bond

What It Is

A bond, also known as a fixed-income security, is a debt instrument created for the purpose of raising capital. They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.

There are four major bond types in the U.S. markets, which are represented by four major issuers:

How It Works

When an investor purchases a bond, they are "loaning" that money (called the principal) to the bond issuer, which is usually raising money for some project. When the bond matures, the issuer repays the principal to the investor. In most cases, the investor will receive regular interest payments from the issuer until the bond matures.

Different types of bonds offer investors different options. For example, there are bonds that can be redeemed prior to their specified maturity date, and bonds that can be exchanged for shares of a company. Other bonds have different levels of risk, which can be determined by its credit rating.

Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

Why It Matters

Bonds and other fixed-income securities play a critical role in an investor's portfolio. Owning bonds helps to diversify a portfolio, as the bond market doesn't rise or fall alongside the stock market. More important, bonds are generally less volatile then stocks, and are usually viewed as a "safer" investment.

If you'd like to read more in-depth bond-related definitions, check out these definitions:

Collateralized Bond Obligation -- A bond that uses high-yielding junk bonds as collateral.
Commercial Paper -- A short-term commercial bond that matures in less than three months.
Convertible Bond -- A bond that can be exchanged for other investment securities.
Covenant -- The specific promises the bond issuer sets in the contract.
Credit Rating -- A grade assigned to a bond to indicate how risky it is.
Debentures -- An unsecured bond not backed by collateral.
Maturity Date -- The specified date when the bond issuer must pay back the investor's principal.
Municipal Bond -- A bond issued by a state or local government.
Treasury Bond -- Long-term bonds issued by the U.S. Treasury.

More bond-related definitions can be found at the InvestingAnswers Bond Category Page.

Source: Investing Answers

What It Is

A bearer bond, often called a coupon bond, is a bond whose certificate includes small detachable coupons. The coupons grant interest payments to the holder from the borrower.

How It Works

Actual bearer bonds are uncommon today because nearly all bonds are registered electronically rather than in certificate form. (although some bondholders still choose to receive paper certificates). Therefore, the term coupon refers to the interest rate of a bond rather than the physical nature of the certificate.

In the 1980s, some financial institutions started buying bearer bonds and selling the coupons as separate securities, called strips.

Let's assume you purchase a $1,000 XYZ Company bearer bond. The coupon rate on the bond is 5%, which means the issuer will pay you 5% interest per year, or $50, on the face value of the bond ($1,000 x 0.05). Even if your bond trades for less than $1,000 (or more than $1,000), the issuer is still responsible for paying you $50 per year. To claim your interest payment, you would simply clip off the appropriate coupon from the bond's certificate and show it to an agent of the issuer.

Why It Matters

Coupon bonds are called bearer bonds for a reason. That is, anyone who presents the coupon to the issuer is entitled to the interest payment even if that person is not the owner of the bond. Therefore, since bearer bonds offer many fraud and tax evasion opportunities, they are nearly unheard of today.

Instead, modern bonds are usually registered bonds or book entry bonds. Registered bonds are bonds with physical certificates that describe the terms of the debt, and the registered holder receives interest payments automatically from the issuer. Book entry bonds are bonds that are electronically registered to the financial institution acting on behalf of the investor. The investor receives a receipt for his or her bond in lieu of a certificate, and the investor's account at the financial institution receives the interest payment.

Source: Investing Answers

What It Is

Blanket bond refers to insurance coverage carried by banks and brokerage houses that protects against any losses incurred by unlawful or dishonest activity on the part of employees. It is also called a blanket fidelity bond or a fidelity bond.

How It Works

A blanket bond is a form of SEC-mandated insurance that protects banks, investment houses, and other financial companies.

Examples where a blanket bond would protect the company include, but are not limited to, trading fraud, embezzlement, material and intellectual theft, and forgery.

Why It Matters

A blanket bond differs from other insurance because it protects against a loss as a direct result of illicit activities from within the company. Most insurance policies would typically cover only losses incurred from external occurrences, such as burglary and property damage.

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What It Is

A convertible bond gives the bondholder the right to convert the bond into a fixed number of shares of common stock in the issuing company.

How It Works

For example, consider a Company XYZ bond with a $1,000 par value that is convertible into Company XYZ common stock. It has a coupon of 6%, payable annually. The bond’s prospectus specifies a conversion ratio, which is the number of shares that the investor will receive if he chooses to convert.  In this example, Company XYZ’s convertible bond has a conversion ratio of 20. The investor is effectively purchasing 20 shares of Stock XYZ for $50 per share ($1000 / 20 = $50).

