What is Bond and How Does It Work?

Bonds are debt instruments used by both private and government entities. Bonds are one of the ways to realize debt instruments with fixed or variable yields. They can be issued by a public entity (a state, regional government, or municipality) or by a private entity (industrial, commercial, or service company). 

They can also be issued by a supranational institution (European Investment Bank, Andean Development Corporation, etc.) with the purpose of obtaining financing directly from the financial markets. 

They are securities usually in the name of the holder and usually traded on a market or stock exchange. The issuer undertakes to repay the capital together with interest.

What is Bond?

A bond is an agreement or contract between lenders and the borrowing organization; typically, a firm or government body. As such, the lenders or bondholders of a corporation have certain rights and privileges not enjoyed by the firm’s owners (those holding shares of common stock). 

A debt holder may force the firm to abide by the terms of the debt contract even if the result is reorganization or bankruptcy of the firm. The periodic interest payments due to the holders of debt securities must be paid or else the creditors can force the firm into bankruptcy.

In the United States, the par value is usually $1,000 for corporate bonds. All but zero-coupon issues pay interest, called coupon payments. If a bond has an 8 percent coupon and a par value of $1,000, it pays annual interest of 8 percent of $1,000, or 0.08 × $1,000 = $80. 

A bond with a 10 percent coupon would pay interest of $100 per year. Eurobonds pay a single annual coupon interest payment. In the United States, bonds pay interest semi-annually; an 8 percent coupon will pay interest of $40 every six months during the life of the bond.

Bondholders have legal status as creditors, not owners, of the firm. As such, they have priority claims on the firm’s cash flows and assets. This means that bondholders must receive their interest payments before the firm’s owners receive their dividends

In the case of bankruptcy, the debt holders must receive the funds owed to them before funds are distributed to the firm’s owners. Because of this first claim on a firm’s cash flow and assets, debt is a less risky investment than equity.

Offsetting the advantages of owning debt is its lower return. The interest payments creditors receive usually are considerably less over a period of years than the returns received by equity holders. Also, as long as the corporation meets its contractual obligations, the creditors have little choice in its management and control except for those formal agreements and restrictions that are stated in the loan contract.

Long-term corporate debt securities fall into two categories: secured obligations and unsecured obligations. A single firm can have many types of debt contracts outstanding. Although ownership of many shares of stock may be evidenced by a single stock certificate, the bondholder has separate security for each bond owned. 

Bonds can be registered bonds or bearer bonds. Bonds currently issued in the United States are registered bonds in that the issuer knows the bondholders’ names and interest payments are sent directly to the bondholder. Bearer bonds have coupons that are “clipped” from the side of the bond certificate and presented, like a check, to a bank for payment. 

Thus, the bond issuer does not know who is receiving the interest payments. Bearer bonds are more prevalent outside of the United States. Regulations prevent their issuance in the United States, primarily because unscrupulous investors may evade income taxes on the clipped coupons.

Bonds can be sold in the public market, following registration with the SEC, and traded by investors. There is a “private” market, too; bonds can be sold in a private placement to qualified investors, typically institutional investors such as insurance companies and wealthy individuals. Other forms of debt capital exist in addition to bonds. Businesses can borrow from banks.

Different Types of Bonds

An important attribute of a bond issue that affects its rating is the security, collateral, or assets that are pledged to back the bond issue. 

In the event the bond issuer defaults and misses a payment of coupon interest or principal, the collateral can be sold and distributed to the bond investors. It makes their investment in the issue more secure. There are a number of different types of bonds, each offering different levels of security to its investors.

Mortgage bonds

Mortgage bonds, despite their name, are not secured by home mortgages. Rather, they are backed, or secured, by specifically pledged property of a firm. As a rule, the mortgage applies only to real estate, buildings, and other assets classified as real property. 

For a corporation that issues bonds to expand its plant facilities, the mortgage usually includes a lien, or legal claim, on the facilities to be constructed.

When a parcel of real estate has more than one mortgage lien against it, the first mortgage filed for recording at the appropriate government office—generally, the county recorder’s office—has priority. 

