TYPES OF BONDS

Bonds are securities that represent a debt owed by the issuer to the investor. Bonds obligate the issuer to pay a specified amount at a given date, generally with periodic interest payments. The par, face, or maturity value of the bond is the amount that the issuer must pay at maturity. The coupon rate is the rate of interest that the issuer must pay. This rate is usually fixed for the duration of the bond and does not fluctuate with market interest rates. If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer. Look at Figure 1. The face value of the bond is given in the top right corner. The interest rate, along with the maturity date, is reported several times on the face of the bond.

Figure 1.

Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds.

Bonds are loans from the bondholder (buyer) to the issuer (seller). A bond is a promise by the issuer to pay back the amount loaned to it (called principal) plus an agreed to amount of interest on or before a stated date. The interest may be paid periodically during the life of the loan or all at once when the loan is paid back. Bonds are also called fixed income instruments, because the amount of income that the bond will generate is fixed by the stated interest rate of the bond. The date when the loan becomes due is called the maturity date of the bond. The loan is represented by a physical piece of paper and if it pays interest periodically during the life of the loan, the certificate may also consist of coupons.

Coupons are detachable from the bond certificate itself, usually by a perforation, and are presented to the paying agent of the issuer, usually a commercial bank, for payment. For this reason they are called coupon bonds. While coupon bonds are no longer widely used, the amount of interest that a bond pays is still known as the coupon rate and the bond is still known as a coupon bond.

Bonds are also identified by the way they are owned. Bearer bonds, for example, belong to the person who holds them and ownership is not otherwise recorded. Eurobonds are issued in this format. While this form of ownership carries the risk of loosing the certificate, it offers the highest degree of anonymity and that is why in some countries, the United States for example, they are no longer allowed.

The other common type of format is a fully registered bond, either in certificate form or in book entry. The owner’s name is recorded with a transfer agent and interest payments are made either by check or electronic credit. The book entry method, where no certificate is issued and ownership is recorded in a ledger, is growing in popularity because it reduces transfer costs, simplifies handling, and decreases the probability of loosing the certificate or having it stolen.

Table 1. Bond terminology.

Treasury Bonds. The U.S. Treasury issues notes and bonds to finance the national debt. The difference between a note and a bond is that notes have an original maturity of 1 to 10 years while bonds have an original maturity of 10 to 20 years. Table 1 summarizes the maturity differences among Treasury securities.

Federal government notes and bonds are free of default risk because the government can always print money to pay off the debt if necessary. This does not mean that these securities are risk-free. Treasury bonds have very low interest rates because they have no default risk. Most of the time the interest rate on Treasury notes and bonds is above that on money market securities because of interest-rate risk.

Municipal bonds are securities issued by local county and state governments. The proceeds from these bonds are used to finance public interest projects such as schools, utilities, and transportation systems. Municipal bonds are issued to pay for essential public projects. This allows the municipality to borrow at a lower cost because investors will be satisfied with lower interest rates on tax-exempt bonds.

There are two types of municipal bonds:general obligation bonds and revenue bonds.

General obligation bonds do not have specific assets pledged as security or a specific source of revenue allocated for their repayment. Instead, they are backed by the "full faith and credit" of the issuer. This phrase means that the issuer promises to use every resource available to repay the bond as promised. Most general obligation bond issues must be approved by the taxpayers because the taxing authority of the government is pledged for their repayment.

Revenue bonds, by contrast, are backed by the cash flow of a particular revenue-generating project. For example, revenue bonds may be issued to build a toll bridge, with the tolls being pledged as repayment. If the revenues are not sufficient to repay the bonds, they may go into default, and investors may suffer losses. Municipal bonds are not default-free. Unlike the federal government, local governments cannot print money, and there are real limits on how high they can raise taxes without driving the population away.

Corporate Bonds. When large corporations need to borrow funds for long periods of time, they may issue bonds. Most corporate bonds have a face value of $1000 and pay interest semiannually (twice per year). Most are also callable, meaning that the issuer may redeem the bonds before a specified date.

The bond indenture is a contract that states the lender's rights and privileges and the borrower's obligations. Any collateral isoffered as security to the bondholders. The degree of risk varies widely among issues because the risk of default depends on the company's health, which can be affected by a number of variables. The interest rate on corporate bonds varies with the level of risk. Bonds with lower risk and a higher rating (AAA being the highest) have lower interest rates than more risky bonds (BBB). A bond's interest rate will depend on its features and characteristics, which are described in the following sections. (see the table in the section of supplementary materials).

Conversion. Some bonds can be converted into shares of common stock. This feature permits bondholders to share in the firm's good fortunes if the stock price rises. Most convertible bonds will state that the bond can be converted into a certain number of common shares at the discretion of the bondholder. The conversion ratio will be such that the price of the stock must rise substantially before conversion is likely to occur.

Types of Corporate Bonds. A variety of corporate bonds are available. They are usually distinguished by the type of collateral that secures the bond and by the order in which the bond is paid off if the firm defaults.

Secured Bonds. Secured bonds, such as mortgage bonds and equipment trust certificates are ones with collateral attached.

Mortgage bonds are used to finance a specific project. For example, a building may be the collateral for bonds issued for its construction. In the event that the firm fails to make payments as promised, mortgage bondholders have the right to liquidate the property in order to be paid. Because these bonds have specific property pledged as collateral, they are less risky than comparable unsecured bonds. As a result, they will have a lower interest rate.

Equipment trust certificates are bonds secured by tangible non-real-estate property, such as heavy equipment or airplanes. Typically, the collateral backing these bonds is more easily marketed than the real property backing mortgage bonds. As with mortgage bonds, the presence of collateral reduces the risk of the bonds and so lowers their interest rates.

Unsecured Bonds. Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer. No specific collateral is pledged to repay the debt. In the event of default, the bondholders must go to court to seize assets. Collateral that has been pledged to other debtors is not available to the holders of debentures. Debenturesusually have attached to them a contract that spells out the terms of the bond and the responsibilities of management. The contract attached to the debenture is called an indenture. (Be careful not to confuse the terms debenture and indenture.) Debentures have lower priority than secured bonds if the firm defaults. As a result, they will have a higher interest rate than otherwise comparable secured bonds.

Variable-rate bonds (which may be secured or unsecured) are a financial innovation stimulated by increased interest-rate variability in the 1980s and 1990s. The interest rate on these securities is tied to another market interest rate, such as the rate on Treasury bonds, and is adjusted periodically. The interest rate on the bonds will change over time as market rates change.

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