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Understanding Bonds

Understanding Bonds

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Author: Sophia Media
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Understand the basic characteristics of bonds.

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[MUSIC PLAYING] Hi. This is Dr. Bob Nolley with a lesson on the security we call bonds. A bond is an instrument of debt. It is a debt security. They provide a way for government and businesses to borrow money in large amounts for a longer period of time.

When an entity issues bonds, it is borrowing money. In the primary market, when an investor buys a bond, it is lending money. The terms of the bond require that the borrower pay the boundary interest. This is also called the coupon rate. And it also requires that they repay the principal at a later date.

This is the par value or the face value that is paid at maturity. The coupon interest is usually paid semiannually, every six months. Bonds can be issued by public authorities, the federal government, state governments, city and county governments and municipalities, credit institutions, companies themselves, and multinational institutions. Companies and individuals themselves can purchase bonds.

It's because these bonds are negotiable, ownership of them can be transferred in the secondary market, as if you or I were to invest in bonds. We're not lending money to the entity that issued them, but we're paying the current bond holder to transfer that security to us.

Let's look again at the overview of bonds. A bond is a form of a loan. And the holder of the bond is the lender. The creditor and the issuer of the bond is the borrower or the debtor. The interest rate is the coupon.

These bonds provide the buyer with external funds to finance long-term investments. And in the case of government bonds, they finance current expenditures. Certificates of Deposit, or CDs, or short-term commercial paper, are not considered to be bonds. They are considered to be money market instruments because the length of term is much shorter than the term for bonds.

There are different categories of bonds. There are corporate bonds that are issued by companies. Municipal bonds are issued by state, county, and local governments, and US treasury bonds, notes, and bills, which all together are referred to as Treasuries.

There are two features of a bond that are the main determinants of a bond's coupon rate. These are credit quality and the time to maturity. Maturities range from one year in treasury bills to a 30-year government bond. Corporate municipal bonds are usually in the three to 10 year range, but can be longer.

The bond indenture is the legal contract issued to the lenders that states all of these terms. The specifications given define responsibilities and commitments of the issuer, as well as those of the borrower, and describes all of the key terms including the interest rate, the maturity date, and the repayment dates.

If it's convertible, any representations or covenants or other terms of the bond offering are stated there. And if a borrower fails to meet any of those payment requirements, the results can be drastic, including bankruptcy or liquidation.

Now because it would be impractical for corporations or any other issuer to enter into an agreement with each one of these bond individual holders, the bond indenture is held by a trustee. It's usually a commercial bank or some other financial institution. They are appointed to represent the rights of the bond holders.

When bonds are originally issued in the primary market, there is an offering memorandum that is prepared in advance of the marketing of the bond. And the indenture is summarized in a section called description of notes.

This offering memorandum is usually called a prospectus. It's the document that describes the bond for potential buyers. The prospectus also provides information about the company's business, financial statements, its executive, information about the company their compensation, and any litigation that might be taking place, along with any material information.

Finally, let's take a look at bond ratings. In finance, the bond's credit rating reflects the credit worthiness of the corporation or the government's debt issue. It's similar to your and my credit rating. And the quality of the bond refers to the probability that the bond holders will receive their coupon payments and the maturity payment on their due dates.

The higher the credit rating, the lower the interest cost to the issuer. Now these bond ratings are created by credit rating agencies. These include Moody's, Standard and Poor's, and others. Ratings are usually given in letter designations with AAA going down through triple BBB, CCC, and lower.

A bond is considered to be investment grade if it is BBB or higher in the Standard and Poor's rating. A bond grade lower than this is not considered to be investment grade bonds.

And those that are very low are usually called junk bonds or high yield bonds. These bonds are rated much lower than investment grade bonds and offer a higher yield because the investor has to take on more risk to earn a higher coupon rate.

Credit rating agencies are paid for their work by investors who wanted impartial information. Later though, they began to be paid by entities issuing securities. And this led to charges that they could not be as impartial as they had in the past. Still today, rating agencies work is thought to be highly respected and for the most part very impartial.

Now let's summarize the key points about bonds. A bond is a debt instrument where the issuer is the borrower and the investor is the lender. Bonds can be issued by corporations, state and local governments, and the federal government.

The bond is a loan that makes interest payments to the bond holder, usually every six months until maturity. At maturity, the face value is repaid.

All of the details of the bond offering are included in a legal contract called the bond indenture. The indenture is held by the trustee, which is usually a financial institution.

Finally, the credit ratings of bond reflect the credit worthiness of the corporation or government bond issue. Similar to a credit rating, the rating of the bond impacts the interest rate the issuer has to pay, as well as the risk assumed by the borrower.

This is Dr. Bob Nolley. And I'll see you in the next list lesson.

[MUSIC PLAYING]

Terms to Know
Bond Indenture

A legal contract issued to lenders.

Convertibility

Quality of a bond that allows the holder to convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.

Corporate Bond

A bond issued by a corporation to raise money effectively in order to expand its business.

Credit Rating Agency

A company that assigns credit ratings to issuers of certain types of debt obligations, as well as to the debt instruments themselves.

Municipal Bond

A bond issued by an American city or other local government, or their agencies.

Treasury Bond

A government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt, with a maturity of 20 years to 30 years.