The bonds outstanding against the mortgage are known as first mortgage bonds. The bonds outstanding against all mortgages subsequently recorded are known by the order in which they are filed, such as second or third mortgage bonds. 

Because first mortgage bonds have priority with respect to asset distribution if the business fails, they generally provide a lower yield to investors than the later liens.

An equipment trust certificate is a type of mortgage bond that gives the bondholder a claim to specific “rolling stock” (movable assets), such as railroad cars or airplanes. The serial numbers of the specific items of rolling stock are listed in the bond indenture and the collateral is periodically examined by the trustee to ensure its proper maintenance and repair.

There are two basic types of mortgage bonds. A closed-end mortgage bond does not permit future bond issues to be secured by any of the assets pledged as security under the closed-end issue. 

Alternatively, an open-end mortgage bond is one that allows the same assets to be used as security in future issues. As a rule, open-end mortgages usually stipulate that any additional real property acquired by the company automatically becomes a part of the property secured under the mortgage. This provides added protection to the lender.

Debenture bonds

Debenture bonds are unsecured obligations and depend on the general credit strength of the corporation for their security. 

They represent no specific pledge of property; their holders are classed as general creditors of the corporation equal to the holders of promissory notes and trade creditors. 

Debenture bonds are used by governmental bodies and by many industrial and utility corporations. The riskiest type of bond is a subordinated debenture. 

As the name implies, the claims of these bondholders are subordinate, or junior, to the claims of debenture holders. Most junk bonds or high-yield bonds, which we discussed earlier, are subordinated debentures.

Another bond market innovation is “asset securitization.” Securitization involves issuing bonds whose coupon and principal payments arise from another existing cash flow stream. 

Suppose a mortgage lender, by virtue of previously issued mortgages, has a steady cash flow stream coming into the firm. By selling bonds that use that cash flow stream as collateral, the mortgage banker can receive funds today rather than waiting for the mortgages to be paid off over time.

Principal and interest on the newly issued bonds will be paid by homeowners’ mortgage payments. In essence, the mortgage payments will “pass-through” the original mortgage lender to the investor who purchased the mortgage-backed securities. 

However, not all the interest payments are passed on; the mortgage lender will be paid a servicing fee from these cash flows to compensate them for collecting the mortgage payments and distributing them to the bondholders.

Securitization allows the original lender to reduce the risk exposure, as any homeowner defaults are a risk borne by the investor. In addition, the lender receives new funds, which can, in turn, form the basis for new loans and new issues of mortgage-backed securities. 

In 2007–2008, the agency issues of this arrangement became clearly known. It led to efforts to encourage loans of questionable quality (“subprime” mortgage loans), as the loans would be packaged and sold to others and the originator would reap a commission while selling these poor-quality loans.

Many other cash flow streams are amenable to securitization. 

Payment streams based on credit card receivables and auto loans have been packaged as bonds and sold to investors. Music artists who collect royalties from past recordings have taken advantage of securitization. 

In 1997, British rock star David Bowie initiated this trend by his involvement in a $55 million bond deal in which royalty rights from his past recordings were pooled and sold to investors. Interest on the bonds is paid by the royalty cash flow generated by the compact disc, radio playtime and music, and ringtone downloads.

Other innovations include offering bonds backed by pools of insurance contracts. Interest on such bonds is paid from the policy premiums of the contract holders. Many times, however, these bonds have provisions for future payoffs that are affected by the occurrence of catastrophes such as hurricanes or earthquakes.

Who Buys Bonds?

The U.S. Treasury has a Treasury Direct program to sell Treasury securities directly to individual investors, but the main buyers of Treasury bonds are large institutions, such as pension funds or insurance companies, which hold them for investment purposes. Others, such as investment banks, may purchase them and then resell them to smaller investors.

Similarly, corporate debt markets are oriented toward the large institutional investor who can purchase millions of dollars of bonds at a time. But several innovative firms, such as Ally Financial (formerly GMAC), IBM, United Parcel Service (UPS), Caterpillar, and GE Capital, initiated programs in recent years to sell $1,000 par value bonds directly to the retail, or individual, investor. 

