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Information > Financial Terms > This page Bond An
interest-bearing certificate of debt, being one of a series constituting
a loan made to, and an obligation of, a government or business corporation;
a formal promise by the borrower to pay to the lender a certain sum of
money at a fixed future day with or without security, and signed and sealed
by the maker (borrower); a promise to pay a principal amount on a stated
future date and a series of interest payments, usually semi-annually until
the stated future date; "all subdivided interest-bearing contracts for
the future payment of money that are drawn with formality whether they
are secured or unsecured, whether the interest is imperative under all
conditions, or not, as in the case of income bonds" (L. Chamberlain, The
Principles of Bond Investment). The
difference between a bond and promissory note is aptly explained by F.A.
Cleveland (Funds and Their Uses) as follows: The
only way that a bond is distinguished from an ordinary promissory note
is by the fact that it is issued as part of a series of like tenor and
amount, and, in most cases, under a common security.
By rule of common law the bond is also more formal in its execution.
The note is a simple promise (in any form, so long as a definite
promise for the payment of money appears upon its face), signed by the
party bound, without any formality as to law form, required a seal and
had to be witnessed in the same manner as a deed or other formal conveyance
of property, and though assignable was not negotiable.
This is still the rule with many jurisdictions. A
bond differs from an investment note only in the time which it has to
run before maturity. Ordinarily
the dividing line is five years; if the term of the funded debt exceeds
this period, the issue is called bonds; if within this period, notes. A
bond differs from a share of stock in that the former is a contract to
pay a certain sum of money with definite stipulations as to amount and
maturity of interest payments, maturity of principal, and other recitals
as to the rights of the holder in case of default, sinking fund provisions,
etc. A stock contains no promise
to repay the purchase price or any amount whatsoever.
The shareholder is an owner; a bondholder is a creditor.
The bondholder has a claim against the assets and earnings of a
corporation prior to that of the stockholder, and while the bondholder
is an investor, the stock holder speculates on the success of the enterprise.
The former's claim is a definite contractual one; the latter's
claim is contingent upon earnings. Numerous
classifications of bonds are possible.
The following classifications have been selected as the most important
and useful: 1. Character
of obligor. a.
Civil bonds.
Examples: government
bonds, state bonds, municipal bonds. b. Corporation
bonds. Examples:
railroad bonds, public utility bonds, industrial bonds. 2. Purpose
of issue. Examples:
equipment bonds, improvement bonds, school bonds, 3. Character
of security. a.
Unsecured.
Examples: civil bonds,
corporate debentures. b.
Secured. (1) Personal
security. Examples:
endorsed bonds, guaranteed bonds. (2) Lien
security. Examples:
first mortgage bonds, general mortgage bonds, consolidated
mortgage bonds, collateral trust bonds, chattel mortgage bonds. 4. Terms
of payment of principal. Examples:
straight maturity bonds, callable bonds, perpetual bonds, sinking
fund bonds, serial bonds. 5. Terms
of payment of interest. a.
Fixed interest as a fixed charge. b.
Contingent interest (payable if earned,
in income bonds). c.
Zero-interest bonds (such bonds pay no
interest, but provide accretion of discount by being issued at discount
but by paying full principal of bond at maturity).
The Internal Revenue Service, however, as of 1982 ruled that the
zero-interest bondholder must pay income tax each year on the effective
annual yield, a negative tax impact. 6.
Evidence of ownership and transfer.
Examples: coupon bonds,
registered bonds, registered coupon bonds. Bonds
may also be classified according to tax exemption, convertibility, eligibility
for investment by savings banks, insurance companies and trust funds,
eligibility for securing government deposits, etc. Bonds
may also be classified as domestic of foreign bonds, the latter including
Eurobonds and bonds payable as to principal and/or interest in specified
choice of foreign currency as well as currency of the country of issuance. Specific
kinds of bonds are described under separate titles, e.g., ADJUSTMENT BONDS,
BEARER BONDS, COLLATERAL TRUST BONDS, DEBENTURE BONDS, EXTENDED BOND,
FIRST MORTGAGE BONDS, GENERAL MORTGAGE BONDS See
BOND CIRCULAR, BOND VALUES TABLES, COUPONS, INVESTMENT, INVESTMENT MARKET,
INVESTMENT MEDIA, INVESTMENT SECURITIES. Corporate
bonds are usually issued in denominations of $1,000.
The amount shown on the bond is the face value, maturity value,
or principal of the bond. Bond
prices are usually quoted as a percentage of face value.
For example, a $1,000 bond priced to sell at $980 would be quoted
at 98, which means that the bond is selling at 98% of $1,000. The
nominal or coupon interest rate on a bond is the rate the issuer agrees
to pay and is also shown on the bond or in the bond agreement.
Interest payments, usually made semiannually, are based on the
face value of the bond and not on the issuance price.
The effective or market interest rate is the nominal rate adjusted
for the premium or discount on the purchase and indicates the actual yield
on the bond. Bonds that have
a single-fixed maturity date are term bonds.
