Basic characteristics
Bonds are loans
A bond, which is considered a type of debt security, is a loan (plain and simple). People take out loans to buy cars, start businesses, purchase homes, etc. When you take out a loan, you pay the amount borrowed, plus interest, over time. Some loans are short-term, while some may last for decades.
Bonds are the same in the way they’re structured. They’re loans, which can be short or long-term, and require the borrower to pay back the principal borrowed, plus interest. If you purchase a bond, you’re lending money to the issuer. Essentially, investors are the bank.
You’re lending money to the federal government if you purchase a US Government bond. You’re lending money to your local government when you purchase a municipal bond. You’re lending money to a billion-dollar corporation when you purchase a Coca-Cola bond.
Many times, issuers borrow hundreds of millions of dollars or more. You’ve probably heard, but the US federal government is over $31 trillion in debt. To finance its activities, the US Treasury continually borrows to sustain its deficit spending (spending more money than it collects in taxes). Too much debt* can lead to a bad financial situation and is something to keep an eye on if you’re an investor.
*Although US government debt is significant and climbing, economists have varying opinions on the severity and impact of US debt levels. For test purposes, you should assume US government debt securities are safe, regardless of the fact our government is trillions in debt.
Par value
You learned about par value in the preferred stock chapter. While there are some differences, the concept is similar with bonds. Par value is a bond’s face value and represents the “principal” of the loan, which never changes. Many bonds are initially issued in the primary market at their par value. Also, a bond’s interest payments are based on par, just like preferred stock dividend payments are based on par.
We’ll talk in depth about how bond values fluctuate later in this unit. For now, assume bond market values fluctuate similarly to preferred stock. Regardless of the bond’s market price, the issuer pays a fixed amount of interest, based on par, to its bondholders.
Assume the following:
A $1,000 par, 5% bond trades at $900
Although this bond is trading at $900, it pays 5% of $1,000 for the life of the bond. The issuer must make $50 annual payments (technically two $25 semi-annual payments) over the bond’s life. The market price does not affect the issuer’s obligation to make the fixed $50 annual payments.
The fixed par value for bonds is typically $1,000. In addition to being the basis for interest payments, par value is also what’s received when a bond matures (discussed later in this chapter).
Interest payments
Bonds are fixed income investments, which means they make consistent fixed payments to their investors. When an issuer sells a bond, they base its interest rate on the current market environment. Depending on the type of bond, the length until maturity, and the issuer’s financial status, the bond’s interest rate may be higher or lower than the current average interest rate. This is the same as everyday people taking out loans. If granted the loan, the borrower will pay an interest rate reflecting the type of loan (e.g., personal, real estate, business), length of the loan, and the borrower’s credit score.
If a bond exposes investors (creditors) to higher risk levels, the issuer must entice investors by offering more. Typically, this means issuing a bond with a higher interest rate. For example, a company facing financial difficulties may issue a bond with an interest rate of 12% when the average rate is 5%. The extra interest compensates investors for the risk they’re taking.
If a bond is relatively safe and low-risk, the issuer can sell the bond with a lower-than-average interest rate. For example, the US Government is considered the safest bond issuer. A US Government bond could be issued with a 3% interest rate when the average interest rate is 5%. Investors don’t demand high interest rates because US Government bonds are relatively low-risk.
Issuers sell bonds at interest rates high enough to attract investors but low enough to afford the interest payments. When the interest rate is set, it never changes over the bond’s life. Once a bond is sold to investors in an initial public offering (IPO) in the primary market, the issuer collects the money raised and utilizes the new capital in various ways. Some issuers use bond proceeds to build new factories, purchase new technology, or hire additional employees. Regardless of the reason, the issuer is now legally obligated to pay the borrowed funds back to their bondholders. Unlike dividends, issuers may not skip interest payments. If this occurs, bondholders will sue and take them to bankruptcy court.
The coupon, the stated rate, or sometimes just ‘the rate’ are nicknames for the interest rate. The term ‘coupon’ might sound out of place, but it’s a historical reference. Before the 1980s, bonds were generally offered 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.
Bonds issued this way were considered to be in bearer form, meaning “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 $20. However, if you drop the $20 on the sidewalk and someone else picks it up, it’s now their $20. Bearer bonds were treated the same. In 1982, Congress outlawed the issuance of bearer bonds because they were hard to track and easy to utilize for illegal purposes. There are many older movies (like Heat) where bank robbers attempt to steal bearer bonds. They still exist outside of the United States but are no longer issued within our country.
Nowadays, it’s 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 recorded by the transfer agent. There is no need to clip coupons or worry about safeguarding your certificates.
Most bonds make regular, semi-annual payments to investors. When the 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 set 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 pays 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 non-zero interest rates.
While “normal” bonds pay interest semi-annually throughout the bond’s life, zero coupon bonds pay interest at maturity. Investors make money based on the price they initially purchased the bond. Issuers sell zero coupon bonds at discounts, then they mature at par. This form of return is sometimes referred to as capital accumulation.
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 unsuitable for investors seeking consistent income. In our example, you wouldn’t see any return from your bond for 20 years!
Longer-term zero coupon bonds suit investors seeking a “set it and forget it” type of investment. Additionally, the longer the maturity, the deeper the initial discount (and bigger return). Think about it - issuers must provide greater incentives when requesting to borrow investor funds for lengthy periods. 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 the investment makes a big payment later at maturity. Easy, right?
Maturity
As we discussed above, all debt securities have a specific maturity date, which determines how long a bond will last. Some debt securities are issued with maturities as short as a few days, while some have 40 year maturities. The time until maturity depends on how long the issuer needs to repay the borrowed funds.
The longer the maturity of the bond, the more risk involved. Because of this, a one month bond typically has a much lower rate of return than a 40 year bond. Only so much can happen in a short period. Like any other loan, the most significant risk a bondholder faces is not being repaid (known as default risk). Even if something drastic changes with the issuer or the bond market, the bond will mature shortly.
The 40-year bond involves a ton of time. Do you know where you’ll be or what the world will look like in 40 years? Unless you’re a psychic, the answer is no. The more time an investor plans to hold a bond, the more uncertainty and risk. Over the next 40 years, we could experience significant interest rate changes, 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 a debt security’s maturity, specific terms may apply. For example, those with one year or less until maturity are called money markets. You’ll learn more about different types of bonds when we discuss specific versions of US Government, municipal, and corporate bonds.
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