by
Charles Lamson
In contrast to stocks, bonds are liabilities---they are nothing more than publicly traded IOUs where the bondholders are actually lending money to the issuer. They represent borrowed funds, and as such are a form of debt capital. Bonds are often referred to as fixed-income securities because the debt service obligations of the issuer are fixed---that is, the issuing organization agrees to pay a fixed amount of interest periodically and to repay a fixed amount of principal at or before maturity. Bonds normally have face values of $1,000 or $5,000, and maturities of 10 to 30 years or more.
Why Invest in Bonds
Like many other types of investment vehicles, bonds provide investors with two kinds of income: (1) They provide a generous amount of current income, and (2) they can often be used to generate substantial capital gains. The current income, of course, is derived from the interest payments received periodically over the life of the issue. Indeed, this regular and highly predictable source of income is one of the key factors that draws investors to bonds. But these securities can also produce capital gains, which occurs whenever market interest rates fall. A basic trading rule in the bond market is that interest rates and bond prices move in opposite directions: when interest rates rise, bond prices fall; and when they drop, bond prices rise. Thus, it is possible to buy bonds at one price and, if interest rate conditions are right, to sell them some time later at a higher price. Of course, it is also possible to incur a capital loss should market rates move against the investor. Taken together, the current income and capital gains earned from bonds can lead to highly competitive investor returns. Bonds are also a highly versatile investment outlet. They can be used conservatively by those who seek high current income, or aggressively by those who actively go after capital gains. Although bonds have long been considered as attractive investments by those going after high levels of current income, it has only been since the advent of volatile interest rates that they have also become recognized for their capital gains potential and as trading vehicles. Indeed, given the relationship between bond prices to interest rates, investors found that the number of profitable trading opportunities increased substantially as wider and more frequent swings in interest rates began to occur. Finally, because of the general high quality of many bond issues, they can also be used for the preservation and long-term accumulation of capital. In fact, some individuals, regularly and over the long haul, commit all or a good deal of their investment funds to bonds because of this attribute. Bonds vs. Stocks Although bonds definitely do have their good points---low risk and high levels of current income, along with desirable diversification properties---they also have a significant downside: their comparative returns. The fact is, relative to stocks, there is a big sacrifice in returns when investing in bonds. However, bond returns are far more stable than stock returns, plus they possess excellent portfolio diversification properties. Thus, except for the most aggressive of investors, bonds have a lot to contribute from a portfolio perspective. Indeed, as a general rule, adding bonds to a portfolio will---up to a point---have a much bigger impact on (lowering) risk than it will on return. Face it: You don't buy bonds for their high returns (except when you think interest rates are heading down); rather, you buy them for their current income and the stability they bring to a portfolio. Basic Issue Characteristics A bond is a negotiable, long-term debt instrument that carries certain obligations on the part of the issuer. Unlike the holders of common stock, bondholders have no ownership or equity position in the issuing firm or organization. This is so because bonds are debt, and the bondholders, in a round-about way, are only lending money to the issuer. As a rule, bonds pay interest every 6 months. The amount of interest paid is a function of the coupon, which defines the annual interest that will be paid by the issuer to the bondholder. For instance, a $1,000 bond with an 8 percent coupon would pay $80 in interest every year (i.e., $1,000 x 0.08 = $80), generally in the form of two $40 semiannual payments. The principle amount of a bond, also known as par value, specifies the amount of capital, that must be repaid at maturity---thus there is $1,000 of principal in a $1,000 bond. Of course, debt securities regularly trade at market prices that differ from their principal (or par) values. This occurs whenever an issue's coupon differs from the prevailing market rate of interest; in essence, the price of an issue will change until its yield is compatible with prevailing market rate of interest; in essence, the price of an issue will change until its yield is compatible with prevailing market yields. Such behavior explains why a 7 percent issue will carry a market price of only $825 when the market yield is 9 percent; the drop in price is necessary to raise the yield on this bond from 7 percent to 9 percent, the drop in price is necessary to raise the yield on this bond from 7 percent to 9 percent. Issues with market values lower than par are known as discount bonds and carry coupons that are less than those on new issues. In contrast, issues with market value in excess of par are called premium bonds and have coupons greater than those currently being offered on new issues. Types of Issues A single issuer may have any number of bonds outstanding at a given point in time. In addition to their coupons and maturities, bonds can be determined from one another by the type of collateral behind them. In this respect, the issues can be viewed as having either junior or senior standing. Senior bonds are secured obligations, because they are backed by a legal claim on some specific property of the issuer that acts as collateral for the bonds. Such issues include mortgage bonds, which are secured by real estate, and equipment trust certificates, which are backed by certain types of equipment and are popular with railroads and airlines. Junior bonds on the other hand, are backed only with a promise by the issuer to pay interest and principle on a timely basis. There are several classes of unsecured bonds, the most popular of which is known as a debenture. Issued as either notes (with maturities of 2 to 10 years) or bonds (maturities of more than 10 years), debentures are totally unsecured in the sense that there is no collateral backing them up---other than the good name of the issuer. But in the final analysis, even in the world of corporate finance, that is all that matters.  Sinking Fund Another provision that is important to investors is the sinking fund, which stipulates how a bond will be paid off over time. Not all bonds have these requirements, but for those that do, a sinking fund specifies the annual repayment schedule that will be used to pay off the issue and continue annually thereafter until all or most of the issue has been paid off. Any amount not repaid by maturity (which might equal 10 to 25 percent of the issue) is then retired with a single balloon payment. Call Feature Every bond has a call feature, which stipulates whether a bond can be called (that is, retired) prior to its regularly scheduled maturity date, and, if so, under what conditions. Often, a bond cannot be called until it has been outstanding for 5 years or more. Call features are normally used to replace an issue with the one that carries a lower coupon; in this way, the issuer benefits by being able to realize a reduction in annual interest cost. In an attempt to compensate investors who have their bonds called out from under them, a call premium (usually equal to about a half to one year's interest) is tacked on to the par value of the bond and paid to investors, along with the issue's par value, at the time the bond is called. For example, if a company decides to call its 12 percent bonds some 15 years before they mature, it might have to pay $1,000 for every $1,000 bond outstanding (a call premium equal to 9 months' interest---$120 x .75 = $90---would be added to the par value of $1,000). Although this may sound like a good deal, it's really not. Indeed, the only party that benefits from a bond refunding is the issuer. The bondholder may indeed get a few extra bucks when the bond is called, but in turn, he or she loses a source of high current income---for example, the investor may have a 10 percent bond called away at a time when the best he or she can do in the market is maybe 7 or 8 percent. To avoid this, stick with bonds that are either noncallable (these issues cannot be called or retired prior to maturity, for any reason), or that have long call-deferment periods, meaning they cannot be called for refunding (or any other purpose) until the call-deferment period ends.
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