| Bonds Bonds are IOUs issued by a municipality, federal government, or a
corporation. Bond owners, or holders, are said to "hold debt".
Bondholders do not own or have rights to the company.
When you buy bonds, you are loaning money to the bond issuer.
Bonds are issued for a set period of time. At the end of that time,
or at the bond maturity date.
During the time between the issue date and the maturity date,
interest payments are typically made by the issuer to the bond
holder. The amount of these payments depends on the fixed interest
rate established by the bond issuer when the bond is sold. This rate
is called a coupon rate.
Some bond holders receive periodic interest payments plus the
eventual return of principal.
Bonds may also be bought and sold to other investors before
maturity. Factors such as changing interest rates affect the value
of a bond between the issue and maturity date.
We begin our review of the principal
types of capital market securities typically owned directly by individual
investors with fixed-income securities. All
of these securities have a specified payment schedule. In most cases, such as
with a traditional bond, the amount and date of each payment are known in
advance. Some of these securities deviate from the traditional-bond format, but
all fixed-income securities have a specified payment or repayment schedule -
they must mature at some future date.
Bonds are fixed-income securities because the interest payments (if
any) and the principal repayment for a typical bond are specified at the time
the bond is issued and fixed for the life of the bond. At the time of purchase,
the bond buyer knows the future stream of cash flows to be received from buying
and holding the bond to maturity. Barring default by the issuer, these payments
will be received at specified intervals until maturity, at which time the
principal will be repaid. However, if the buyer decides to sell the bond before
maturity, the price received will depend on the level of interest rates at that
time. The par value (face value) of most
bonds is $1,000, and we will use this number as the amount to be repaid at
maturity. The typical bond matures (terminates) on a specified date and is
technically known as a term bond. Most bonds are coupon bonds, where coupon
refers to the periodic interest that the issuer pays to the holder of the bonds.
Interest on bonds is typically paid semiannually.
The most radical innovation is the format of traditional bonds is the
zero coupon bond, which is issued with no
coupons, or interest, to be paid during the life of the bond.
The purchaser pays less than par value for zero coupons and receives par
value at maturity. The difference in these two amounts generates an effective
interest rate, or rate of return. As in the case of Treasury bills, which are
sold at discount, the lower the price paid for the coupon bond, the higher the
effective return.
Issuers of zero coupon bonds include corporations, municipalities, government
agencies, and the U.S. Treasury. In 1985 the Treasury created its STRIPS, or
Separate Trading of Registered Interest and Principal of Securities. Under this
program, all new Treasury bonds and notes with maturities greater than ten years
are eligible to be "stripped" to create zero coupon Treasury securities that are
direct obligations of the Treasury.
Bond prices are quoted as a percentage of par value. By convention,
corporates and Treasuries use 100 as par rater than 1,000. Therefore, a price of
90 represents $900, and a price of 55 represents $550 using the normal
assumption of a par value of $1,000. Each "point", or a change of "1",
represents 1% of $1,000 or $10. The easiest way to convert quoted bond prices to
actual prices is to remember that they are quoted in percentages, with the
common assumption of a $1,000 par value.
The bond buyer must pay the bond seller the price of the bond as well as the
interest that has been earned (accrued) on the bond since the last semiannual
interest payment. This allows an investor to sell a bond any time without losing
the interest that has accrued. Bond buyers should remember this additional
"cost" when buying a bond because prices are quoted in the paper without the
accrued interest.
At any point in time some bonds are selling at premiums (prices above par
value), reflecting a decline in market rates after that particular bond was
sold. Others are selling at discounts (prices below par value of $1,000),
because the stated coupons are less than the prevailing interest rate on a
comparable new issue.
The call provision gives the issuer the
right to “call in” the bonds, thereby depriving investors of that particular
fixed-income security. Exercising the call provision becomes attractive to the
issuer when market interest rates drop sufficiently below the coupon rate on the
outstanding bonds for the issuer to save money. Costs are incurred to call the
bonds, such as a "call premium" and administrative expenses. However, issuers
expect to sell new bonds at a lower interest cost, thereby replacing existing
higher interest-cost bonds with new, lower interest-cost bonds.
