What Are Bonds?

The term “stocks and bonds” is commonly used by those referring to investment instruments, but there are fundamental differences between these types of investments. Both stocks and bonds are offered by companies seeking to raise capital, but bonds can also be issued by the government (at all levels) and even by local power districts. While stocks offer investors an equity interest in the company, effectively making each stockholder an owner of the company, bonds are debt instruments which make each bondholder a creditor of the company. Stocks can be held for an unlimited time, while bonds have a limited life. In addition, stocks offer dividends (cash payments) declared each year, while bonds offer investors fixed payments of interest. Both stocks and bonds are sold in a secondary market, and both are used to build mutual funds. This will examine the basic issues associated with bonds, particularly corporate bonds, although much of the same analysis can apply to municipal bonds.

When a company issues a bond, specific conditions are identified as part of the bond. This includes the amount of the bond (par value), the interest rate (coupon rate), the dates on which interest payments will be made over the life of the bond, and the date on which the capital (principal) will be paid to investors (the maturity date). Bonds can also be callable, which means that the company can redeem the bond earlier than the maturity date. The coupon rate is so called because coupons are used to redeem the interest payments from the issuer. Bonds which do not pay any interest over the life of the bond are called zero coupon bonds. These bonds are issued at a discount, and the interest accrues over the life of the bond such that par value is paid at maturity. Generally, bonds are issued in $1,000 denominations, and the last zero is dropped when referring to bond prices. Thus, a $1,000 bond is said to sell at 100 when it has no premium or discount.

The yield of a bond is the percentage of the bond value that the bondholder receives each year. Thus, a bond with a par value of $1,000 and a promise of $80 interest per year has a nominal yield (coupon yield) of 8 percent. However, bonds do not always yield the state (nominal) percentage. While the face value of the bond is what will be redeemed at maturity, the market value of a bond may move up or down during the life of the bond. The current market value of a bond may be higher (at a premium) or lower (at a discount) than the par value because of the demand for the bond (present value of a future stream of payments also affects prices).

The current yield of a bond, which gives investors a better picture of how the bond is currently performing and allows them to compare it to other types of investments, is calculated by dividing the amount of annual interest by the current value of a bond. Thus, a bond with a nominal rate of 8 percent and a current value of $1,040 has a current yield of 7.69 percent, which is below the nominal rate. This decline occurs because the bond is currently selling at a premium ($1,040) over its par value ($1,000).

When investors refer to yield, they often use the term to represent yield to maturity. This calculation takes into account any discount or premium that might have been paid for the bond as well as any interest payments that will be received during the time that the bond is held. Thus, the yield for a bond purchased for 96 with a nominal rate of 6 percent should include not only the $60 per year to be received in interest over the time the bond is held, but also the $40 profit that will be received when the $1,000 is finally paid at maturity (Hylton 1996). Bond yield tables have been developed to enable investors to calculate quickly the yield to maturity for various nominal yields, costs and years to maturity.

As with stocks, newly issued bonds typically sell for their par value; however, once bonds have been available for some amount of time (sometimes only a few hours), their prices begin to fluctuate. This is because bonds are sold on secondary markets (as are stocks), and those markets have an effect on the price of a bond. The market price of a bond can increase or decrease because it is the only component of a bond which can do so. The maturity date is fixed (except in the case of callable bonds), the interest rate is fixed, so the price is the only component which can vary in the market.

One of the primary reasons that bond prices fluctuate is the prevailing interest rate. This rate represents the interest that investors could receive on other investment instruments. When interest rates fall, bonds with higher coupon rates sell at a premium because they represent a high rate of return compared to the rest of the economy. When interest rates rise, bond prices fall because the incremental rate of return is smaller.

Prevailing economic conditions are not the only influences on bond prices, however. The company’s own ability to meet its obligations is also a critical factor affecting bond prices. A company which has a high level of outstanding debt, for example, may be considered a poor risk with regard to bonds because it not only must pay the par value of the various issues it has outstanding, but also must make the interest payments on each of those issues. If a company is highly leveraged (has a high level of debt), a downturn in its revenues could affect its ability to meet its obligations.

Similarly, a company which is going through difficult times because of reorganization or a downturn in demand for its product may be unable to support a debt issue even if it is not otherwise highly leveraged. This is because the company needs a strong revenue stream in order to support the coupon payments, and it also must be able to redeem the issue at the maturity date.

Since many factors can affect any one company’s ability to meet its obligation and since the company’s financial condition can change over time, for investors to maintain accurate information on specific bonds can be a cumbersome activity. Because of this, rating services have evolved which evaluate conditions affecting particular companies and their issues. A favorable rating can positively influence the market price of a bond, while a negative rating negatively affects the bond price.

Moody’s Investors Service and Standard & Poor’s Corp., both based in New York, are two of the most often cited ratings organizations. These companies research bond issuers and industry factors which might affect the companies’ ability to repay their bonds. Since much of the information is provided by the issuers themselves, investors must be wary of relying too much on these rating services. However, their long history and their consistency in their rating standards provide a measure by which bond prices can be affected.

For example, a company might issue a bond in order to finance a new product. After some time, sales for that product might not have
materialized to the level originally anticipated, and the profits for the company might not be as high as originally projected. The ratings services are likely to lower their ratings for the bond because the risk associated with the bond has increased (because of lower profits). This is likely to lower the price of the bond, resulting in a higher yield.

Ratings services do not offer specific buy or sell opinions; instead, they offer risk assessment of various issues. In some cases, bonds issued by the same company can have different ratings associated with them depending on the type of bond issued and the prevailing conditions. In this way, investors can use the ratings provided by these services combined with the investors’ own risk tolerances to make investment decisions.

Bonds that are considered high risk often can be purchased at low prices because of the risk factor; this results in a high yield for those investors willing to bear the risk. So-called junk bonds gained much attention in the 1980s when companies such as Drexel Burnham Lambert and individuals such as Michael Milken steered their clients into these bonds. However, investors who do not fully appreciate the risk associated with the high yields may find that they are holding worthless bonds when companies are unable to meet their obligations.
As with other types of investments, investors can issue contracts to buy or sell a particular bond at a particular price on a particular date. If the market value of the bond increases and the contract is for a sell, the investor makes money. If, however, the market value drops, the investor loses money. The reverse is true for a buy contract. Bond contracts are sophisticated investment instruments which anticipate changes in ratings and in the investment market as a whole and which are not good instruments for the casual investor.

Bonds offer companies a way to raise capital without diluting their equity holdings, and they give public agencies a way to raise capital that otherwise would not be available. Investors in bonds can rely on ratings services and their own expertise to determine the risk associated with these loans, and bonds can be a strong part of a diversified portfolio. However, the risk associated with bonds should not be understated, and investors who pursue high-yield bonds must be able to bear high risk, as well.

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