Reading: Lesson 1 - Key Characteristics of Bonds

5.1.A - Key Characteristics of Bonds

1. Bonds

1. Growing companies must acquire land, buildings, equipment, inventory, and other operating assets. The debt markets are a major source of funding for such purchases. Therefore, every manager should have a working knowledge of the types of bonds that companies and government agencies issue, the terms that are contained in bond contracts, the types of risks to which both bond investors and issuers are exposed, and procedures for determining the values of and rates of return on bonds.
   
2. A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. For example, on January 5, 2013, a firm. issued $200 million of bonds. For convenience, we assume that this firm sold 200,000 individual bonds for $1,000 each. Actually, it could have sold one $200 million bond, 10 bonds with a $20 million face value, or any other combination that totals to $200 million. In exchange for $200 million, the firm promised to make annual interest payments and to repay the $200 million on a specified maturity date.
   
3. Investors have many choices when investing in bonds, but bonds are classified into four main types: Treasury, corporate, municipal, and foreign. Each type differs with respect to expected return and degree of risk.
   
4. Treasury bonds, sometimes referred to as government bonds, are issued by the U.S. federal government. It is reasonable to assume that the federal government will make good on its promised payments, so these bonds have almost no default risk. However, Treasury bond prices decline when interest rates rise, so they are not free of all risks. Federal agencies and other government-sponsored entities (GSEs) include the Tennessee Valley Authority, the Small Business Administration, Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System, among others. Agency debt and GSE debt are not officially backed by the full faith and credit of the U.S. government, but investors assume that the government implicitly guarantees this debt, so these bonds carry interest rates only slightly higher than Treasury bonds. In 2008, the implicit guarantee became much more explicit as the government placed several GSEs into conservatorship, including Fannie Mae and Freddie Mac.
   
5. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasury bonds, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and the terms of the specific bond. Default risk is often referred to as “credit risk,” and the larger the credit risk, the higher the interest rate the issuer must pay.
   
6. Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds, munis have default risk. However, munis offer one major advantage: The interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk.
   
7. Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are, of course, exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if a U.S. investor purchases a corporate bond denominated in Japanese yen, and if the yen subsequently falls relative to the dollar, then the investor will lose money even if the company does not default on its bonds.
   

2. Key Characteristics of Bonds

1. The par value is the stated face value of the bond; for illustrative purposes, we generally assume a par value of $1,000. In practice, some bonds have par values that are multiples of $1,000 (for example, $5,000) and some have par values of less than $1,000 (Treasury bonds can be purchased in multiples of $100). The par value generally represents the amount of money the firm borrows and promises to repay on the maturity date.
   
2. A firm's bonds require the company to pay a fixed number of dollars of interest every year (or, more typically, every 6 months). When this coupon payment, as it is called, is divided by the par value, the result is the coupon interest rate. For example, a firm’s bonds have a $1,000 par value, and they pay $90 in interest each year. The bond’s coupon interest is $90, so its coupon interest rate is $90/$1,000 = 9%. The coupon payment, which is fixed at the time the bond is issued, remains in force during the life of the bond.2 Typically, at the time a bond is issued, its coupon payment is set at a level that will enable the bond to be issued at or near its par value.
3. In some cases, a bond’s coupon payment will vary over time. For these floating-rate bonds, the coupon rate is set for, say, the initial 6-month period, after which it is adjusted every 6 months based on some market rate. Some corporate issues are tied to the Treasury bond rate; other issues are tied to other rates, such as LIBOR (the London Interbank Offered Rate). Many additional provisions can be included in floating-rate issues. For example, some are convertible to fixed-rate debt, whereas others have upper and lower limits (“caps” and “floors”) on how high or low the rate can go.
   
4. Some bonds pay no coupons at all but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income. These securities are called zero coupon bonds (“zeros”). Most zero coupon bonds are Treasury bonds, although a few corporations, such as Coca-Cola, have zero coupon bonds outstanding. Some bonds are issued with a coupon rate too low for the bond to be issued at par, so the bond is issued at a price less than its par value. In general, any bond originally offered at a price significantly below its par value is called an original issue discount (OID) bond. 
   