Called InterNotes, medium-term notes, or direct access notes (depending on the issuer and the investment banker selling them), the programs target small investors who have only a few thousand dollars rather than millions to invest in bonds.

Time to Maturity

A straight bond will have a set time to maturity. That is, it will pay coupon interest every six months until the bond matures, at which time the final interest payment is made and the bond’s par value is paid to investors. But a variety of features can affect the bond’s final maturity.

Geography can play a role. U.S. firms routinely issue bonds with ten to 30-year maturities (and even longer in some instances). Bonds in the European market rarely extend their maturity past the seven to the ten-year range, but this may change as European firms are accessing the capital markets more and rely on bank debt less for their longer-term financing needs.

Indeed, as interest rates have been quite low, some firms and governments are issuing very long-term bonds to “lock in” low-interest rates. Norfork Southern (railroad), Électricité de France (a utility firm in France), Petrobras (Brazilian state oil company), and the government of Mexico have issued 100-year bonds in recent years.

A convertible bond can be changed or converted, at the investor’s option, into a specified number of shares of the issuer’s common stock (defined as the bond’s conversion ratio). 

The conversion ratio is set initially to make conversion unattractive. If the firm meets with success, however, its stock price will rise and the bond’s price will be affected by its conversion value (the stock price times the conversion ratio) rather than its value as a straight bond. 

For example, suppose a firm has issued a $1,000 par value convertible bond. Its conversion ratio is 30 and the stock currently sells for $25 a share. The conversion value of the bond is 30 × $25/ share or $750. 

It makes sense to hold onto the bond rather than convert a bond with a purchase price of about $1,000 into a stock that is worth only $750. Should the stock’s price rise to $40, the bond’s conversion value will be 30 × $40/share or $1,200. 

Now it may be appropriate for investors to convert their bonds into more valuable shares. Why would a firm issue convertible bonds? Some may do so as a way to raise equity at a time when the firm’s stock or the overall stock market is out of favor. By selling convertible bonds, they can raise capital and erase the debt from their books when the bonds are converted after the stock price rises.

Callable bonds can be redeemed prior to maturity by the firm. Such bonds will be called and redeemed if, for example, a decline in interest rates makes it attractive for the firm to issue lower coupon debt to replace high coupon debt. A firm with cash from successful marketing efforts or a recent stock issue also may decide to retire its callable debt.

Most indentures state that, if called, a callable bond must be redeemed at its call price; typically, par value plus a call premium of one year’s interest. Thus, to call a 12 percent coupon, $1,000 par value bond, an issuer must pay the bondholder $1,120.

Investors in callable bonds are said to be subject to call risk. Despite receiving the call price, investors are usually displeased when their bonds are called away. 

As bonds are typically called after a substantial decline in interest rates, the call eliminates their high coupon payments; investors will have to reinvest the proceeds in bonds that offer lower yields.

To attract investors, callable bonds must offer higher coupons or yields than noncallable bonds of similar credit quality and maturity. Many indentures specify a call deferment period immediately after the bond issue during which the bonds cannot be called.

Putable bonds (sometimes called retractable bonds) allow investors to force the issuer to redeem them prior to maturity. Indenture terms differ as to the circumstances when an investor can “put” the bond to the issuer prior to the maturity date and receive its par value. Some bond issues can be put only on certain dates. 

Others can be put to the issuer in case of a bond rating downgrade.14 The put option allows the investor to receive the full face value of the bond, plus accrued interest. Since this protection is valuable, investors “pay” for it in the form of a lower coupon rate.

Extendable notes have their coupons reset every two or three years to reflect the current interest rate environment and any changes in the firm’s credit quality. At each reset, the investor may accept the new coupon rate (and effectively extend the maturity of the investment) or put the bonds back to the firm.

An indenture may require the firm to retire the bond issue over time through payments to a sinking fund. A sinking fund requires the issuer to retire specified portions of the bond issue over time. This provides for an orderly and steady retirement of debt over time. 

Sinking funds are more common in bonds issued by firms with lower credit ratings. A higher-quality issuer may have only a small annual sinking fund obligation due to a perceived ability to repay the investor’s principal at maturity.

