A bond is an IOU, a record of the loan and the terms of repayment. Unlike stockholders, who have equity, or part ownership in a company, bondholders are creditors. The bond is an IOU, or a record of the money they’ve lent and the terms on which it will be repaid.
Until 1983, all bondholders received certificates that detailed this information. Bearer bonds had coupons attached to the certificate; when it was time to collect an interest payment, the investor (or bearer) detached the coupon and redeemed it. That’s why a bond’s interest rate is known as its coupon rate.
Although new bonds aren’t usually issued in certificate form, there are thousands of investors still holding bond certificates. Today most new bonds are registered and stored electronically, like stock purchases. They’re called book-entry bonds. In addition, bonds are registered by the insurer and carry an identifying number. The owner’s name also appears.
On the face of a bond are a number of important notations. The issuer is the corporation, government or agency that issues the bond. It is identified by name and often by a symbol or logo. Its official seal authenticates the bond’s validity. When a company issues bonds the documents have the same design as the company’s stock certificates. And they are protected against counterfeiting in the same way, with special paper, elaborate borders and intaglio printing.
Interest is the percentage of par value that is paid to the bondholder on a regular basis. For example, a $1,000 bond that pays 9.5 percent yields $95 a year. If the original buyer holds the bonds to maturity, the yield (or return on investment) is also 9.5 percent a year. However, if the bond is traded, the yield could change even through the interest rate stays the same. For example, if an investor buys the bond for $1,100 in the secondary market, the interest will still be $95 a year, but the yield will be reduced to 8.6 percent, because the new owner paid more for the bond. As interest rates rise the price of bonds fall and as rates go lower, bond prices go higher.
Par value or the dollar amount of the bond at the time it was issued, appears several times on the face of the bond. Par value is the amount that will be repaid at maturity. Most bonds are sold in multiples of $1,000.
Finally maturity date is the date the bond comes due and must be repaid. A bond can be bought and sold in its lifetime for more or less than par value, depending on market conditions. Whoever owns the bond at maturity is the one who gets par value back.
Investors want to know the risks in buying a bond before they take the plunge. Rating services measure those risks and generate reports. Bond investors want to be reasonably sure that they’ll get their interest payments on time and their principal back at maturity. It’s almost impossible for an individual to do the necessary research. But rating services make a business of it. The best-known services are Standard & Poor’s and Moody’s.
Issuers rarely publicize their ratings, unless they are top of the line. So investors need to get the information from the rating services themselves, the financial press or their brokers.
The rating services pass judgment on municipal bonds, all kinds of corporate bonds and international bonds. U.S. Treasury bonds are not rated — the assumption is that they’re obligations of the federal government, backed by its full faith and credit. This means the government has the authority to raise taxes to pay off its debts.
A credit rating not only indicates an issuer’s ability to repay a bond, but it also influences that yield on a bond. In general, the higher the bond’s rating, the lower its interest rate will tend to be. For example, issuers of higher-rated bonds don’t need to offer high interest rates; their credibility does part of the selling for them. But issuers of lower-rated bonds need to offer higher rates to entice investors. Junk bonds, for example, pay high interest, since they’re rated very low because of their risk.
One danger bondholders face is that a rating service may downgrade its rating of a company or municipal government during the life of a bond, creating a fallen angel. That happens if the issuer’s financial condition deteriorates, or if the rating service feels a business decision might have poor results. If downgrading occurs, investors instantly demand a higher yield for the existing bonds. That means the price of the bond falls in price in the secondary market. It also means that if the issuer wants to float new bonds, the bonds will have to be offered at a higher rate to attract buyers.
Quote of the Week: “Life improves slowly and goes wrong fast, and only catastrophe is clearly visible.” — Edward Teller
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.