{"id":436,"date":"2018-11-28T20:30:52","date_gmt":"2018-11-28T20:30:52","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&p=436"},"modified":"2018-11-28T20:39:35","modified_gmt":"2018-11-28T20:39:35","slug":"bonds-and-bond-markets","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/bonds-and-bond-markets\/","title":{"raw":"16.1 Bonds and Bond Markets","rendered":"16.1 Bonds and Bond Markets"},"content":{"raw":"
\r\n
<\/div>\r\n<\/div>\r\n
\r\n
\r\n
\r\n
\r\n

Learning Objectives<\/h3>\r\n
    \r\n \t
  1. Identify bond features that can determine risk and return.<\/li>\r\n \t
  2. Differentiate the roles of various U.S. government bonds.<\/li>\r\n \t
  3. List the types and features of state and municipal bonds.<\/li>\r\n \t
  4. Compare and contrast features of the corporate bond markets, the markets for corporate stock, and the markets for government bonds.<\/li>\r\n \t
  5. Explain the role of rating agencies and the process of bond rating.<\/li>\r\n<\/ol>\r\n<\/div>\r\n \r\n\r\n<\/div>\r\n

    Bonds are a relatively old form of financing. Formalized debt arrangements long preceded corporate structure and the idea of equity (stock) as we know it. Venice issued the first known government bonds of the modern era in 1157,Isadore Barmash, The Self-Made Man<\/em> (Washington, DC: Beard Books, 2003), 55.<\/span> while private bonds are cited in British records going back to the thirteenth century.George Burton Adams, The Constitutional History of England<\/em> (London: H. Holt, 1921), 93.<\/span> Venice issued bonds to raise funds to finance a Crusade against Constantinople, which included expansion of a shipyard attached to the Venetian Arsenal. (Go to http:\/\/en.wikipedia.org\/wiki\/Venetian_Arsenal<\/a> to view images.)<\/p>\r\n\r\n

    \r\n

    Bonds<\/h2>\r\n

    In addition to financing government projects, bonds are used by corporations to capitalize growth. Bonds are also a legal arrangement, couched in conditions, obligations, and consequences. As a result of their legal and financial roles, bonds carry a quaint and particular vocabulary. Bonds come in all shapes and sizes to suit the needs of the borrowers and the demands of lenders. Figure 16.1 \"Basic Bond Features\"<\/a> lists the descriptive terms for basic bond features.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"989\"]\"image\" Figure 16.1 Basic Bond Features[\/caption]\r\n\r\n<\/div>\r\n

    The coupon<\/strong>[footnote]The interest payment on a bond, specified as a feature of the bond at issuance.[\/footnote] is usually paid to the investor twice yearly. It is calculated as a percentage of the face value<\/strong>[footnote]For a bond, the amount to be repaid to the bondholder upon redemption.[\/footnote]\u2014amount borrowed\u2014so that the annual coupon = coupon rate \u00d7 face value. By convention, each individual bond has a face value of $1,000. A corporation issuing a bond to raise $100 million would have to issue 100,000 individual bonds (100,000,000 divided by 1,000). If those bonds pay a 4 percent coupon, a bondholder who owns one of those bonds would receive a coupon of $40 per year (1,000 \u00d7 4%), or $20 every six months.<\/p>\r\n

    The coupon rate<\/strong>[footnote]The interest rate offered on a bond.[\/footnote] of interest on the bond may be fixed or floating and may change. A floating rate is usually based on another interest benchmark, such as the U.S. prime rate<\/strong>[footnote]A benchmark interest rate understood to be the rate that major banks charge corporate borrowers with the least default risk.[\/footnote], a widely recognized benchmark of prevailing interest rates.<\/p>\r\n

    A zero-coupon bond<\/strong>[footnote]A bond that has a coupon rate of zero, and therefore a coupon of zero. Its only cash flow return is the principal repayment at maturity.[\/footnote] has a coupon rate of zero: it pays no interest and repays only the principal at maturity. A \u201czero\u201d may be attractive to investors, however, because it can be purchased for much less than its face value. There are deferred coupon bonds<\/strong>[footnote]Bonds whose coupon payments are deferred until a specified time.[\/footnote] (also called split-coupon bonds<\/strong>[footnote]Deferred coupon bonds that pay no interest for a specified period, followed by higher-than-normal interest payments until maturity.[\/footnote] and issued below par), which pay no interest for a specified period, followed by higher-than-normal interest payments until maturity. There are also step-up bonds<\/strong>[footnote]A bond with a floating-rate coupon that is scheduled to increase at specified intervals.[\/footnote] that have coupons that increase over time.<\/p>\r\n

    The face value, the principal amount borrowed, is paid back at maturity. If the bond is callable<\/strong>[footnote]A bond that may be redeemed before maturity.[\/footnote], it may be redeemed after a specified date but before maturity. A borrower typically \u201ccalls\u201d its bonds after prevailing interest rates have fallen, making lower-cost debt available. Borrowers can borrow new, cheaper debt and pay off the older, more expensive debt. As an investor (lender), you would be paid back early, which sounds great, but because interest rates have fallen, you would have trouble finding another bond investment that would pay as high a rate of return.<\/p>\r\n

    A convertible bond<\/strong>[footnote]A bond that may be converted to common stock under specific conditions.[\/footnote] is a corporate bond that may be converted into common equity at maturity or after some specified time. If a bond were converted into stock, the bondholder would become a shareholder, assuming more of the company\u2019s risk.<\/p>\r\n

    The bond may be secured by collateral, such as property or equipment, sometimes called a mortgage bond<\/strong>[footnote]A bond secured by a specific asset such as real property or equipment.[\/footnote]. If unsecured, or secured only by the \u201cfull faith and credit\u201d of the borrower (the borrower\u2019s unconditional commitment to pay principal and interest on the debt), the bond is a debenture<\/strong>[footnote]A bond secured by only the \u201cfull faith and credit\u201d of the borrower and not by any specific asset.[\/footnote]. Most bonds are issued as debentures.<\/p>\r\n

    A bond specifies if the borrower has more than one bond issue outstanding or more than one set of lenders to repay, which establishes the bond\u2019s seniority in relation to previously issued debt. This \u201cpecking order\u201d determines which lenders will be paid back first in case of default on the debt or bankruptcy. Thus, when the borrower does not meet its coupon obligations, investors holding senior debt<\/strong>[footnote]A bond issue that has a superior claim in case of bankruptcy.[\/footnote] as opposed to subordinated debt<\/strong>[footnote]A bond issue that has an inferior claim in case of bankruptcy.[\/footnote] have less risk of default.<\/p>\r\n

    Bonds may also come with covenants<\/strong>[footnote]A condition of a loan that restricts the borrower to protect the lender.[\/footnote] or conditions on the borrower. Covenants are usually attached to corporate bonds and require the company to maintain certain performance goals during the term of the loan. Those goals are designed to lower default risk<\/strong>[footnote]The risk that a borrower will not be able to meet interest obligations or principal repayment.[\/footnote] for the lender. Examples of typical covenants are<\/p>\r\n\r\n