The call feature is a disadvantage to investors who must give up the higher
yielding bonds. The wise bond investor will note the bond issue’s provisions
concerning the call, carefully determining the earliest date at which the bond
can be called and the bond’s yield if it is called at the earliest date
possible. Some investors have purchased bonds at prices above face value and
suffered a loss when the bonds were unexpectedly called in and paid off at face
value.
Some bonds are not callable. Most Treasury bonds cannot be called, although
some older Treasury bonds can be called within five years of the maturity date.
A bond has certain legal ramifications. Failure to pay either interest or
principal on a bond constitutes default for that obligation. Default, unless
quickly remedied by paying or a voluntary agreement with the creditor, leads to
bankruptcy. A filing of bankruptcy by a corporation initiates litigation and
involvement by a court, which works with all parties concerned.
U.S. Government and Agency Bonds
There are four major types of bonds in the United States based on the issuer
involved (U.S. government, federal agency, municipal, and corporate bonds), and
variations exist within each major type.
U.S. Government Bonds. The U.S.
government, in the course of financing its operations through the Treasury
Department, issues numerous notes and bonds with maturities greater than one
year. The U.S. government is considered the safest credit risk because of its
power to print money; therefore, for practical purposes investors do not
consider the possibility of risk of default for these securities. An investor
purchases these securities with the expectation of earning a steady stream of
interest payments and with full assurance of receiving the par value of the
bonds when they mature.
Treasury Bonds generally have maturities
of 10 to 30 years, although a bond can be issued with any maturity. Like
Treasury bills, they are sold at competitive auctions; unlike bills, they are
sold at face value, with investors submitting bids on yields.
Interest payments (coupons) are paid semiannually. Face value
denominations are $1000, $5000, $10,000, $100,000, $500,000, and $1 million.
Federal Credit Agencies. Since the 1920s,
the federal government has created various federal agencies designed to help
certain sectors of the economy, through either direct loans or guarantee of
private loans. These various credit agencies compete for funds in the
marketplace by selling government agency securities.
There are two types of federal credit agencies: federal agencies and
federally sponsored credit agencies. Legally, federal agencies are part of the
federal government and their securities are fully guaranteed by the Treasury.
The most important “agency” for investors is the Government National Mortgage
Association (often referred to as "Ginnie Mae").
In contrast to federal agencies that are officially a part of the government,
federally sponsored credit agencies are privately owned institutions that sell
their own securities in the marketplace in order to raise funds for their
specific purposes. Although these agencies have the right to draw on Treasury
funds up to some approved amount, their securities are not guaranteed by the
government as to principal or interest. Nevertheless, the rapidly growing agency
market is dominated by these federally sponsored credit agencies, which include
the Federal National Mortgage Association, the Federal Home Loan Mortgage
Corporation, the Federal Home Loan Ban,, the Farm Credit System, and the Student
Loan Marketing Association.
Perhaps the best known of these federally sponsored agencies is the Federal
National Mortgage Association (FNMA, typically referred to as "Fannie Mae"),
which is designed to help the mortgage markets. Although government sponsored,
it is now a privately owned corporation, and its securities are not a direct
obligation of the U.S. government. A variety of Fannie Mae issues are available,
with maturities ranging from short term to long term.
The Federal National Mortgage Association, the Government National Mortgage
Association, and the Federal Home Loan Mortgage Corporation (Freddie Mac) issues
and guarantee securities backed by conventional mortgages bought from lenders.
These securities are pat of the rapidly growing market of fixed-income
securities known as asset-back securities, which are discussed separately below.
