bond

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.

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.

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.

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.

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.

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.

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.

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.

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.