Income From Bonds

A typical bond will pay a fixed amount of interest each year over the bond’s life. As we noted above, U.S. bonds pay interest semi-annually while Eurobonds pay interest annually.

Although most bonds pay a fixed coupon rate, some bonds have coupon payments that vary over time. 

The bond’s indenture may tie coupon payments to an underlying market interest rate so that the interest payment will always be a certain level above, or will be a specified percentage of a market interest rate, such as the ten-year Treasury note rate. 

As of 2014, the U.S. Treasury has offered floating rate notes (or FRNs) to investors. The FRNs mature in two years and offer an interest rate that is tied to the three-month Treasury bill rate.15 Others, such as the Deutsche Telekom bond issue mentioned above, will have a coupon rate that will increase if the bond’s rating falls.

Zero-coupon bonds pay no interest over the life of the bond. The investor buys the bond at a steep discount from its par value; the return to the investor over time is the difference between the purchase price and the bond’s par value when it matures. 

A drawback to taxable investors is that the Internal Revenue Service (IRS) assumes interest is paid over the life of the bond so investors must pay tax on the interest they don’t receive. 

Because of these tax implications, zero-coupon bonds are best suited for tax-deferred investment accounts, such as individual retirement accounts (IRAs), or tax-exempt investment organizations, such as pension funds.

Why would an investor purchase a zero-coupon bond? Many bond investors have long-term time horizons before the invested funds are needed (to pay for a child’s college education, personal retirement, or other financial goals). Such investors will not spend the bond’s coupon interest when it is received; they will reinvest it in other securities. 

When these investors purchase regular bonds, they face the risk of not knowing what the return will be on the reinvested coupons over the life of the bond. Interest rates may rise, fall, or cycle up and down over the life of the investment. Zero-coupon bonds eliminate this uncertainty by, in essence, locking in the return (the difference between the price paid and the par value) when the bond is purchased.

A large risk faced by bond investors is an unexpected change in inflation. An unexpected increase in inflation can cause lower real returns to an investor as the bond’s fixed interest rate does not adjust to varying inflation.

In 1997, the U.S. Treasury offered an innovation to investors in U.S. debt: Treasury Inflation Protected Securities. They are issued in $1,000 minimum denominations and the principal value of the notes changes in accordance with changes in the consumer price index (CPI).

Here’s how Treasury Inflation Protected Securities (TIPS) work. Interest payments are computed based upon the inflation-adjusted principal value. In times of rising consumer prices, the principal value and interest payments rise in line with inflation. 

Should the CPI fall, the principal amount is reduced accordingly. As an example, suppose an inflation-indexed note with a $1,000 par value is sold at a 3 percent interest rate. 

If inflation over the next year is 4 per-cent, the principal value rises to $1,000 plus 4 percent, or $1,040. The annual interest payment will be 3 percent of $1,040; that is, 0.03 × $1,040, or $31.20. With 4 percent inflation, the principal rises by 4 percent (from $1,000 to $1,040) as does the interest (from $30 to $31.20).

Although the principal is not paid until the note matures, the IRS considers the year-by-year change in principal as taxable income in the year in which the change in value is made. 

In the above example, the investor will pay taxes on $71.20, which is the sum of the $31.20 in interest received and the $40 increase in principal value. 

Because of this, these bonds will be most attractive to tax-exempt or tax-deferred investors, such as pension funds and individual IRA accounts.18 To make inflation protection more affordable to smaller investors, the U.S. Treasury now offers inflation-protected U.S. savings bonds.

Why are there so many variations in bondholder security, maturity, and income payouts among bond issues? 

For the same reason, there are different computers, carbonated beverages, and pizza; namely, to meet different needs in the market or, in the case of bonds, to meet the needs of different types of borrowers and lenders. Some borrowers reduce borrowing costs by offering lenders better collateral. 

Others want to maintain flexibility (or they have no collateral to offer), so they issue debentures and pay higher interest rates. From the lenders’ perspective, zero-coupon bonds may be attractive as they eliminate reinvestment risk (the risk of reinvesting coupon income at lower interest rates). 

Similarly, sinking funds or call, put, or convertibility provisions are attractive to different investors in ever-changing market environments.

