OCW041: Overview of Bonds

Characteristics of Bonds

In finance, bonds are a form of debt: the creditor is the bond holder, the debtor is the bond issuer, and the interest is the coupon.

Learning Objectives

Summarize the characteristics of a bond

Key Takeaways

Key Points

  • Interest on bonds, or coupon payments, are normally payable in fixed intervals, such as semiannually, annually, or monthly.
  • Variations exist in bond types, payment terms, and features.
  • The yield is the rate of return received from investing in the bond.
  • The issuer has to repay the nominal amount on the maturity date.

Key Terms

  • perpetuity: An annuity in which the periodic payments begin on a fixed date and continue indefinitely.
  • coupon: Any interest payment made or due on a bond, debenture, or similar.
  • par: Equal value; equality of nominal and actual value; the value expressed on the face or in the words of a certificate of value, as a bond or other commercial paper.

Overview Of Bonds

Bonds are debt instruments issued by bond issuers to bond holders. A bond is a debt security under which the bond issuer owes the bond holder a debt including interest or coupon payments and or a future repayment of the principal on the maturity date. Variations exist in bond types, payment terms, and features.

Interest on bonds, or coupon payments, are normally payable in fixed intervals, such as semiannually, annually, or monthly. Ownership of bonds are often negotiable and transferable to secondary markets. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

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Government Bond: This is an image of a state-issued debt instrument including all the essential information for the indenture.

Bonds and stocks are both securities, but the major difference between the two is that stockholders have an equity stake in the company, whereas bondholders have a creditor stake in the company. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is an irredeemable bond, such as a perpetuity.

Principal

Nominal, principal, par, or face amount—the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term.

Maturity

The issuer has to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or maturity of a bond. In the market for United States Treasury securities, there are three categories of bond maturities:

  • short term (bills): maturities between one to five year (instruments with maturities less than one year are called money market instruments)
  • medium term (notes): maturities between six to twelve years
  • long term (bonds): maturities greater than twelve years

Coupon

The coupon is the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic.

Yield

The yield is the rate of return received from investing in the bond. It usually refers either to the current yield, or running yield, which is simply the annual interest payment divided by the current market price of the bond. It can also refer to the yield to maturity or redemption yield, which is a more useful measure of the return of the bond, taking into account the current market price, and the amount and timing of all remaining coupon payments and of the repayment due on maturity. It is equivalent to the internal rate of return of a bond.

Credit Quality

The “quality” of the issue refers to the probability that the bondholders will receive the amounts promised on the due dates. This will depend on a wide range of factors. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment-grade bonds, investors expect to earn a higher yield. Therefore, because of the inherent riskiness of these bonds, they are also called high-yield or “junk” bonds.

Market Price

The market price of a tradeable bond will be influenced among other things by the amounts, currency, the timing of the interest payments and capital repayment due, the quality of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets.

The issue price at which investors buy the bonds when they are first issued will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price less issuance fees.

Optionality

Occasionally a bond may contain an embedded option:

Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates. These are referred to as retractable or putable bonds.

Types of Bonds

In finance, there are many different types of bonds that vary in term agreements, duration, structure, source, and other characteristics.

Learning Objectives

Differentiate be the various types of bonds including secured and unsecured, registered and unregistered and convertible

Key Takeaways

Key Points

  • Bonds can be either secured or unsecured.
  • Bonds can be registered or unregistered.
  • Some bonds are exchangeable or convertible.

Key Terms

  • default: The condition of failing to meet an obligation.
  • coupon: Any interest payment made or due on a bond, debenture or similar (no longer by a physical coupon).
  • secured bond: a debt security in which the borrower pledges some asset as collateral
  • debenture: A certificate that certifies an amount of money owed to someone; a certificate of indebtedness.
  • convertible bond: a type of debt security that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price
  • principal: The money originally invested or loaned, on which basis interest and returns are calculated.

In finance, there are many types of bonds. This section provides a overview of the most common types that exist in the financial world today.

Secured bonds

This is a bond for which a company has pledged specific property to ensure its payment.

Mortgage bonds

The most common secured bonds. It is a legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments.

Unsecured bonds

A debenture bond, or simply a debenture. This is an unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. More easily issued by a company that is financially sound.

Registered bonds

This bears the owner’s name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal (or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner’s name.Therefore, owners can easily replace lost or stolen registered bonds.

Unregistered (bearer) bonds

This is the property of its holder or bearer and the owner’s name does not appear on the bond certificate or in a separate record. Physical delivery of the bond transfers ownership.

Coupon bonds

These are not registered as to interest. Coupon bonds carry detachable coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and presents it to a stated party, usually a bank, for collection.

Term bonds and serial bonds

A term bond matures on the same date as all other bonds in a given bond issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.

Callable bonds

These contain a provision that gives the issuer the right to call (buy back) the bond before its maturity date, similar to the call provision of some preferred stocks. A company is likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.

Convertible bonds

A convertible bond may be exchanged for shares of stock of the issuing corporation at the bondholder’s option. These bonds have a stipulated conversion rate of some number of shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make risky debenture bonds more attractive to investors.

Bonds with stock warrants

A stock warrant allows the bondholder to purchase shares of common stock at a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of stock through exercise of the warrants.

Junk bonds (High-yield bonds)

These are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged buyouts or LBOs), and hostile or friendly takeovers of companies by outside parties. By early 1990s, junk bonds lost favor as many issuers defaulted on their interest payments. Some issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.

Fixed rate bonds

These have a coupon that remains constant throughout the life of the bond. A variation is stepped-coupon bonds, whose coupon increases during the life of the bond.

Floating rate notes

Also known as FRNs or floaters, these have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor.

Zero-coupon bonds

Zeros pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date.

