Bonds are long-term
debt instruments used by business firms and governments
to raise money. Most bonds pay interest semiannually
at a stated interest rate with
an initial maturity of 10 to 30 years
with a face value of $1,000 that must
be repaid at maturity.
A company sells its bonds, in the sense that
it gives a promise of future payments in return
for current cash.
Private issues are sold to
a small group of investors, often big institutional
investors like mutual funds and insurance companies.
These bonds can trade among institutional investors
in private markets. Under the federal securities
laws, formal disclosure is not required for
privately-issued bonds.
Public issues are sold to
dispersed investors, usually through an underwriting
syndicate of securities firms. These bonds often
trade in public markets, such as the NYSE. The
federal securities laws require that publicly-issued
bonds be registered with the SEC, and issuers
must provide investors an extensive disclosure
document known as a "prospectus".
There are different types of bonds:
- Mortgage bonds are backed
by real assets pledged as security.
- Debentures are not backed
by any security.
- Subordinate bonds can only
be paid after senior obligations are satisfied.
- Convertible bonds offer the
investor the option to convert bonds to shares
of the firm's equity.
- Income bonds are so named
because interest payments are only made if the
company generates sufficient income.
- Zero coupon bonds pay no
coupons, and their return is purely from purchasing
at a discount.
- Floating rate bonds are so
named because the coupon rate is tied to some
basic rate such as T-bill rates. These provide
protection against inflation and interest rate
risk and keep bonds selling close to their par
values.
- Puttable bonds offer the
option of returning the bonds at face value.
- Junk bonds are high risk,
high return bonds. Typically, these are issued
by lower-rated entities and are often tied to
mergers or leveraged buyouts.
Nature of corporate bonds.
Most bonds state that the issuer (sometimes called
the “borrower” or “seller”)
agrees to pay the buyer (sometimes called the “investor”
or “lender”) a series of fixed interest
payments. Usually these payments are to be made
every six months (semiannually) until the bond matures.
To determine the amount of interest that a bond
pays, simply multiply its coupon rate times the
bond’s par value (sometimes called its “face
value” or "principal”).This par
value is usually $1,000 and is printed on the bond.The
coupon rate is also printed on the bond and does
not change during the bond’s life.
For example, if General Electric issues a bond
whose coupon rate is 10%, this means that the
bond pays the buyer 0.10 × 1,000 or $100
per year. Because the interest payment is made
semiannually, the buyer actually receives $50
every six months.Despite the fact of semiannual
payment, the coupon rate is always stated on annual
basis.
The bond will also state its maturity date.On
that date the issuer will make the last interest
payment and also pay the buyer the par value or
principal. If the General Electric bond matures
in 10 years and has a 10% coupon rate, the company
will pay the buyer $50 every six months for 10
years plus $1,000 at the end of the tenth year
(or 20th period).
What price will the buyer pay for this stream
of interest payments and single principal payment?
Don’t assume that price will be the par
value.Rather, the bond will be sold for the prevailing
market price—that is, how much the buyer
is willing to pay for the particular issuer’s
promise to make the bond payments.This will be
a present value calculation, and its determination
will depend on several factors, primarily the
risk of the investment as perceived by the bond
purchasers.General Electric, with its long history
of profitability and quality management, will
have a better credit rating than the newly founded
“Jack’s Light Bulb and Jet Engine
Company.” Because bricks and mortar booksellers
are currently more profitable and stable than
online booksellers, Barnes & Noble will be
seen as a safer investment than Amazon. Accordingly,
the buyer will likely value GE’s and Barnes
& Noble’s bonds more highly than Jack’s
or Amazon’s bonds.
Government bonds. The same comparisons
can be made in the public sector. Governments that
are fiscally disciplined and well managed are seen
as better credit risks.This is why you’ll
often hear elected officials touting their government’s
“AAA” or otherwise high credit rating.They’re
simply referring the power of their city, state,
or other entity to raise public money through bonds
on the most favorable terms. |
Bond Terminology
Coupon
rate ... |
... is another name for interest
rate. This terms comes from when interest
was paid by clipping a coupon from the bottom
of the bond certificate. |
Notes ... |
... refer to shorter-term debt instruments,
with maturities typically less than five
years; bills refer to shorter-term debt
instruments issued by governments, the most
famous being U.S. Treasury bills. |
Par value ... |
... is the bond's face value (or principal);
under older corporate law, it refers to
the uniform price all investors must pay
for the bond. |
Maturity... |
... .is the date the firm promises to
repay the par value of the bond. The bond
ceases to exist at the maturity date. |
Par value .... |
... is the bond's face value or principle
amount. This is the amount the firm promises
to pay at maturity (usually $1,000). Under
older corporate law, it refers to the uniform
price all investors must pay for the bond. |
Indenture... |
...is the debt contract that includes
the details of the issue such as the repayment
provisions and restrictive covenants. |
Debt ratings ... |
.....are the "grades" assigned
to a bond issue reflecting an assessment
of that issue's risk. The most prevalent
rating agencies are Moody's and Standard
and Poor's. For example, Moody's rates
issues from Aaa (the best) to C, which
means the issue has "an extremely
poor prospect of every attaining any real
investment standing."
See the attached description of Moody's
rating system. |
|
Debt ratings. Are
debt ratings worth it? See Frank
Partnoy, The Siskel and Ebert of Financial Markets:
Two Thumbs Down for the Credit Rating Agencies,
77 Wash U L Q 619-712 (1999).
This paper critiques the role of credit ratings
and credit rating agencies in providing information
about bonds. The dominant "reputational
capital" view of credit rating agencies
is that the agencies have survived and prospered
since the early 1900s based on their ability
to accumulate and retain reputational capital
(i.e., good reputations) by providing valuable
information about the bonds they rate. The paper
argues that this view fails to explain, and
is inconsistent with, certain types of market
behavior including: the estimation of credit
spreads, the number of credit ratings-driven
transactions, and the explosion in use of credit
derivatives.
In place of the reputational capital view,
the paper offers a "regulatory license"
view of rating agencies as generating value,
not by providing valuable information, but by
enabling issuers and investors to satisfy certain
regulatory requirements. The paper concludes
that regulators should eliminate regulatory
dependence on credit ratings by substituting
a regime based on market-determined bond credit
spreads (i.e., the difference between the yield
on a bond and the yield on a risk-free bond
of comparable maturity). Such credit spreads
reflect all available information, including
credit ratings, and therefore are more accurate
and reliable than credit ratings.
See also Frank Partnoy, The
Paradox of Credit Ratings (2001).
The SEC is planning to issue a concept
release on information flow, conflicts of interest
as they affect credit rating agencies. |
4.2 Bond Valuation