Most of us have a basic understanding that a share of stock represents a fractional ownership in a company. Bonds, on the other hand, are surprisingly less well understood despite their relative simplicity. Today we will look at the fundamentals of this important class of investment security.
A bond is simply a loan. While a bank loan involves a single lender, bonds allow for the participation of multiple lenders through the creation of an instrument called a security. For example, Apple Computer borrowed $1 billion in May by issuing bonds paying 2 percent that mature in 2022. Hundreds or even thousands of investors and funds participated in lending the money to Apple by purchasing those bonds. Corporate bonds are usually denominated in $1,000 increments, so Apple issued a total of 1 million bonds at $1,000 each.
The first and probably most important variable is the interest rate on the loan. This rate is usually fixed at the time of issue and remains constant (although some bonds do carry variable rates). The rate is called the "coupon," because at one time investors received physical bond certificates attached to which were coupons that were detached and presented at the local bank for redemption on the appointed interest dates. Traditionally this was twice per year, although more frequent coupon dates are increasingly common. Today, bonds are strictly electronic.
Christopher HopkinsNext in importance is the length of the loan, also fixed at issuance. At maturity, the borrower is obligated to repay the principal value of the loan in full, plus any remaining interest due. This principal due is called the "par" value, the original amount borrowed at issue (also called the face value). Unlike stocks, bonds have limited lives and are extinguished once the par value is redeemed.
In our example, Apple's bonds carry a coupon rate of 2.3 percent, a maturity date of May 11 2022, and a par value of $1,000 each ($1 billion total).
Bonds are not only issued by corporations. You may have heard that the U.S. government borrows a few bucks as well. To finance the government, the U.S. Treasury sells billions in new bonds each year, with maturities ranging from four weeks to 30 years. States and cities also routinely borrow by issuing so-called "municipal bonds," which often carry an exemption from federal and issuing-state income taxes.
It is important for investors to assess the risk of a bond before purchase. As might be expected, a U.S. Treasury bond is considered the safest class and therefore carries a relatively low coupon rate.
Ten private rating agencies are authorized by U.S. regulators to issue opinions on the creditworthiness of bond issuers. The most familiar, Standard and Poor's, uses a letter system beginning with AAA to signify the highest quality (lowest risk) and descending through AA, A, BBB and so forth to D. Interstitial modifiers (+ and -) were later added, allowing finer gradations (A-, BBB+ etc.). Other agencies affix a similar but slightly variant latter scale.
It is accepted practice to refer to bonds rated BBB- and higher as "investment grade." Bonds below this threshold (BB+ and lower), are considered to be at higher risk of default and are often called "junk bonds," although the relative risk of bonds below BB+ are actually quite disparate.
Additional classes of bonds include what might be called hybrids: collections of individual loans or notes against which individual bonds are issued. Mortgage-backed securities (MBS) for instance are bonds backed by pools of hundreds of individual mortgage loans.
With these basics in mind, we continue our discussion next week with a look at how bond prices are determined.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.