A corporate bond is a debt that a corporation has incurred to the holder of the bond. Bonds are a fixed sum of money and that the corporation promises to repay at a future date. Also, for use of this money, the corporation agrees to pay at specified intervals (usually twice a year) interest at a stated rate. When bonds are issued, the maturity date or the date at which the company must pay the principal of the bonds is usually a long time in the future – 20 to 30 years. They are usually issued in $1,000 denominations, but denominations range from $50 to $10,000. Denominations of less than $500 are called small, or baby, bonds. In short, a bond is evidence of debt, and the bondholder is a creditor of the corporation. A stockholder, on the other hand, is a part equity owner and therefore the company is not indebted to shareholders.
The company must pay the interest and principal on bonds when due and in full. With the exception of income bonds, there is no option on the amount or the time of the payments. Failure to pay interest on principal, when due, almost always means insolvency and often the appointment of new management. Therefore, corporations make every effort to live up to their contracts by paying principal and interest.
The terms of payment are usually in legal tender, at maturity. In the early part of the twentieth century, bonds were payable in gold at maturity. But the gold clause was legislated out in 1933. Sometimes bonds are payable at the option of the holder in U.S. dollars, German marks, Swiss or French francs.
The interest is almost always payable semiannually. Further, the bondholder, as long as he or she receives their interest, does not have any voice in the management of the corporation.
The obligations of the corporation are set forth in the deed of trust or indenture drawn when the bonds are issued. The trust indenture outlines the duties of the corporation, such as paying interest, maintaining sinking funds, and keeping the property insured and in satisfactory condition. Also, it outlines the rights of the bondholder in the event of default. It also sets forth the duties and qualifications of the institution—that is, the bank or trust company with the capital funds that must act as trustee for the bondholders. Above all, the trustee must be independent of the issuing corporation. This indenture usually must be drawn in accord with the Trust Indenture Act of 1939 summarized in the appendix. Basically, this act is aimed to protect the bondholders by the appointment of an impartial, solvent and competent institutional trustee.
There are three types of yields on bonds: nominal, yield, current yield and yield to maturity.
• The nominal yield is usually the interest rate that is set when a bond is first issued. For instance, a $1,000 bond that pays $50 a year has a nominal yield of 5 percent.
• The current yield is almost always different from the nominal yield. This happens when you buy a bond in open market and not from the issuer. If interest rates have changed up or down since a bond was issued, it may sell at a premium or discount in order to make up for the change in interest rates. For instance, if an investor buys an 8% bond at $1,050, that person is investing$1,050 but is only getting $80 a year. The current yield would then be lower than 8 percent because the investor is pay more than the original $1,000 for the bond and will only receive $1,000 from the company when it comes due. The investor then loses $50 on the bond and therefore when the $50 loss is taken into consideration the bond will yield 7.169 percent instead of 8 percent. This happens if interest rates moved up since the bond was issued. The opposite happens if interest rates went down and you bought the bond in the open market.
• A bonds yield to maturity is the rate of return that an investor would earn when the bond is bought at its current market price and held it until it matures. This is the rate that most people are interested in when buying bonds in the secondary market and not directly when it is issued by a corporation.
Finally, many of the large bond issues are companies listed on the New York Stock Exchange. Some issues trade on NYSE Amex which is the old American Stock Exchange now owned by NYSE Euronext. However, most bond issues, whether listed or not, are traded through the Automated Bond System or over-the-counter.
Quote of the Week: “We have confused the free with the free and easy.”—Adlai E. Steveson
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.