Negotiable Financial Instruments > This page
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 semiannually 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 witnesses or seal. The bond, on the other hand, in its old common-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 deviding 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 stockholder 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:
Character of obligor
Examples: government bonds, state bonds, municipal bonds.
Purpose of issue
Examples: equipment bonds, improvement bonds, school bonds, terminal bonds, refunding bonds, adjustment bonds.
Character of security
Examples: civil bonds, corporate debentures.
Terms of payment of principal
Examples: straight maturity bonds, callable bonds, perpetual bonds, sinking fund bonds, serial bonds.
Terms of payment of interest
as a fixed charge.
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 or 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.
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.
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 Values
Table. When mathematics is used, the price of a bond can be computed
using present value table. The price of a bond is:
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:
Present value of an annuity
of 8 interest receipts of $35 each at effective interest rate of 3%:
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 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 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.
Although the various stock exchanges list bonds, the principal markets for bonds U.S. Government, federal agency, international and foreign, state and municipal, and corporate are the over-the-counter markets, with markets made and trading carried on by bond houses tending to specialize in trading as well as underwriting in one or more of these sectors. Commercial banks of larger size are also found in this field as bank dealers, underwriting and trading U.S. Government and general obligation state and municipal securities.
The bond market is predominantly institutional, with commercial banks particularly heavy investors in state and local government issues.
The above trends reflect the restriction of savings institutions largely to the bond market by statutes and administrative regulations and, on the other hand, their low motivation because of light taxability to invest in state and municipal issues, which are exempt (as to their interest income) from the federal income tax. Commercial banks however, are subject to federal income taxes, and thus have found the tax exempts to be attractive in recent years in view of higher volume of time and savings deposits and the higher interest rates paid on such deposits.
By contrast, pension funds, investment companies, and individuals in recent years have shown relatively light increases in ownership of straight bonds, reflecting their investing preferences for convertible bonds and debentures and for common stocks directly.
Measures or yardsticks of investment quality, i.e., of business risk and financial risk present in bonds. The principal rating agencies publishing ratings on bonds are Moody's (a subsidiary of Dun & Bradstreet, the latter itself specializing in municipal bond ratings) and Standard & Poor's (a subsidiary of McGraw Hill Inc.).
Standard & Poor's Corporation, Moody's Investors Service, and Fitch Publishing Company provide quality ratings for corporate bonds, expressed in alphabetical letter grades, ranging from the highest quality designation to successively lower levels of investment quality down to speculative and in default. Bond ratings are value judgments as to possibility of default and encompass comprehensive analyses of earning power and financial condition. Although banks, in the Investment Securities Regulation of the Comptroller of the Currency, are no longer to be primarily reliant upon such bond ratings, nevertheless by analogy the four highest ratings are considered to indicate bonds eligible for investment by banks.
U.S. Government bonds are not rated, but are considered as a yardstick against which to measure all other issues. Beyond figures on the company's probable future earning power, its financial resources, its property protection (encumbrance of property by other debt), and the bond's indenture provisions, data for ratings are supplemented by managerial facts obtained from top management (e.g., product planning, research goals, expansion plans, etc.).
Revenue bonds of municipalities, which are not full faith and credit obligations and depend for debt service upon profitability of the facilities involved, are akin to corporate obligations in their dependence upon revenue trends, operating ratios, and earnings coverage's of debt service. Although it is still conventional in analysis of general obligations to compute quantitative ratios, rating of municipal bonds is even more of an art than rating of corporate obligations. Quantitative ratios such as net debt to full assessed valuation, net debt per capita, and debt service percentage of operating budget have decreased in relevancy in recent years, especially for the larger municipalities, for the following reasons:
the changed composition of
sources of revenues, the property tad decreasing in importance while reliance
upon federal and state grants-in-aid has been increasing proportionately;
the operating budgets that provide for such social services and aid rising faster than the debt service, so that this ratio has actually declined in many instances. Instead, qualitative factors have assumed increased importance, such as trends and structural diversification of business and industry, and internal versus external sources of revenues and their relative stability. Overall, the quality of the municipality's administration in facing the numerous social and economic problems is crucial.