bond offering equates to 6.5 million $1,000 par bonds. If 6.5 million different investors bought a $1,000 par bond, each investor faces the risk of losing their investment. Losing $1,000 wouldn’t be fun, but it also wouldn’t bankrupt most investors. By spreading risk around, Apple was able to borrow a significant sum of money and pay a relatively low interest rate (yielding less than 1% above Treasuries).
General characteristics
Whether a bond investor is a person like you or an institution, investors take the role of a bank when a bond is issued. Issuers tend to initially offer bonds at their face value, also known as 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, also known as its maturity, the issuer makes one last interest payment and repays the face (par) value. This is how the average bond works, but there are always exceptions. In the following chapters, we’ll learn about specific types of bonds and how they function.
The par value for bonds is typically $1,000, although it’s very possible you could encounter questions with higher par values. The bond’s interest rate, also known as its coupon or nominal rate, is based on par. For example:
$1,000 par, 5% bond
This bond will pay two $25 interest payments a year, totaling $50 of annual interest. Regardless of who owns the bond or what price was paid for the bond, it always pays this amount of interest. The par value and the interest rate never change over the life of the bond.
Unlike dividends, interest payments cannot be skipped. If the issuer skips an interest payment, they will be sued by the bondholders and taken to bankruptcy court. Simply put, bond issuers must make their interest payments. Otherwise, it’s considered a default, similar to a person declaring bankruptcy because they can’t pay outstanding loans.
The term ‘coupon’ might sound out of place, but there’s a historical reference. Before the 1980s, bonds were generally sold in certificate form.
As you can see in the picture above, bond certificates were divided into two different sections. The majority of the certificate represents the principal or par value of the bond. The coupons are at the bottom of the certificate (in grey). When an interest payment was due, the bondholder would clip the appropriate coupon and mail it to the issuer. Each coupon displayed a specific date that told the investor when it should be clipped and mailed. After receiving the clipped coupon, the issuer sent the bondholder a check for the interest owed. This is where the term ‘coupon’ comes from.
When bonds were issued this way, they were issued in bearer form. This is 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 your money. However, if you drop the $20 on the sidewalk and someone else picks it up, it’s now theirs. Bearer bonds are treated exactly the same.
In 1982, Congress outlawed the issuance of bearer bonds because they were difficult to track and easy to utilize for illegal purposes. There are some older movies (e.g. Heat) involving bank robbers stealing bearer bonds (because they were difficult for authorities to track and represented large amounts of money per certificate). Bearer bonds still exist outside of the United States but are no longer issued within our country.
Nowadays, it’s very difficult to steal bonds because of their form. Bonds are now issued in book entry form, which means there is no certificate and everything is tracked digitally. When you buy a bond, your ownership is tracked by the transfer agent. There is no need to clip coupons or worry about safeguarding your certificates. When interest and/or principal is due, it just shows up to the investor’s account.
Maturity
The longer the maturity of the bond, the more risk is involved. Because of this, a one-month bond typically has a much lower rate of return than a 30-year bond. Only so much can happen in a short period of time and investors can usually predict what will happen in the bond market over the next several weeks. Even if something drastic changes with the issuer or the bond market, the bond will mature shortly.
A 30-year bond has a lot of time on its hands. Do you know where you’ll be or what the world will look like in 30 years? Probably not. The more time involved, the more uncertainty and risk. Over the next 30 years, we could experience significant interest rate fluctuations, economic downturns, and fundamental changes in the market. To compensate investors for these potential risks, bonds with longer maturities are generally sold by issuers with higher interest rates.
Depending on the maturity of a bond, certain terms may 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 US Government, municipal, and corporate bonds.
Interest payments
When a bond is created and sold to investors, the issuer sets specific intervals for the interest payments. These intervals are stated in a type of “finance language.” Let’s take a look at some common bond interest payment intervals:
J&J 1
- Pays interest on January 1st and July 1st
F&A 15
- Pays interest on February 15th and August 15th
Each of the dates above is six months apart. When an interest payment is due, the issuer pays bondholders for their last six months of bond 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 - June 30th.
Zero coupon bonds
Zero coupon bonds are exactly what they sound like - bonds with a 0% interest rate. These are a unique type of bond, as most bonds have interest rates above 0%.
