Bonds are among the oldest and most important financial instruments. They are simply a tradable form of a loan — an IOU that represents a loan agreement between the issuer as borrower and the investor as lender. They require the payment of specified interest periodically, usually semiannually in the U.S. and annually elsewhere and the repayment of principal amount when due at final maturity.
Bonds have been in use almost since the beginning of commerce and industry centuries ago and are a primary medium of borrowing by governments and corporations. Their vital role in the creation of credit and capital is evidenced by the staggering amount in existence.
Corporations tend to issue bonds instead of stock because bonds don’t dilute the value of their equity (stock) outstanding and the interest paid on the bonds is tax deductible. Governments sell bonds to finance major new projects as well as ongoing operations.
Bonds and other similar debt securities such as notes, debentures and certificates are a more senior obligation than common stock or preferred stock. They have a priority claim on the issuer’s assets in the event of a financial crisis such as a severe cash-flow shortage or bankruptcy. In other words, bondholders are paid first and foremost above shareholders.
The bondholder’s relationship to the issuer differs from that of the stockholder, who is in effect a part owner and thus dependent for reward on the issuer’s operating performance. The bondholder, by contrast, is an objective outsider who cares only if their loan payments are met on time.
Bonds, also known as fixed-income securities because they provide a steady and predictable investment return, are favored by conservative investors from individuals nearing retirement to actuarial institutions such as pension funds and insurance companies to meet their own periodic payouts.
The bond market contains an extraordinary variety of securities differing by types of issuer, lengths of maturity and degrees of credit quality. Ever newer kinds are being created continuously to meet the increasing needs of an expanding and more sophisticated global investment community.
There are three basic types of bonds, however: Treasury and other federal agency bonds, such as those issued by the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Bank Board (FHLBB) and Government National Mortgage Association (Ginnie Mae); those issued by corporations; and those issued by states and other local government entities.
Money market instruments include treasury bills, bank certificates of deposit, corporate commercial paper, bankers’ acceptances and tax-exempt notes. They mature in one year or less and are very liquid, meaning they can be bought or sold quickly, making them a favored temporary shelter for investors during periods of general market turmoil.
Treasury securities are the safest and most marketable in the world; hence, they are the benchmark against which all other types of bonds tend to be measured. Although their market value fluctuates, they are considered to be free from payment risks due to their backing by the U.S. government.
Corporations sell mortgage bonds, senior and subordinated debentures, equipment trust certificates, collateral trust bonds, convertible bonds, income bonds and notes. Their preferred stock, although a form of equity like common stocks, are widely viewed as a bond substitute because they generally pay a fixed dividend.
State and local government bonds fall into two broad classes. General obligation bonds are secured by the issuer’s taxing authority. Revenue bonds are backed by the income from public facilities such as toll highways and bridges, airports and convention centers.
Finally, foreign governments and companies also offer bonds in the U.S. public market. Their issues, known as Yankee bonds, are subject to the same regulatory requirements as those of domestic entities.
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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.