Bonds

Bonds, often used as a generic term, are characterized by a long-term life cycle. The bond rights are specified in the bond indenture often referred to as the “teeth”. Bonds contain options for the buyer and seller to terminate the bond. The cash flow of the bond is fixed meaning at a prescribed rate, or floating meaning the rate will regularly fluctuate. Bonds are repaid at the maturity date. Bonds can be sold at a premium meaning the market price is higher than the face value of the bond, at a discount meaning the market price is lower than the face value of the bond, or par meaning the market price is equal to the face value of the bond.

Bond covenants are contractual provisions which as stated in the bond indenture require or limit specified actions. The bond covenant states a bond is considered in default if any one of the covenants is violated in which case an investor can get his or her money back. Specifically, an asset covenant governs the firm’s acquisition, use, and disposition of assets. Dividend covenants restrict the firm’s payment of dividends. Financing covenants restrict the firm from incurring additional debt or loans.

A secured bond is backed by a specific asset, a mortgage bond is backed by real property, a collateral trust bond is backed by other bonds or common stock, an equipment trust bond is backed by equipment such as an engine or railroad car, and a debenture is an unsecured bond with no specific backing.

Bonds are callable meaning the issuing corporation can call back the bond when desired. In the situation where the interest rate has decreased, the bond would be called in order to refinance with higher interest rate bonds. Bonds are also putable meaning the buyer can put the bond back to the corporation in return for his or her money. Bonds are convertible meaning the owner can exchange for a more junior security (i.e. common stock). Bonds are exchangeable meaning a bond may be returned in order to purchase a different type of bond.

Straight coupon bonds pay flat interest payments for life and face value at maturity. Zero coupon bonds sell at a discount because there are no interest payments. Deferred coupon bonds defer interest payment obligations for a period. Perpetuity bonds pay interest forever with no interest paid at maturity. Annuity bonds pay a mix of interest and principle over the life of the bond. Annuity bonds are similar to a mortgage in which there is no balloon payment.

Treasury bonds are appealing to the risk adverse investor because the likelihood of default is not a concern as these are backed by the US government. An investor does however face the risk of interest rate inflation. Doe to the uncertainty in the stock market, many investors prefer to invest in individual treasury securities. Learn more about individual securities at http://www.treasurydirect.gov/indiv/products/products.htm.