The bondholder keeps the bond for two years and collects a $60 interest payment each year. At the end of year two, he elects to convert his bond into 20 shares of stock. By this time, the stock price has risen to $75 per share. The bondholder converts his bond to 20 shares at $75 per share, and now his investment is worth $1,500.

What makes this feature attractive to investors is that it allows bondholders to participate in the appreciation of the underlying security.

The conversion ratio is not the only aspect of a convertible bond to analyze. Like other bonds, convertible bonds usually offer a coupon, and their prices are based on prevailing market rates and the credit quality of the issuer.

Why It Matters

A firm issuing debt may add a convertibility feature to make the bonds more attractive to investors. The firm may be able to get a lower interest rate or better terms by adding a convertibility feature.

From the investor's perspective, a convertibility feature allows for collection of a steady stream of interest income plus an opportunity to take advantage of future stock price appreciation. Investors should be aware of the issuer's credit quality before investing and that there is reinvestment risk if the bond is callable. Investors should thoroughly review a bond’s prospectus before investing.

Source: Investing Answers

What It Is

A coupon bond, frequently referred to as a bearer bond, is a bond with a certificate that has small detachable coupons. The coupons entitle the holder to interest payments from the borrower.

How It Works

Actual coupon bonds are rare today because most bonds are not issued in certificate form; rather, they are registered electronically (although some bondholders still choose to hold paper certificates). Thus, these days the term coupon refers to the rate of interest on a bond rather than the physical nature of the certificate.

In the 1980s, some financial institutions began purchasing coupon bonds and selling the coupons as separate securities, called strips.

Let's assume you purchase a $1,000 XYZ Company coupon bond. The coupon rate on the bond is 5%, which means the issuer will pay you 5% interest per year, or $50, on the face value of the bond ($1,000 x 0.05). Even if your bond trades for less than $1,000 (or more than $1,000), the issuer is still responsible for paying you $50 per year. To claim your interest payment, you would simply clip off the appropriate coupon from the bond certificate and present it to an agent of the issuer.

Why It Matters

The fact that coupon bonds are usually bearer bonds is important, because it means that anyone who presents the coupon to the issuer is entitled to the interest payment regardless of whether that person is the owner of the bond. For obvious reasons, coupon bonds present a wide range of fraud and tax evasion opportunities, so they are nearly unheard of today.

Instead, modern bonds are usually registered bonds or book entry bonds. Registered bonds are bonds with physical certificates that describe the terms of the debt, and the registered holder receives interest payments automatically from the issuer. Book entry bonds are bonds that are electronically registered to the financial institution acting on behalf of the investor. The investor receives a receipt for his or her bond in lieu of a certificate, and the investor's account at the financial institution receives the interest payment.

Source: Investing Answers

What It Is

A guaranteed bond is a bond whose interest and principal payments are guaranteed by a third party.

How It Works

An entity that issues a guaranteed bond has solicited a third party (usually a bank, insurance company or another corporation) that agrees to pay the interest and principal payments on the bond should they, the issuer, be unable to make such payments. In exchange for guaranteeing the bond, the third-party guarantor receives a fee.

To illustrate, suppose City XYZ issues guaranteed municipal bonds. Company ABC guarantees the bonds in exchange for a $100,000 fee. If City XYZ is ever unable to make principal and interest payments to the bond holders, Company ABC will be responsible for making the payments.

Why It Matters

Guaranteed bonds are mutually beneficial to the issuers and the guarantors. Issuers can often get a lower interest rate on debt if there is a third-party guarantor.  And the third-party guarantor receives a fee for incurring the risk that comes with guaranteeing another entity's debt.

During the recent financial crisis, the U.S. government guaranteed many different types of debt in order to get credit flowing again. If you want to learn about some of the double-digit yields that come with ultra-safe, government-guaranteed debt, click here to read Forget Treasuries -- Buy This 12% Yield Instead.

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What It Is

A mortgage bond uses a mortgaged property as collateral.

How It Works

A mortgage bond is collateralized by one or several mortgaged properties. In case of default, the mortgaged properties may be sold to pay back bondholders.

For example, suppose bond ABC is backed by a mortgage on property XYZ. If bond ABC goes into default, the holders of the bond may liquidate property XYZ as compensation.

