The Anatomy of a Bond

We have already mentioned bonds, and that they are marketable securities that are purchased by financial intermediaries like mutual funds and pension funds as well as by individuals. We are all aware of U.S. Government bonds, but we also know that you cannot buy stock in Uncle Sam! Clearly, bonds must be different from stocks, though both are investments. Now let’s be specific about what a bond is and how the bond market works.

What is a Bond?

A bond is a contract between the issuer of the bond and the owner of the bond. The issuer promises to pay the stated face value of the bond at a specified date in the future called the maturity date. The issuer also promises to make periodic coupon payments until maturity. Upon payment of the face value at maturity, a bond ceases to exist. Thus, a bond is fully described by its issuer, coupon, and maturity date.

It is unnecessary to specify the face value of a bond because, by tradition, the price of a bond is always quoted per $100 of face value. For example, if someone says that they bought the “Safeway 10s of ‘11 at 109” they mean that they bought the bond issued by the Safeway Corp. that pays a coupon of $10 per year and matures in 2011, and they paid $109 per $100 of face value for it. That bond would actually be available only in units of $1,000 face value, so one bond would cost the buyer $1,090. Some bonds are “callable” at the discretion of issuer at an earlier date than the maturity date. It is important when buying bonds to find out if the bond is callable or has special features that may affect its value (for example, “convertible” bonds may be exchanged for stock under certain conditions).

Notice that the market price of the Safeway bond in this example is more than its face value, $109 vs. $100. What determines the price of a bond? Supply and demand, of course! Bonds are supplied both by issuers such as the Safeway Corp. and by investors who already own bonds but wish to sell. Bonds are in demand from investors including both individuals and financial intermediaries. Buyers and sellers interact in the market place, bidding prices up or down until the quantity of bonds supplied equals the quantity demanded. The Safeway bond trades at $109 because investors are willing to pay that much for Safeway’s promise to pay $10 each year until 2001 and then repay the principal or face value of $100. Note that there is no necessary equality between face value and market price.

A bond combines some of the characteristics of a loan with some of those of a stock. Like a loan, a bond is a promise by the borrower to make payments at specified dates in the future. However, the issuer promises to pay whomever owns the bond rather than a specific lender.

Bonds, like stocks, are bought and sold at prices determined in the marketplace. As mentioned in the previous section, stocks and bonds together make up the class of marketable securities. When a bond is sold by one investor to another, the new owner then is entitled to all payments promised under the terms of the bond.

What if the Issuer Fails to Pay?

If the issuer fails to pay the coupon or principal on time, then the bonds are declared in default and the bondholders may take legal action against the issuer through a trustee who is appointed to represent hem.

A firm that goes into default may be liquidated (disbanded and its assets sold) under bankruptcy law, and the rights of the bondholders to receive a share of the proceeds will be considered by the court along with the rights of other creditors. While bondholders are entitled to be paid before stockholders, both are vulnerable if the firm fails. The possibility of default is referred to as credit risk. There is never an absolute guarantee that the bondholders will receive what they were promised when the bonds were issued. It is therefor important for investors to consider credit risk before purchasing a bond.

Since it is costly for investors to evaluate credit risk, it is not surprising that issuers of bonds are typically governments and very large corporations that are relatively well known and perceived to be good credit risks. Smaller borrowers who are less well-known usually borrow directly from financial intermediaries, particularly from commercial banks, which specialize in evaluating credit risk.

In the 1980s it became briefly fashionable for poorer credit risks to issue bonds and these were dubbed “junk bonds”. Some of these bond issues turned out to deserve their nickname and went into default, usually resulting in losses to the bondholders. But many junk bonds paid off handsomely for those who held on to them. Today, this sector of the bond market is more frequently referred to as the “high yield bonds”, reflecting the premium interest rate paid to compensate for higher credit risk, and the buyers are generally financial intermediaries who specialize in evaluating these securities.

How is the Coupon Determined?

Returning to our favorite airline, Blue Skies could raise the $125 million it needs if it could issue 1,250,000 bonds with face value of $100 each at a price of $100. But will investors be willing to pay $100 for these bonds? That depends on the size of the coupon and their confidence that Blue Skies will be able and willing to make the promised payments. It is customary to set the coupon on a newly issued bond so that the bond will sell at par, which means that the market value of the bond on the date of issue is equal to its face value.

The less confidence investors have in the borrower, the higher is the coupon required to induce investors to pay $100 for the new bond. Blue Skies is competing for the investor's dollar with other borrowers and it will have to be prepared to pay a higher coupon than borrowers who are perceived to be better credit risks with a lower risk of default. For example, if firms having the highest credit ratings, such as General Electric and IBM, are paying a coupon of $8, Blue Skies may find that it needs to offer a substantially larger coupon, perhaps $10, to sell its bonds at par.

Interest is payment for the use of money, so the coupon on a bond is interest. When Blue Skies issues a $100 bond at par with a coupon of $10 it is paying $10 in interest to the bondholders or, equivalently, an interest rate of 10% per year. That interest rate is not set by Blue Skies Airlines but by the marketplace where Blue Skies must compete with other borrowers for investors’ dollars.

If all goes well at Blue Skies, bondholders will receive a coupon payment of $10 each year during the life of the bond and then the face value payment of $100 on the maturity date. Of course, unexpected events such as a jump in fuel costs or a decline in airline travel could force Blue Skies to default on its bonds. In that case, bondholders may not receive all the payments promised them. On the other hand, the bondholders will never receive more than the promised coupons and face value, even if Blue Skies prospers well beyond the most optimistic expectations. Rather, it is the shareholders who reap all the gain from a good business climate. Thus, the bondholder gives up participation in the risks and rewards of ownership for the right to receive specified payments.

Exercises 3.3

A. Locate the table called "NEW YORK EXCHANGE BONDS" in the Wall Street Journal or other business newspaper. Each bond is identified by the name of the company that issued it, the coupon rate in percent, and maturity year, in that order. Find the AT&T bond with the maturity furthest in the future. What are the coupon, maturity year, and price (under the column heading "close") of that bond? What is AT&T promising to pay a purchaser of this bond? Now locate bonds with substantially larger coupons than that paid by AT&T. Are these corporations as well known as AT&T?

B. Some bonds are denoted “cv” meaning they are convertible into stock, and they frequently carry a lower coupon. Why would that make sense? C. Locate a bond with an "f" after the year. This denotes a bond that has defaulted on coupon payments. What is the bond market lingo for such bonds (see notes to the bond table), and how does a bond having this designation seem to relate to the price quoted on that bond?