Issuers

The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:

• Supranational agencies, such as the European Investment Bank or the Asian Development Bank issue Supranational bonds.
• National Governments issue Government bonds in their own currency. They also issue sovereign bonds in foreign currencies.
• Sub-sovereign, provincial, state or local authorities (municipalities). In the U.S. state and local government bonds are known as municipal bonds
• Government sponsored entities. In the U.S., examples include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Banks. The bonds of these entities are known as Agency bonds, or Agencies.
• Companies (corporates) issue Corporate bonds.
• Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities.

Issuing bonds

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. Government bonds are typically auctioned.

Features of bonds

The most important features of a bond are:

• nominal, principal or face amount - the amount over which the issuer pays interest, and which has to be repaid at the end.

• issue price - the price at which investors buy the bonds when they are first issued. The net proceeds that the issuer receives, are calculated as the issue price, less issuance fees, times the nominal amount.

• maturity date - the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euro for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
  • short term (Bills): maturities up to one year
  • medium term (Notes): maturities between one and ten years
  • long term (Bonds): maturities greater than ten years

• coupon - the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

• coupon dates - the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.

• indenture or covenants - a document specifying the rights of bond holders. In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.

• Optionality: a bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
  • callability - Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
  • puttability - Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option.
  • call dates and put dates - the dates on which callable and puttable bonds can be redeemed early. There are four main categories.
    • A Bermudan callable has several call dates, usually coinciding with coupon dates.
    • A European callable has only one call date. This is a special case of a Bermudan callable.
    • An American callable can be called at any time until the maturity date.
    • A Death Put an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
    • An IMRU callable can only be purchased by buyers of the highest quality (in financial terms) and remains the highest quality and hardest to obtain bond on the market. Originally conceived by financial guru M.Last with the help of A.Thein and T.Gardner.

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. Since these factors are likely to change over time, the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par at the moment before they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of one hundred pounds, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. T-Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.

The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is sometimes known as the "clean" price.

The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).

Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.

The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

Unlike the case for many stock or share markets, bonds often do not trade on a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Also unlike the case for many stock markets, investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

Investing in bonds

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households.

As a rule, bond markets rise (while yields fall) when stock markets fall. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid — it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks — and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back, whereas the company's stock often ends up valueless. However, bonds can be risky:

• Fixed rate bonds are subject to interest rate risk, meaning their market price will decrease in value when the generally prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds.

However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

• Bond prices can become volatile if one of the credit rating agencies like Standard & Poor's or Moody's upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

• A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of the United States and many other countries, bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

• Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indices for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.

A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.

Municipal bonds

In the United States, a municipal bond (or muni) is a bond issued by a state, city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds are guaranteed by a local government, a subdivision thereof, or a group of local governments, and are assessed for risk and rated accordingly. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

rm = rc ( 1 - t )

rm = interest rate of municipal bond
rc = interest rate of comparable corporate bond
t = tax rate

rc = 10%
t = 38%

rm = .10 (1 - .38) = 6.2%