Federal agency securities can be though of as an alternative to U.S. Treasury
securities from the investor’s standpoint. The feeling in the market-place seems
to be that the Treasury would not stand by and permit a government-sponsored
agency to default; however, they have to be viewed as having slightly8 greater
default risk. Also, longer term issues may trade less frequently8 than
comparable Treasury bonds. Together, these two factors cause these securities to
carry slightly higher yields than Treasury securities of comparable maturity.
Municipal Bonds
Bonds sold by states, counties, cities, and other political entities (e.g.,
airport authorities, school districts) other than the federal government and its
agencies are called municipal bonds. There are roughly 50,000 different
issuers with roughly 1.5 million different issues outstanding and credit ratings
ranging from very good to very suspect. Thus, risk varies widely, as does
marketability. Overall, however, the default rate on municipal bonds has been
quite favorably compared to corporate bonds.
Two basic types of municipals are general obligation bonds, which are
repaid from the revenues generated by the project they were sold to finance
(e.g., a toll road or airport improvement). In the case of general obligation
bonds, the issuer can tax residents to pay for the bond interest and principal.
In the case of revenue bonds, the project must generate enough revenue to
service the issue.
Most long-term municipals are sold as serial bonds, which means that a
specified number of the original issues mature each year until the final
maturity date. For example, a 10-year serial issue of the municipals might have
10 percent of the issue maturing each year for the next 10 years.
The distinguishing feature of most municipals is their exemption from federal
taxes. Because of this feature, the stated rate on these bonds will be lower
than that on comparable nonexempt bonds. The higher an investor’s tax bracket,
the most attractive municipals become. To make the return on these bonds
comparable to those of taxable bonds, the taxable equivalent yield (TEY)
can be calculated. The TEY shows the interest rate on taxable bonds necessary to
provide an after-tax return equal to that of municipals. The TEY for any
municipal bond return and any marginal tax bracket can be calculated using the
following formula:
An investor in the 28 percent marginal tax bracket who invests in a 5 percent
municipal bond would have to receive...
0.05/(1 - 0.280) = 6.94%
... from a comparable taxable bond to be as well off.
In some cases, the municipal bondholder can also escape state and/or local
taxes. For example, a North Carolina resident purchasing a bond issued by the
state of North Carolina would escape all taxes on the interest received.
Corporate Bonds
Most of the larger corporations, several thousand in total, issue
corporate bonds to help finance their
operations. Many of these firms have more than one issue outstanding. Although
an investor can find a wide range of maturities, coupons, and special features
available from corporates, the typical corporate bond matures in 20 to 40 years,
pays semiannual interest, is callable, carries a sinking fund, and is sold
originally at a price close to par value, which is almost always $1000.
Corporate bonds are senior securities.
That is, they are senior to any preferred stock and to the common stock of a
corporation in terms of priority of payment and in case of bankruptcy and
liquidation. However, within the bond category itself there are various degrees
of security. The most common type of unsecured bond is the
debenture, a bond backed only by the issuer’s overall financial
soundness. Debentures can be subordinated, resulting in a claim on income that
stands below (subordinate to) the claim of the other debentures.
Foreign Bonds
Why would one consider foreign bonds for inclusion in their portfolios?
One reason is that at times foreign bonds may offer higher returns at a
given point in time than alternative domestic bonds. Each country has its
own economy and inflation and interest rates can vary dramatically from
country to country depending upon the current stages of economic condition.
A second important reason for buying foreign bonds is the
diversification aspect. Diversification is extremely important, both in a
stock portfolio and a bond portfolio. Bond prices in some foreign countries
may be rising at the same time that U.S. bond prices are declining.
Keep in mind that investors rarely receive an advantage through an investment
without at least some disadvantage being present. One of the disadvantages an
investor faces is the difficulty of investing directly in foreign bonds. It is
relatively costly and can be time-consuming. Selling foreign bonds that are
directly owned also can be a problem. Secondary markets in foreign countries are
not comparable to the large bond markets in the U.S. This means that individual
investors selling small amounts of foreign bonds abroad will typically incur
significant price concessions. Investors who are considering direct investment
in foreign bonds face the additional issue of transaction costs. Dollars must be
converted into the foreign currency to make purchases, and receipts from the
foreign bonds must be converted back into dollars. On small transactions, these
costs can significantly impact returns. These problems can generally be overcome
by investing in mutual funds that hold foreign bonds. Regardless of whether the
investment is made direct or through mutual funds, investors of foreign bonds
must always deal with exchange rate risk. An adverse movement in the dollar can
result in an American investor’s return being lower than the return on the
asset, or even negative.
