How do companies issue bonds? If a firm decides that bonds are a good financing option, they contact a financial advisory firm to help issue them. Like stocks, issuing bonds is a complex process. The timing of the issue, the issuing price, the structure of the bonds, and other factors have to be carefully evaluated. Similar to the initial sale of stocks, a financial advisory firm prepares the documents that must be filed with the SEC before the bonds being issued. In addition to charging the company issuing the bonds a fee for these services, the financial advisory firm makes money by forming and managing a group of other financial advisory firms to underwrite, or purchase, the newly issued bonds. The bonds are issued at a discounted price, and then they attempt to sell them to investors at higher prices.

What are the characteristics of a bond? The key characteristics of a bond are as follows: maturity date, par (face) value, and coupon (interest rate):

• The maturity date is the date on which the bond matures and the investor’s principal is repaid. Short-term bonds (generally with a maturity of less than five years) pose less risk to investors than long-term bonds and therefore have lower interest rates than long-term bonds do.

• The par (face) value is the amount of money the bondholder will get back once a bond matures. Most newly issued bonds sell at par value. Treasury bills, discussed later in this section, sell for less than par (face) value.

• The coupon is the bond’s interest rate. It is a percentage of the par (face) value. So, a coupon of 10 percent on a bond with $1,000 par value would generate $100 in interest a year. Although most bonds pay interest twice a year, some bonds offer monthly, quarterly, or annual payments. Originally, bonds had coupons that the investor would tear off and redeem to receive interest. Today, investors do not need to tear off coupons; instead, interest payments are transferred electronically to the investor’s account.

Are there different types of bonds? As shown in Figure 16.9, bonds are categorized primarily by the type of entity that is issuing the bonds:

Figure 16.9

Types of Bonds

• Corporate bonds

• Government bonds

• Municipal bonds

What are corporate bonds? Corporate bonds are debt securities issued by corporations. There are several types of corporate bonds:

• Secured bonds are backed by collateral, an asset of the corporation that will pass to the bondholders (or be sold to reimburse them) if the corporation does not repay the amount borrowed. Revenue streams that come from the project the bonds were sold to finance can also be used as collateral. Mortgage-backed securities are special secured bonds that are backed by real property owned by a corporation.

• Debenture bonds are unsecured bonds, backed only by a corporation’s promise to pay.

• Convertible bonds are another modification of traditional bonds that give a bondholder the right (but not the obligation) to convert the bond into a predetermined number of shares of the company’s stock. Convertible bonds generally carry lower interest rates because the investor is able to convert them to stock, which offers an advantage regular bonds don’t.

What are government bonds? Government bonds are debt securities issued by national governments; U.S. government bonds are considered to be the safest of investments because the government backs them and the risk of default is very low. These bonds are divided into several categories based on their maturity:

• Treasury bills (T-bills) are bonds with maturities ranging from 4 weeks to 52 weeks. Instead of paying interest, T-bills are sold at a discount, so you pay less up front for them. When the bond matures, you receive the full face value of the bond. The difference between the purchase amount and the face value is the interest. For example, to buy a $1,000 T-bill, you might pay $975 up front. When the T-bill matures 26 weeks later, you would receive the face value of $1,000. The $25 difference is interest earned.

• Treasury notes (T-notes) are bonds that mature in 2, 3, 5, 7, and 10 years. Interest is paid semiannually. You can hold T-notes to maturity, or you can sell them prior to their maturity. When a T-note matures, you receive its face value.

• Treasury Inflation-Protected Securities (TIPS) protect investors from inflation, as their name implies. A TIPS’s principal is adjusted to the U.S. Consumer Price Index (CPI). When the CPI rises, the principal adjusts upward and vice versa. Interest is paid semiannually. Although the interest rate remains constant, the interest payment adjusts as the rate is multiplied by the inflation-adjusted principal amount, thus providing the protection against inflation. TIPS are available in 5-, 10-, and 30-year maturities.

• Treasury bonds (T-bonds) are bonds that mature in 30 years and pay interest semiannually. When a T-bond matures, you receive the face value.

• Floating rate notes (FRNs) are debt instruments issued for a term of two years. FRNs pay interest quarterly. The interest payments are variable and are based on discount rates for 13-week T-bills. The price of an FRN may not be its face value, but when an FRN matures, you are paid its face value.

• Zero-coupon bonds are Treasury-backed securities that are sold at a deep discount and redeemed at full face value when they mature in 6 months to 30 years. Interest is not paid until the bond matures, but the bond holder must pay taxes on the “phantom interest” that you earn.