While “normal” bonds pay interest semi-annually throughout the life of the bond, zero coupon bonds pay interest at maturity. Investors make money from a zero coupon bond based on the price they originally purchase the bond for. Issuers sell zero coupon bonds at discounts, and they mature at par. The longer the maturity of the bond, the deeper the discount.
For example, assume you purchase a $1,000 par, 20-year zero coupon bond issued at $600. You won’t receive ongoing interest from the issuer, but you obtain a return of $400 over 20 years. Unlike most bonds, zero coupon bonds are not suitable for investors seeking consistent income. In our example, you wouldn’t see any return from your bond for 20 years!
Although zero coupon bonds do not have an interest rate, their market values are influenced by interest rate changes in the market. Just like other bonds, their market prices rise when interest rates fall, and vice versa. In fact, we’ll learn later in this chapter how long-term, zero coupon bonds experience some of the most volatile changes in price when interest rates change.
Longer-term zero coupon bonds are great for investors seeking a “set it and forget it” type of investment. Many investors purchase zero coupon bonds with longer maturities for long-term goals, such as saving for a young child’s college or retirement. Invest today, forget about it, and several years later the investment will make a big payment to you. Easy, right?
Secured vs. unsecured bonds
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 is backed by something of value. If a bond is full faith and credit, it is only backed by the borrower’s promise to pay back the loan.
A bond is collateralized if it is secured, meaning there is collateral backing the loan. Mortgages are secured loans; if you fail to make your mortgage payments, the bank will take your home. Similarly, if a bond has collateral backing its bond, it is secured in the same way. If the issuer fails to pay bondholders their interest and/or principal, the collateral will be liquidated (sold) and the funds will be passed on to the 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 only backed by the issuer’s promise to pay back the borrowed funds. If the issuer fails to make the required payments, they can still be sued by the bondholders. 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 safer investments and therefore are typically issued with lower interest rates and trade at lower yields. To compensate their investors for risk, unsecured bonds are issued with higher interest rates and traded at higher yields.
Callable bonds
We first learned about call features in the preferred stock chapter. It’s exactly the same with bonds. If a bond is callable, it allows the issuer to pay back its principal (par) value prior to maturity and put an end to the bond earlier than maturity. 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 no longer pays interest and the bond ceases to exist.
An issuer calling a bond is similar to a person paying off a loan early. They repay the principal of the loan to the lender and no longer make interest payments. The borrower is happy to stop paying interest, but the lender could be losing out on years of interest income. Callable bonds work the same way!
There are a few good reasons an issuer would call a bond. The most common is to refinance. Assume an issuer has a $100 million 7% bond outstanding, which results in the issuer paying $7 million in interest payments annually. If interest rates fall to 3%, they could issue a new bond with a 3% coupon and use the money raised to call the older, 7% bond. By doing so, they’ve reduced their interest rate by 4%, which results in saving $4 million in interest annually (going from paying $7 million in interest on the 7% loan to paying $3 million in interest on the 3% loan). If you’ve ever refinanced a loan, you know this process.
An issuer could also call a bond simply because they have money to do so. It’s similar to paying off a credit card loan because there’s money in the bank. Why would anyone pay interest on borrowed funds when they don’t need to?
Callable bonds are issuer-friendly and not beneficial to bondholders. More often than not, bonds are called when interest rates fall. If you owned the 7% bond referenced above and were called, it would be very difficult to find another 7% yielding bond in a 3% interest rate environment. In order to do so, you would need to seek out a much riskier bond. This is an example of call risk.
Because of the risk they expose investors to, callable bonds are issued with higher interest rates than similar non-callable bonds. While the feature is a benefit to issuers, it costs them because of the larger interest payment requirements. In the market, callable bonds trade at lower prices, which offer higher overall rates of return to their 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 of money 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 could still attempt to put an end to their debts earlier than maturity. They could simply go to the market and attempt to purchase as many bonds back as possible. Additionally, a debt issuer could also entertain issuing a tender offer to current bondholders. A tender offer is a formal offer to investors to buy back their securities, typically at a premium to market value.
Put features
A put feature is similar to a call feature, except for who controls it. If a bond is puttable, it allows the bondholder to sell the bond back to the issuer for its par value prior to maturity. Puttable bonds are attractive to investors, especially if interest rates rise.
