Bonds - Basics

Bonds - Basics

A bond is just an organization's IOU; i.e., a promise to repay a sum of money at a certain interest rate and over a certain period of time. In other words, a bond is a debt instrument. Other common terms for these debt instruments are notes and debentures. Most bonds pay a fixed rate of interest (variable rate^ bonds are slowly coming into more use though) for a fixed period of time.

Why do organizations issue bonds? Let's say a corporation needs to build a new office building, or needs to purchase manufacturing equipment, or needs to purchase aircraft. Or maybe a city government needs to construct a new school, repair streets, or renovate the sewers. Whatever the need, a large sum of money will be needed to get the job done.

One way is to arrange for banks or others to lend the money. But a generally less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date). This process is nothing but the taking back of the certificate and returning of the principal.

Companies of all sizes issue corporate bonds. Bondholders are not owners of the corporation. But if the company gets in financial trouble and needs to dissolve, bondholders must be paid off in full before stockholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy.

Municipal bonds are issued by cities, states, and other local agencies and may or may not be as safe as corporate bonds. The taxing authority of the state of town backs some municipal bonds, while others rely on earning income to pay the bond interest and principal. Municipal bonds are not taxable by the federal government (some might be subject to A Minimum Tax, AMT) and so don't have to pay as much interest as equivalent corporate bonds.

U.S. Bonds are issued by the Treasury Department and other government agencies and are considered to be safer than corporate bonds, so they pay less interest than similar term corporate bonds. Treasury bonds are not taxable by the state and some states do not tax bonds of other government agencies. Shorter-term bonds are called notes and much shorter term bonds (a year or less) are called bills, and these have different minimum purchase amounts.

  

Debt instruments are nothing but loans taken by either company or the govt. or the municipality. There are various types of debt instruments like debenture, bond, notes, bills and many more. The name varies depending upon the issuer or nature of the instrument. But one common characteristic of most of them is that, they all carry some coupon Interest rate. I say most and not all because Zero coupon bonds do not carry any coupon rate. We will discuss about these instruments else where in this document.

 Variable rate of interest:

 The interest of these securities are linked to some reference rate, many cases to LIBOR (London Inter Bank Offer Rate). They may be some basis points above LIBOR, say 200 basis points. This means LIBOR + 2%. If LIBOR is 5%, then the interest comes to 7%. Depending upon the LIBOR movement, the interest rate on the bond also varies.