5. Some bonds don’t pay cash coupons but pay coupons consisting of additional bonds (or a percentage of an additional bond). These are called payment-in-kind bonds, or just PIK bonds. PIK bonds are usually issued by companies with cash flow problems, which makes them risky. Some bonds have a step-up provision: If the company’s bond rating is downgraded, then it must increase the bond’s coupon rate. Step-ups are more popular in Europe than in the United States, but that is beginning to change. Note that a step-up is quite dangerous from the company’s standpoint. The downgrade means that it is having trouble servicing its debt, and the step-up will exacerbate the problem. This combination has led to a number of bankruptcies.
   
6. Bonds generally have a specified maturity date on which the par value must be repaid. A firms bonds issued on January 5, 2013, will mature on January 5, 2028; thus, they have a 15-year maturity at the time they are issued. Most bonds have original maturities (the maturity at the time the bond is issued) ranging from 10 to 40 years, but any maturity is legally permissible.3 Of course, the effective maturity of a bond declines each year after it has been issued. Thus, a firm’s bonds have a 15-year original maturity, but in 2014, a year later, they will have a 14-year maturity, and so on.
   
7. Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption.4 The call provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. The additional sum, which is termed a call premium, is often set equal to 1 year’s interest if the bonds are called during the first year, and the premium declines at a constant rate of INT/N each year thereafter (where INT = annual interest and N = original maturity in years). For example, the call premium on a $1,000 par value, 10-year, 10% bond would generally be $100 if it were called during the first year, $90 during the second year (calculated by reducing the $100, or 10%, premium by one-tenth), and so on. However, bonds are often not callable until several years (generally 5 to 10) after they are issued. This is known as a deferred call, and the bonds are said to have call protection.
   
8. Some bonds include a sinking fund provision that facilitates the orderly retirement of the bond issue. On rare occasions the firm may be required to deposit money with a trustee, which invests the funds and then uses the accumulated sum to retire the bonds when they mature. Usually, though, the sinking fund is used to buy back a certain percentage of the issue each year. A failure to meet the sinking fund requirement throws the bond into default, which may force the company into bankruptcy. In most cases, the firm is given the right to administer the sinking fund in either of two ways. 1. The company can call in for redemption (at par value) a certain percentage of the bonds each year; for example, it might be able to call 5% of the total original amount of the issue at a price of $1,000 per bond. The bonds are numbered serially, and those called for redemption are determined by a lottery administered by the trustee. 2. The company may buy the required number of bonds on the open market.
9. Owners of convertible bonds have the option to convert the bonds into a fixed number of shares of common stock. Convertibles offer investors the chance to share in the upside if a company does well, so investors are willing to accept a lower coupon rate on convertibles than on an otherwise identical but nonconvertible bond. Warrants are options that permit the holder to buy stock at a fixed price, thereby providing a gain if the price of the stock rises. Some bonds are issued with warrants. As with convertibles, bonds with warrants have lower coupon rates than straight bonds. An income bond is required to pay interest only if earnings are high enough to cover the interest expense. If earnings are not sufficient, then the company is not required to pay interest and the bondholders do not have the right to force the company into bankruptcy. Therefore, from an investor’s standpoint, income bonds are riskier than “regular” bonds. Indexed bonds, also called purchasing power bonds, first became popular in Brazil, Israel, and a few other countries plagued by high inflation rates. The interest payments and maturity payment rise automatically when the inflation rate rises, thus protecting the bondholders against inflation. In January 1997, the U.S. Treasury began issuing indexed bonds called TIPS, short for Treasury Inflation-Protected Securities. Later in this chapter we show how TIPS can be used to estimate the risk-free rate.
   
10. Corporate bonds are traded primarily in electronic/telephone markets rather than in organized exchanges. Most bonds are owned by and traded among a relatively small number of very large financial institutions, including banks, investment banks, life insurance companies, mutual funds, and pension funds. Although these institutions buy and sell very large blocks of bonds, it is relatively easy for bond dealers to arrange transactions because there are relatively few players in this market as compared with stock market