Convertible Bonds
Convertible bonds have a built-in conversion feature. The holders of these
bonds have the option to convert whenever they choose. Typically, the bonds are
turned in to the corporation in exchange for a specified number of common
shares, with no cash payment required. Convertible bonds are two securities
simultaneously: a fixed-income security paying a specified interest payment and
a claim on the common stock that will become increasingly valuable as the price
of the underlying common stock rises. Thus, the prices of convertibles may
fluctuate over a fairly wide range, depending on whether they currently are
trading like other fixed-income securities or are trading to reflect the price
of the underlying common stock.
Investors should not expect to receive the conversion option free. The issuer
sells convertible bonds at a lower interest rate than would otherwise to paid,
resulting in a lower interest return to investors.
Asset-backed Securities
The money and capital markets are constantly adapting to meet new
requirements and conditions. This has given rise to new types of securities that
were not previously available.
Securitization refers to the transformation of illiquid, risky
individual loans into more liquid, less risky securities referred to as
asset-backed securities (ABS). The best
example of this process, the mortgage-backed securities issued by the
federal agencies mentioned above, such as Ginnie Mae, are securities
representing an investment in an underlying pool of mortgages.
The federal agencies discussed earlier purchase mortgages from banks and
thrift institutions, repackage them in the form of securities, and sell them to
investors as mortgage pools. Investors in mortgage-backed securities are, in
face, purchasing a piece of a mortgage pool, taking into consideration such
factors as maturity and the spread between the yield on the mortgage security
and the yield on 10-year Treasuries (considered a benchmark in this market).
Investors in mortgage-backed securities assume little default risk because most
mortgages are guaranteed by one of the government agencies. However, these
securities present investors with uncertainty because they can receive varying
amounts of monthly payments depending on how quickly homeowners pay off their
mortgages. Although the stated maturity can be as long as 40 years, the average
life of these securities to date has been much shorter.
Ginnie Mae issues are well known to investors. This wholly owned government
agency issues fully backed securities (i.e., they are full faith and credit
obligations of the U.S. government) in support of the mortgage market. The GNMA
pass-through securities have attracted considerable attention in recent
years because the principal and interest payments on the underlying mortgages
used to collateralize them are "passed through" to the bondholder monthly as the
mortgages are repaid.
As a result of the trend to securitization, other asset-backed securities
have proliferated as financial institutions have rushed to securitize various
types of loans.
Marketable securities have been backed by car loans, credit-card receivables,
railcar leases, small-business loans, photocopier leases, aircraft leases, and
so forth. The assets that can be securitized seem to be limited only by the
imagination of the packagers, as evidenced by the fact that by 1996 new asset
types include royalty streams from films, student loans, mutual fund fees, tax
liens, monthly electric utility bills, and delinquent child support payments.
Who do investors like these asset-backed securities? The attractions are
relatively high yields and relatively short maturities (often, five years)
combined with investment-grade credit ratings, typically the highest two ratings
available. Investors are often protected by a bond insurer. Institutional
investors such as pension funds and life insurance companies have become
increasingly attracted to ABS because of the higher yields, and foreign
investors are now buying these securities more often.
As for risks, securitization works best when packaged loans are homogeneous,
so that income streams and risks are more predictable. This is clearly the case
for home mortgages, for example, which must adhere to strict guidelines. This is
not the case for some of the newer loans being considered for packaging, such as
loans for boats and motorcycles; the smaller amount of information results in a
larger risk from unanticipated factors.
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