Bond Covenants

The trust indenture is an extensive document that details the various provisions and covenants of the loan arrangement. A trustee represents the bondholders to ensure the bond issuer respects the indenture’s provisions.

In essence, an indenture is a contract between the bondholders and the issuing firm. The indenture details the par value, maturity date, and coupon rate of the issue. A bond indenture may include covenants, which can impose restrictions or extra duties on the firm.

Examples of covenants include stipulations that the firm maintains a minimum level of net working capital, keep pledged assets in good working order, and send audited financial statements to bondholders. Others include restrictions on the amount of the firm’s debt, total annual dividend payments, the amount and type of additional covenants it may undertake, and asset sales.

These examples illustrate the purpose of covenants, which is to protect the bond- holders’ stake in the firm. Bonds have value, first, because of the firm’s ability to pay coupon interest and, second, because of the value of the assets or collateral backing the bonds in case of default. Without proper covenant protection, the value of a bond can decline sharply if a firm’s liquidity and assets depreciate or if its debt grows disproportionately to its equity. 

These provisions affect the issue’s bond rating (discussed below) and the firm’s financing costs since bonds giving greater protection to the investor can be sold with lower coupon rates. The firm must decide if the restrictions and duties in the covenants are worth the access to lower-cost funds.

Covenants are important to bondholders. Holders of RJR Nabisco bonds owned high-quality, A-rated bonds prior to the firm’s takeover in 1988 by a leveraged buyout. After the buyout, large quantities of new debt were issued; RJR Nabisco’s original bonds were given a lower rating and fell by 17 percent in value. Lawsuits by disgruntled bondholders against the takeover were unfruitful. 

The courts decided that the bondholders should have sought protection against such increases in the firm’s debt load by seeking appropriate covenant language before investing, rather than running to the courts to correct their mistake. Covenants are the best way for bondholders to protect themselves against dubious management actions or decisions. 

For example, some bonds allow the investor to force the firm to redeem them if the credit rating falls below a certain level; others, such as Deutsche Telekom’s $14.5 billion issue in 2000, increase the coupon rate (in this case by 50 basis points, or 0.50 percentage points) if the bond rating falls below an “A” rating. We’ll discuss bond ratings in the next section.

Bond Ratings

Most bond issuers purchase bond ratings from one or more agencies, such as Standard & Poor’s (S&P), Moody’s, or Fitch. For a one-time fee, the rater examines the credit quality of the firm (e.g., its ability to pay the promised coupon interest), the indenture provisions, covenants, and the expected trends of the firm and industry operations. 

From its analysis and discussions with management, the agency assigns a bond rating that indicates the likelihood of default (nonpayment of coupon or par value, or violation of the bond indenture) on the bond issue.

In addition, the rating agency commits to continually reexamining the issue’s risk. For example, should the financial position of the firm weaken or improve, S&P may place the issue on its Credit Watch list, with negative or positive implications. After that, S&P will downgrade, upgrade, or reaffirm the original rating.

Despite the initial cost and the issuer’s concern about receiving a lower-than-expected rating, a bond rating makes it much easier to sell the bonds to the public. The rating acts as a signal to the market that an independent agency has examined the qualities of the issuer and the bond issue, and has determined that the credit risk of the bond issue justifies the published rating. 

An unrated bond issue will likely obtain a cool reception from investors. Investors may have good reason to wonder, “What is the firm trying to hide? If this was an attractive bond issue, the firm would have rated it.” In addition, certain types of investors, such as pension funds and insurance companies, may face restrictions against purchasing unrated public debt.

A bond’s security, or collateral provisions, (discussed below) affect its credit rating. Bonds with junior or unsecured claims receive lower bond ratings, leading investors to demand higher yields to compensate for the higher risk. Thus, bond issues of a single firm can have different bond ratings if their security provisions differ.

Investment-grade bonds are those with ratings of Baa3, BBB–, or better. They are called “investment grade” as, historically, investors (individuals and managed funds, such as bank trust department portfolios and pension funds) were allowed to invest in such bonds. Bonds below an investment-grade rating were deemed too risky for such conservative portfolios and were not allowed to be held.