Exchangeable bonds

These allow for exchange to shares of a corporation other than the issuer.

War bond

These are issued by a country to fund a war.

Municipal bond

These are bonds issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal tax and the issuing state’s income tax. Some municipal bonds issued for certain purposes may not be tax exempt.

Treasury bond

Also called a government bond, this is issued by the Federal government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. Backed by the “full faith and credit” of the federal government, this type of bond is often referred to as risk-free.

Issuing Bonds

On issuance, the journal entry to record the bond is a debit to cash and a credit to bonds payable.

Learning Objectives

Explain how a company would record a bond issue and how to determine the selling price of a bond

Key Takeaways

Key Points

  • Bonds differ from notes payable because a note payable represents an amount payable to only one lender, while multiple bonds are issued to different lenders at the same time.
  • Bonds are a form of financing for a company, in which the company agrees to pay the bondholders interest over the life of the bond. When bonds are issued they are classified as long-term liabilities.
  • Other journal entries associated with bonds is the accounting for interest each period that interest is payable. The journal entry to record that is a debit interest expense and a credit to cash.
  • The amount of risk associated with the company issuing the bond determines the price of the bond. The more risk assessed to a company the higher the interest rate the issuer must pay to bondholders.

Key Terms

  • liabilities: An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.
  • journal entry: A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

Issuing Bonds

Bonds are essentially a form of financing for a company, but instead of borrowing form a bank the company is borrowing from investors. In exchange, the company agrees to pay the bondholders interest at predetermined intervals, for a set amount of time.

Bonds differ from notes payable because a note payable represents an amount payable to only one lender, while multiple bonds are issued to different lenders at the same time. Also, the bondholders may sell their bonds to other investors any time prior to the bonds maturity.

Bond prices

The market price of a bond is expressed as a percentage of nominal value. For example, a bond issued at par is selling for 100% of its face value. Bonds can sell for less than their face value, for example a bond price of 75 means that the bond is selling for 75% of its par (face value).

The amount of risk associated with the company issuing the bond determines the price of the bond. The more risk assessed to a company the higher the interest rate the issuer must pay to buyers. If a bond has a coupon interest rate that is higher than the market interest rate it is considered a premium.

The premium (higher interest rate) is to offset the assumed higher than average risk associated with investing in the company.

Bonds are considered issued at a discount when the coupon interest rate is below the market interest rate.That means a company selling bonds at a discount rate receive less than the face value of the bond in the sale.

When bonds are issued, they are classified as long-term liabilities. On issuance, the journal entry to record the bond is a debit to cash and a credit to bonds payable.

Other journal entries associated with bonds is the accounting for interest each period that interest is payable. The journal entry to record that is a debit interest expense and a credit to cash.

Bonds Payable and Interest Expense

Journal entries are required to record initial value and subsequent interest expense as the issuer pays coupon payments to the bondholder.

Learning Objectives

Summarize how a company would record the original issue of the bond and the subsequent interest payments

Key Takeaways

Key Points

  • Issuers must account for interest expense during the term of issued bonds.
  • Bonds are recorded at face value, when issued, as a debit to the cash account and a credit to the bonds payable account.
  • Bonds require additional entries to record interest expense as the issuer pays coupon payments to the bondholder according to the agreed terms of the bond.
  • National governments, municipalities and companies issue bonds to raise cash.

Key Terms

  • yield: The current return as a percentage of the price of a stock or bond.
  • face value: The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.
  • record date: the date at which a shareholder must be registered in order to receive a declared dividend
  • coupon: Any interest payment made or due on a bond, debenture or similar (no longer by a physical coupon).

Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the future, and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the maturity date.

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Old Lousianna State Bond: Louisiana “baby bond”, 1874 series, payable 1886

Example of bonds issued at face value on an interest date:-

Valley Company’s accounting year ends on December 31. On 2010 December 31, Valley issued 10-year, 12% yield bonds with a USD 100,000 face value, for USD 100,000. The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for the 10 years are as follows:

On 2010 December 31, the date of issuance, the entry is:

2010 Dec. 31 Cash (+A) 100,000

Bonds payable (+L) 100,000

To record bonds issued at face value.

On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry would be: Each year June 30 And Dec.31

Bond Interest Expense ($100,000 x 0.12 x½) (-SE) 6,000

Cash (-A) 6,000

To record periodic interest payment. On 2020 December 31, the maturity date, the entry would be:

2020 Dec. 31

Bond interest expense (-SE) 6,000

Bonds payable (-L) 100,000

Cash (-A) 106,000

To record final interest and bond redemption payment.

Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the accounting period. The income statement for each of the 10 years (2010-2018) would show Bond Interest Expense of USD 12,000 (USD 6,000 X 2); the balance sheet at the end of each of the years (2010-2018) would report bonds payable of USD 100,000 in long-term liabilities. At the end of 2019, Valley would reclassify the bonds as a current liability because they will be paid within the next year.

The real world is more complicated. For example, assume the Valley bonds were dated 2010 October 31, issued on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on December 31 to accrue interest for November and December. That entry would be:

2010 Dec. 31

Bond interest expense ($100,000 x 0.12 x 2/12) (-SE) 2,000

Bond interest payable (+L) 2,000

To accrue two month’s interest expense.

The 2011 April 30, entry would be: 2011 Apr. 30

Bond interest expense ($100,000 x 0.12 x(4/12)) (-SE) 4,000

Bond interest payable (-L) 2,000

Cash (-A) 6,000

To record semiannual interest payment.

The 2011 October 31, entry would be:

2011 Oct. 31

Bond interest expense (-SE) 6,000

Cash (-A) 6,000

To record semiannual interest payment.

Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest. The firm would report the USD 2,000 Bond Interest Payable as a current liability on the December 31 balance sheet for each year.


Source: Accounting