What are savings bonds? U.S. savings bonds aren’t sold on the secondary market. You can only purchase them directly from the government. Traditionally, U.S. savings bonds have been given as gifts to babies to help finance their education once the bonds mature. Savings bonds are issued at face value, and as of January 1, 2012, can be purchased only electronically. There are two types of savings bonds:

• Series EE bonds have a 20-year maturity but will pay interest up to a total of 30 years. Interest accumulates monthly and is paid when the holder redeems the bond.

• Series I bonds have an interest rate that is part fixed and part variable. The variable part is reset annually to match the inflation rate. In this regard, they are similar to TIPS.

What are municipal bonds? Municipal bonds (or munis) are bonds issued by state or local governments or governmental agencies. There are two varieties of municipal bonds: general obligation bonds and revenue bonds:

• General obligation bonds are supported by the taxing power of the issuer, so they tend to be safe.

• Revenue bonds are supported by the income generated by the projects they finance. For example, the New Jersey Turnpike Authority may issue $1 billion in municipal revenue bonds to finance the construction and renovation of the I-95 corridor that runs through the state. The tolls collected on that portion of I-95 would be used to pay the interest and principal of the bonds.

The advantage of investing in municipal bonds, FRNs, and government bonds is that the interest generated from many of them are exempt from federal income tax and, in many cases, state and local income taxes as well.

What are serial bonds? Municipal bonds, as well as some corporate bonds, are often issued as serial bonds. Serial bonds have a series of dates on which portions of the total bond offering mature, unlike traditional bonds, which are paid back to the investors all at once on one date. Serial bonds are advantageous to the issuer because they reduce the overall interest expense of the bond issue. Additionally, serial bonds allow the issuer to time the maturity dates to the income from the project financed by the bonds. Thus, for the toll road example, serial bonds would mature as phases of the toll road are completed and tolls from those portions of the road are generated.

What are callable bonds? Most corporate and municipal bonds remain outstanding until their maturity dates. With callable bonds, however, the issuer can either repay investors their initial investment at the maturity date or choose to retire the issue early and repay investors at the “callable date.” The issuers of callable bonds often exercise their early repayment options when interest rates have fallen, and the bonds can be refinanced at lower rates. For this reason, callable bonds pay higher interest rates than similar noncallable bonds.

Are bonds a risky investment? Relative to stocks, bonds are viewed as a more conservative investment for several reasons:

• The investor has a legal promise that his or her initial investment will be returned; stocks offer no such promise.

• The investor has a legal promise that he or she will receive periodic interest payments at a fixed rate; a firm can pay a dividend on the stock it has issued but isn’t obligated to.

• Historically, the bond market overall has been less volatile; thus, there is less variability in the prices of bonds.

However, bonds are not entirely risk free. Those carrying a higher risk will provide a higher return to the investor, but they are also associated with more risk. There are different types of risk that affect bonds; some are listed in Figure 16.10.

Figure 16.10

Types of Bond Risk

How is bond risk determined? The financial advisory firm also consults with rating agencies such as Moody’s or Standard & Poor’s, to assess the issuer’s creditworthiness (that is, whether the firm is deemed financially sound), and the bonds are assigned an investment grade. The bond rating is an indication of the likelihood of a default. A higher grade rating reflects a lower credit risk, and vice versa.

Table 16.1 shows the bond rating scales used by both Moody’s and Standard & Poor’s. To improve the investment grade of a bond issue, many bonds are backed by insurance policies that guarantee repayment to the bondholders in the event the issuer goes into default. Those bonds with the lowest ratings—and the most risk—are known as junk bonds. Because of their high risk, junk bonds offer high interest rates to attract investors. Investors should clearly understand the associated risks of junk bonds before adding them to their portfolios.

Table 16.1

Bond Rating Scales Used by Moody’s and Standard & Poor’s

Do I have to hold a bond to maturity? Although you certainly can hold a bond to maturity, many investors sell bonds, especially long-term bonds, before they mature. Just like stocks, after they are issued, bonds are bought and sold on the secondary market. (The exceptions are U.S. savings bonds, which, as noted previously, are not sold on the secondary market.) What makes buying bonds on the secondary market complicated is that bonds do not trade at par value but at a price higher than par (at a premium) or lower than par (at a discount). Bond prices move in the opposite direction of interest rates. So, if you are trying to sell a bond that has a coupon of 10 percent and the current market interest rate in the economy is 8 percent, your bond is worth more to investors, so its price will go up. Conversely, if the current interest rate is 12 percent, then the demand for your bond will be weak because it is earning less than the current interest rate. As a result, the price an investor is willing to pay for your bond will go down.

Although not completely riskless, bonds are a good investment if you are looking for a relatively conservative investment or a steady stream of income. When it comes to investing in bonds, there are several things to keep in mind, such as the type of bond, the bond’s risk rating, the face value of the bond, and the interest rate. Investors can determine a bond’s risk based on an issuer’s credit rating.