Times and regulations change, however, and bonds that are below investment grade, meaning they have ratings of Ba1, BB+, or lower, have gained a spot in many investment portfolios. Known as junk bonds or (euphemistically) high-yield bonds, they have more risk but offer higher expected returns and have benefits in lowering unsystematic risk in diversified portfolios. 

Formerly, issuing companies would seek the highest bond rating possible for new issues for two reasons. First, having high-rated debt added prestige to the company; an AAA-rated firm was viewed as being managed well, financially stable, and strong. 

In addition, such bonds gave the appearance of being a safe investment and, as they had an investment-grade rating, they would find demand among investors such as trust departments and pension funds. 

The second main reason for seeking a high bond rating is that the higher rating saves the firm interest expense, as coupon rates on highly rated bonds are lower than those on lower-rated bonds because of the risk–expected return trade-off.

The growth of the high-yield sector of the bond market has attracted investors and issuers. Some firms prefer to issue debt rather than dividend-paying common stock as interest payments are tax-deductible to the issuer. 

Others, as part of the firm’s financial strategy, have issued bonds and used the funds to repurchase shares of common stock. Investors have noted that having junk bonds in a portfolio offers potential return enhancements and may diversify risk.

Over time, the stigma attached to junk bonds has diminished. Issuers and investors are more amenable to these securities. For example, in 1980, less than a third of S&P-rated bonds were not investment quality and many of those were “fallen angels”; that is, bonds that were originally issued with an investment-grade rating but then fell into the junk category because the issuing firm ran into financial difficulty.

By the late 1980s, more than half of rated debt was in the high-yield category, and by 2007 over 70 percent of S&P-rated firms had junk bonds outstanding. The number of AAA-rated and AA-rated companies fell from 17 percent of issuers in 1980 to 2 percent in 2007; B-rated bonds, on the other hand, have grown from 7 percent of issues in 1980 to over 40 percent of issues in 2007. 

Only two nonfinancial firms had an AAA rating in 2016: Johnson & Johnson, and Microsoft.5 ExxonMobil was the third firm with an AAA bond rating, but it was downgraded in early 2016 because of the implications of falling oil prices and the firm’s commitment to large capital expenditures and dividends to shareholders.

Global Bond Market

Many U.S. corporations have issued Eurodollar bonds. Eurodollar bonds are dollar-denominated bonds that are sold outside the United States. Because of this, they escape review by the SEC, somewhat reducing the expense of issuing the bonds. 

Eurodollar bonds usually have fixed coupons with annual coupon payments. Most mature in five to ten years, so they are not attractive for firms that want to issue long-term debt. Most Eurodollar bonds are debentures. 

This is not a major concern to investors, as only the largest, financially strongest firms have access to the Eurobond market. Investors do care that the bonds are sold in bearer form because investors can remain anonymous and evade taxes on coupon income. Some researchers believe this is the main reason Eurodollar bond interest rates are low relative to U.S. rates.

U.S. firms aren’t the only issuers of securities outside their national borders. For example, foreign firms can issue securities in the United States if they follow U.S. security registration procedures. 

Yankee bonds are U.S. dollar-denominated bonds that are issued in the United States by a foreign issuer. Some issuers find the longer maturities of Yankees attractive to meet long-term financing needs. 

While Eurodollar bonds typically mature in five to ten years, Yankees may have maturities as long as 30 years. Nonetheless, the euro (€) is becoming a strong competitor to the U.S. dollar for firms that want to raise funds in a currency that has broad appeal to many investors.

Increasingly, the international bond market is ignoring national boundaries. A growing number of debt issues are being sold globally. The World Bank issued the first global bonds in 1989. Global bonds usually are denominated in U.S. dollars. As they are marketed globally, their offering sizes typically exceed $1 billion. 

In addition to the World Bank, issuers now include the governments of Brazil, Finland, and Italy, and corporations such as Deutsche Telekom ($14.5 billion raised), Ford Motor Credit ($8.6 billion), Tecnost International Finance (Netherlands) ($8.3 billion), AT&T ($8 billion), Glitnir Bank (Iceland) ($1.25 billion), and Walmart ($5.8 billion).

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