Bonds Defined and CatagorizedPresentation Transcript
Bonds What are they and What do they do?
Bonds are, at their basis, loans given to either a government or to a corporation.
Bonds have three basic components:
The Par Value
This is the amount that the purchaser pays for the bond, and that will be repaid by the issuer when the bond matures. This can also be referred to as the Principle invested or the Face Value of the investment.
This is the length of time before the bond is repaid by the issuer.
The Coupon Rate
This is the interest rate that will be paid by the issuer to the purchaser of the bond.
This can be different than the Yield on the bond, which is the annual rate of return on the bond if it were held to maturity.
Bonds are rated on their risk be specialty ratings companies, such as Moody’s or Standard and Poor’s.
They are rated AAA (The Highest – or Safest) through D (The riskiest)
The higher the rating, generally the lower the coupon rate due to the decreased risk
The lower the rating, generally the higher the coupon rate due to the increased risk associated with it
Bonds are not always kept until they reach maturity
They usually can be resold at any time due to changes in expected returns or the financial needs of the holder
If interest rates have changed since the bond was issued, the holder may have to sell the bond for less than par value to get someone to purchase it
This is referred to as selling at a discount
Issuing Bonds - The Good.
Bonds are beneficial to the issuer for a couple of reasons:
Upon issuance, the coupon rate is guaranteed – the financial obligations involved are then known and stable
Bond issuance does not impart ownership of the issuing entity to the bond holder
Issuing Bonds – The Bad.
Upon issuance of a bond, the issuer is legally obliged to make the set payments regardless of economic conditions
Coupon rates are heavily influenced by the financial health of the issuing entity so economic changes can greatly impact the ability to, and the cost of, issuing bonds
Types of Bonds
Bonds can be loosely grouped into 5 categories:
Savings Bonds are low par value bonds issued by the US Government.
They do not draw interest payments – instead the bond is purchased for less than par value.
A $100 par value bond will be purchased for $50. When the bond matures in 20 years, it pays out the $100 to the holder.
Corporate Bonds are high par value bonds issued by independent corporations.
Interest earned on these bonds is taxable by the US Government.
They are generally considered of moderate risk because they are only backed by the future success of the corporation.
The issuance of corporate bonds is regulated by the Securities and Exchange Commission (SEC)
Municipal Bonds are issued by State and Local Governments.
Interest earned on these bonds is not taxable by the US Government.
These are generally considered low risk because they are backed by the tax revenues of the issuing entity.
Treasury Bonds, Bills, and Notes
The US Government issues bonds of various maturity lengths.
These bonds are considered some of the safest investments in the world because they are backed by the “full faith and credit” of the United States government.
Junk Bonds sometimes offer the highest yields of any bonds.
This is because they also offer the highest risks of any bonds.
There coupon rates are set very high to entice purchasers to take the risk that they present.