Page 78 - Encyclopedia of Business and Finance

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Bonds

BONDS: LONG-TERM AND VARIED “middleman” for the corporation and the bondholders.
Bonds are generally considered long-term obligations. (Sometimes more than one underwriter participates in the
Nevertheless, since there is trading in the secondary mar- sell of an issue, especially if the value of the issue is high.)
ket for some types of bonds, it is possible to buy and sell The issuing company also engages a trustee, generally a
such bonds at any time. Bonds are issued by entities seek- bank or trust company, to monitor the sale to ensure that
ing funds for a variety of reasons. all the details of the bond indenture are honored by the
underwriters.
Corporations issue bonds often for expansion pur-
poses, when they have determined that extension of their The contract for a purchase of bonds is called a bond
long-term debt obligations is a better strategy than to indenture, which provides a description of the bond issue
expand their ownership base through the issuance of addi- as well as the rights of both the buyer and seller. The
tional stock. Corporations are frequently motivated to buyer, for example, may have the right to convert a bond
choose bonds over expansion of stock owners for two into stock. Sellers often state options, which modify the
basic reasons: The cost of interest is deductible as a yearly basic agreement. For example, a common option is the
expense, and there is no dilution of ownership through right to retire a bond before its maturity date. Such bonds
the extension of the company’s liabilities. are called callable bonds. Before the possibility of paper-
less transactions, bond certificates were issued, but now
The federal government issues bonds, along with
transactions tend to be book entries only.
short-term notes, for the expenditures required to operate
the federal government and to pay off debt that is matur- Bonds have a predetermined rate of interest called the
ing. Municipalities and states issue bonds for capital stated or contract rate, which is established by the board
expenditures that are perceived necessary to maintain the of directors. The actual interest rate, however, determined
infrastructure of the entity. Such bonds provide funds to at auction, is referred to as the market rate. The market
build local roads, stadiums, schools, and other public rate may equal the stated rate, or it may be higher or
buildings. lower. The bond that sells at the stated rate is considered
to have sold at par value. If the market rate is higher, the
Investors can choose from a wide variety of bonds.
bond is sold at discount, which means that the buyer will
Among them are: corporate bonds, federal government
pay less than the face value of the bond, therefore earning
bonds, municipal bonds, asset-backed bonds, mortgage-
interest at a rate higher than the stated rate. If the market
based bonds, and foreign government bonds. For each of
rate is lower, the bond is sold at a premium, which means
these categories, there are variations. Additionally, there that the buyer is paying more than the face value of the
are bond funds related to government bonds, corporate bond, and earning less than the stated rate. Although
bonds, and foreign government bonds. It is possible to there may be a difference between stated and market rates,
buy bonds that are convertible into stock. The bond mar-
the actual interest paid is based on the stated rate and the
ket is indeed complex and varied. For purposes of the dis-
face value of the bond. Interest is usually paid semiannu-
cussion here, the focus will be on basic bond types: ally.
corporate, federal government, and municipal. There will
Bonds are registered in the name of the person who
follow a discussion of bonds as an investment for an indi-
purchased them. The registered owner receives the inter-
vidual.
est on the interest payment date. If a $1,000 bond carried
interest at a contract rate of 6 percent, the registered
CORPORATE BONDS owner would received a check for $30 semiannually. Since
In a corporation, the board of directors is responsible for electronic processing began, the book entry means that
making the decisions related to a bond issue including the bonder holds a virtual bond. The corporation’s com-
determining how much money is to be raised, what type puter files merely contain the names and addresses of
of bond will be sold, what the maturity date will be, and those to whom interest checks will be sent on the appro-
what the interest rate will be. Corporations with sound priate dates. Additionally, with the ability to transfer
credit standing are able to issue bonds without pledging funds electronically, corporations are able to deposit inter-
assets. Such bonds are called debenture bonds, or unse- est payments directly into their bondholders’ bank
cured bonds. Companies with low credit standing often accounts.
issue secured bonds, for which specified assets have been
pledged as collateral. The Nature of the Bond Market. The bond market is
dominated by institutional investors, such as insurance
Issuance Process. Corporations generally do not sell companies, mutual funds, and pension funds, but bonds
directly to the public; rather, they sell their entire issues to can be purchased by individual investors as well. Bonds
an underwriter, often an investment bank, which acts as are traded both in the primary market, which is the initial

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 55