When interest rates rise, bond values fall because of their fixed coupon. If new bonds being issued today have higher interest rates than older bonds trading in the secondary market, those older bonds must be sold at a discount to make them marketable. However, puttable bonds should never trade at discounts. If you owned a bond that was puttable, why would you ever sell it in the market for less than $1,000? You could just put the bond back to the issuer and force them to pay back its par value ($1,000).
Investors tend to put their bonds when interest rates rise so they can lock in higher rates of return. If you held a puttable 4% bond and interest rates were to rise to 8%, you should put your bond. The issuer would pay you back your $1,000 par value, which could then be used to buy a newly issued bond with similar features providing an 8% rate of return.
Bond issuance formats
When a bond offering occurs, thousands (if not millions) of $1,000 par individual bonds are typically sold by one issuer. Sometimes, all of the bonds being issued have the same issue date and maturity. However, it doesn’t always look that way. Let’s take a look at all of the different types of bond issuance formats:
Term
- All bonds issued on the same day and mature on the same day
- Example:
- 1,000 bonds are issued on January 1, 2020
- 1,000 bonds mature on January 1st, 2030
Serial
- All bonds are issued on the same day, but mature on different days
- Example:
- 1,000 bonds are issued on January 1, 2020
- 500 bonds mature on January 1, 2025
- 500 bonds mature on January 1, 2030
Series
- Bonds are issued on different days, but all mature on the same day
- Example:
- 500 bonds are issued on January 1, 2020
- 500 bonds are issued on January 1, 2025
- 1,000 bonds mature on January 1, 2030
Bonds are structured in different forms depending on the type of bond and the issuer. 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. While these are the generalities, there are some exceptions we’ll learn about 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 assume some bonds are quoted with prices and some bonds are quoted with yields. Let’s look at a few examples:
Price quote example
- Bond trading at 95
Yield quote example
- Bond trading at a 6% yield
You’ll learn how to translate each of these quotes, but it’s obvious they are different. One refers to the price of a bond (95 = 95% of par, which is $950), while the other refers to yield (which is the overall rate of return on a bond).
Bonds issued in certain formats are quoted in specific ways. Term bonds are most often quoted in price form. Sometimes, price quotes are referred to as percentage of par quotes. As discussed in the paragraph above, a bond quote at 95 means the bond is trading at 95% of par. Hence, why it’s called a percentage of par quote. They can 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 is equal to .01%. In your career, you’ll find basis points utilized when discussing performance. For example:
“The company’s revenues exceeded expectations by 50 basis points.”
This is a fancy way of saying the company exceeded revenue expectations by 0.50%. You may encounter basis points on the exam, and there are a few ways to remember what a basis point is:
- 1 basis point = 0.01%
- 100 basis points = 1.00%
If basis points are mentioned in reference to a bond quote, it’s referring to a bond’s yield. This is why yield quotes are sometimes referred to as basis quotes.
Underwriting commitments
Underwriters are in the business of marketing securities to the investing public on behalf of issuers. Issuers pay significant amounts of money to underwriters to help them raise capital (money) by selling their securities. For example, the underwriters for Uber’s IPO in 2019 collected over $100 million in fees. Many factors determine how much an underwriter can collect, but their commitment is a significant component.
Underwriting commitments can be firm or best efforts. Whether the issuer or underwriter keeps any unsold securities determines the commitment. For example, if an underwriter attempts to sell $100 million of bonds but only sells $75 million, who is stuck with the $25 million in unsold bonds?
If a bond is sold on a firm commitment basis, the underwriter is stuck with the unsold securities. This is an example of a principal transaction, where the underwriter buys the security from the issuer, places it into inventory, and sells it to investors out of their inventory. In our example above, the underwriter would pay the issuer close to $100 million for the entire bond issue and try to make a profit on the resale to its customers (by selling the bonds for more than they paid for them). However, if any bonds go unsold, the underwriter is stuck with those bonds.
If a bond is sold on a best efforts basis, the issuer is stuck with the unsold securities. This is an example of a agency transaction, where the underwriter attempts to sell as many shares on behalf of the issuer, but does not purchase any of the securities into their inventory. This type of commitment awards the underwriter with an underwriting fee for every security sold but does not require the underwriter to keep the unsold shares or bonds.
Firm commitments are riskier for underwriters, and therefore require a higher underwriting fee than best efforts commitments. As with everything else in finance, more risk provides more return!
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