Bonds are debt instruments issued by corporations and a variety of government entities to raise money to purchase assets and finance deficits. In effect the bond issuer borrows money from the bond purchaser and agrees to pay interest at an established rate over a fixed period. The "loan," or face value of the bond, is repaid at the end of the bond's term when it matures. The bond serves as a contract between the two parties, with stipulations regarding the obligations of the bond issuer to the bondholder. While shareholders are considered owners of a corporation, bondholders are among its creditors. A company's stock is part of its equity, while bonds are part of its debt. If the bond issuer is a corporation, bondholders have a prior claim against the corporation's assets and earnings to that of the corporation's shareholders.
There are many classifications of bonds. Within the United States there are government or civil bonds that are issued by the federal government, individual states, and municipalities, and corporate bonds that are issued by corporations. The international bond market includes bonds issued by international bodies, governments of other countries, and companies based in other countries.
Bonds may also be classified according to the reason for issuing them, such as school bonds, airport bonds, equipment bonds, or general improvement bonds. Bonds may be secured or unsecured, which refers to whether or not the bondholder has a specific claim against the assets of the bond issuer. Bonds also vary in terms of principal and interest payments, and they may be registered or unregistered. Unregistered bonds are also known as bearer bonds.
Regardless of classification, all bonds share certain features. Bonds are a form of contract, and the rights of investors as well as the obligations of the issuer are usually set forth in what is known as a bond indenture. Most bonds are issued for a specified length of time, usually from one to 30 years, and are called term bonds. At the end of the term the bond reaches maturity, and all liabilities that have not been paid off before maturity must be paid to the bondholder. Bonds are usually categorized as short-term (I to 5 years), intermediate-term (5 to 12 years), and long-term (more than 12 years). Short-term bonds are often referred to as notes, while those with terms of fewer than 12 months are called money market instruments.
All bonds pay interest to their holders. The nominal or coupon interest rate is the rate shown on the bond that the issuer has agreed to pay. If the bond has been sold or purchased for more than the face amount, then it is said to have been sold at a premium and the effective interest rate becomes less than the coupon rate. That is, the bond purchaser will actually earn less than the coupon rate because more than the face amount was paid for the bond. Similarly, if the bond is sold for less than the face amount, it is sold at a discount and the effective interest rate is more than the coupon rate.
Bond interest is usually paid twice a year, but there are several variations as to how bond interest is paid. Zero coupon bonds pay all of the interest at maturity, for example. The interest a bond pays may be fixed or floating. That is, it may yield a specified interest rate for its entire term, or the interest rate may be adjusted periodically.
Bonds that are callable are those that can be called in, or redeemed, by the bond issuer. Since bond issuers typically call in such bonds when interest rates are lower than the bond is paying, callable bonds usually yield higher rates of return than bonds that are not callable. On the other hand, convertible bonds are usually issued at lower rates of return. A convertible bond is one that gives the bondholder the option of converting the bond into another type of investment, usually some form of stock in the company.
Domestic corporate and government bonds are assigned credit ratings by five agencies recognized by the Securities and Exchange Commission, with Standard & Poor's and Moody's Investor Service being the two dominant rating agencies. Other agencies provide similar ratings for bonds in other countries. Bond ratings are based on such factors as the credit-worthiness of the issuer, the issuer's past record of interest and/or dividend payments, and the nature of the assets or revenues that will be applied to repayment. Bond ratings range from AAA, the highest rating, to C. A D rating indicates the issuer is already in default. Bonds with lower ratings carry a higher risk of default and consequently usually pay a higher interest rate. Bonds with low ratings are also known as junk bonds.
[ David P Bianco ]
Fabozzi, Frank J. ed. Bond Markets, Analysis and Strategies. 4th ed. Upper Saddle River, NJ: Prentice Hall, 2000.