Serial bonds provide for the repayment of principal in a series
of periodic installments. If
bonds are sold above face value, they are said to be sold at a premium.
If bonds are sold at a premium, the effective interest rate is
less than the nominal rate because the issuers received more than the
face amount of the bond but are required to pay interest on only the face
amount. If bonds are sold
below face value, they are said to be sold at a discount.
If bonds are sold at a discount, the effective interest rate paid
is more than the nominal rate since the issuer received less than the
face amount of the bonds but are required to pay interest on the face
amount. Callable
bonds are bonds that can be redeemed by the issuer at specific prices,
usually at a premium, prior to their maturity.
Convertible bonds are bonds that at the option of the bondholder
can be exchanged for other securities, usually equity securities of the
corporation issuing the bonds during a specific time at a determined or
determinable conversion rate. The
conversion price is the price at which convertible securities can be converted
into common stock. The conversion
ratio is the number of shares of common stock or other securities that
may be obtained by converting one convertible bond. Secured
bonds are bonds that have a specific claim against assets of the issuing
corporation. If the corporation
fails to make interest payments or the maturity payment, the pledged assets
can be seized by the bondholders or his/her representative.
Real estate mortgage bonds have a specific claim against certain
real property of the issuer, such as land and building.
A chattel mortgage bond has a claim against personal property,
such as the securities owned by the bond issuer, such as stocks or bonds.
Guaranteed bonds are bonds on which the payment of interest and/or
principal is guaranteed by another party.
Income bonds are bonds on which interest payments are made only
from operating income of the issuing entity.
Unsecured bonds, or debentures, are bonds the holder of which has
no claim against any specific asset(s) of the issuer or others but relies
on the general creditworthiness of the issuer for security. Senior
securities are securities that have claims that must be satisfied before
payments can be made against junior securities.
Junior securities have a lower-priority claim to asset(s) and income
of the issuer than senior securities. Registered
bonds are issued in the name of the owner and are recorded in the owner's
name on the records of the issuer.
Coupon bonds are bearer bonds that can be transferred from one
investor to another by delivery.
Interest coupons are attached to the bonds.
On interest payment dates, the coupons are detached and submitted
for payment to the issuer or an agent.
Sinking fund bonds are bonds for which a fund is established into
which periodic cash deposits are made for redeeming outstanding bonds. Bonds
may be sold by the issuing company directly to investors or to an investment
banker who markets the bonds. The
investment banker might underwrite the issue, which guarantees the issuer
a specific amount, or sell the bonds on a commission (best efforts basis
for the issuer). The
price of bonds can be determined either by a mathematical computation
or from a BOND VALUE TABLE. When
mathematics is used, the price of a bond can be computed using present
value table. The price of
a bond is: 1. The
present value at the effective rate of a series of interest payments (that
is, an annuity) and 2. The
present value of the maturity value of the bond. To
determine the price of a $1,000 four-year bond having a 7% nominal interest
rate with interest payable semiannual purchased to yield 6%, use the following
procedure: 1.
Present value of maturity value at effective
rate (3%) for 8 periods: $1,000
x .7894909 2. Present
value of an annuity of 8 interest receipts of $35 each at effective interest
rate of 3%: $35
x 7.01969 (= present value of an annuity of 1 at 3% for 8 periods)
245.69 Price
of the bond
$1,035.10 The
carrying value (or book value) of the bond issue at any time is the face
value plus any amortized premium or minus any unamortized discount.
The periodic write-off of a bond discount or bond premium adjusts
the carrying value of the bond toward the bond's face value.
Amortization of the discount increases the amount of interest expense
while the amortization of a premium decreases the amount of interest expense
reported. Credit
rating agencies, such as Standard & Poor's, Moody, and others, report
on the quality of corporate and municipal bond issues.
The reports of these agencies serve as a basis for evaluating the
risks, profitability, and probability of default on bond issues.
Bond ratings are based on various factors, including the issuer's
existing debt level; the issuer's previous record of payment; the safety
of the assets or revenues committed to paying off principal and interest;
the mortgage provisions in the bond indenture, the existence of a sinking
fund, and others. Symbols
such as AAA or Aaa (referred to as triple A) refer to the highest-quality
rating. Other symbols are
used to refer to high-quality bonds, investment grade bonds, substandard
bonds, speculative bonds, and bonds in default. Once
established, the rating on a particular issue of corporate or municipal
debt is reviewed periodically by the rating agencies.
When rating changes occur, they almost always have a substantial
effect on the market price of the securities.
Usually, when a company announces a large new public debt issue,
the rating agencies review the ratings on all of the company's outstanding
securities. To avoid triggering
such an overall rating review, companies have sometimes turned to bank
financing in the expectation of postponing a rating review until their
financial condition improves. BIBLIOGRAPHY DARST,
D.M. The Handbook of the
Bond and Money Markets. McGraw-Hill
Book Company,
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