Why It Matters

Mortgage bonds, unlike traditional bonds with similar characteristics, tend to have lower yields. The reason is that mortgage bonds are lower risk because the mortgaged property is pledged as collateral.

Source: Investing Answers

What It Is

A municipal bond, commonly referred to as a "muni" bond, is a debt security issued by a state or local government.

How It Works

The purchaser of a municipal bond is effectively loaning money to a government entity, which will make a predetermined number of interest and principal payments to the purchaser. Issuers typically use municipal bond proceeds to finance day-to-day operating activities or capital expenditures for the public good such as road, hospital, school, or infrastructure projects.

There are many kinds of municipal bonds, but the two most prominent are general obligation bonds and revenue bonds. General obligation bonds are repaid with taxes collected by the issuer. They are unsecured and generally have maturities of at least 10 years. Revenue bonds are repaid with the revenue generated by the projects financed with the bond proceeds (such as a toll road).

Municipal bonds may be purchased directly from the issuer at the time of issuance or in the secondary market through a broker/dealer. One of the most popular ways to invest in municipal bonds is by purchasing shares of a municipal bond fund.

Why It Matters

One of the biggest advantages of investing in municipal bonds is their tax-advantaged status. That means many investors in high tax brackets particularly benefit from investing in municipal bonds. Furthermore, since they are issued by government entities, municipal bonds are more likely to repay their debts. This low-risk makes the bonds attractive to conservative investors. Finally, some investors feel a sense of civic pride by investing in projects that will positively affect the community in which they live.

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What It Is

A Z-bond is a bond representing the last tranche of a bond that relies on payments from underlying securities.

How It Works

To understand how Z-bonds work, it's important to understand how they're created. Let's assume you want to buy a house, and so you get a mortgage from XYZ Bank. XYZ Bank transfers money into your account, and you agree to repay the money according to a set schedule. XYZ Bank (which could also be a thrift, credit union, or other originator) may then choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over the next several years) or sell it.

If XYZ Bank sells the mortgage, it gets cash to make other loans. So let's assume that XYZ Bank sells your mortgage to ABC Company, which could be a governmental, quasi-governmental, or private entity. ABC Company groups your mortgage with similar mortgages it has already purchased (referred to as "pooling" the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates, maturities, etc.).
ABC Company then sells securities that represent an interest in the pool of mortgages, of which your mortgage is a small part (called securitizing the pool). It sells these (Mortgage-backed Securities) MBS to investors in the open market. When you make your monthly mortgage payment to XYZ Bank, XYZ Bank keeps a fee or spread and sends the rest of the payment to ABC Company. ABC Company in turn takes a fee and passes what's left of your principal and interest payment along to the investors who hold the MBS (ABC Company hires a central paying agent to accomplish this administratively).

Investors who buy the Z-bonds start receiving interest and principal payments only after all the other tranches have been paid. These bonds can have maturities as long as 20 years or more. Interest accrues on these bonds, but no cash payments are made until the other tranches have been retired.

Why It Matters

Z-bonds are the riskiest MBS because investors receive no cash payments for an extended period of time and thus may be more likely to be left holding the bag if the underlying mortgages default. However, the presence of Z-bonds also makes the senior tranches more secure -- after all, those tranches (and their investors) get the Z-bond's payments first. One advantage, however, is that the holder of a Z-bond does not face much reinvestment risk -- he or she will continue to accrue interest as the stated interest rate for the life of the bond (even though no cash payments may come immediately).

For investors, an MBS is much like a bond. Most offer semi-annual or monthly income, and this payment frequency enhances the compounding effects of reinvestment. However, it is important to note that payments that are part interest and part principal could be unfavorable to some investors, because with each decrease in outstanding principal there is a corresponding decrease in the amount of interest that accrues. For example, if a $50,000 Ginnie Mae with a 5% coupon would pay $208.33 ($50,000 x .05/12) in interest every month, but it might also pay $100 in principal. This means that only $49,900 is earning interest next month, and by the end of the year there may only be $48,800 earning interest. The return of principal could also vary depending on how quickly the underlying mortgages are repaid.

Prepayment risk is a large concern for MBS investors. When people move, for example, they sell their houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. Like bonds, changes in interest rates affect MBS prices, but the change is exacerbated by the fact that MBS investors are more likely to get their principal back early. They might have to reinvest that principal at rates below what their MBS were yielding.

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