Bonds are a diverse group of investments. They have many different provisions, options or features that differentiate them from one another. This tutorial discusses information about many common bond characteristics. Some of these properties may be privileges for the bondholders. Others are advantageous to the issuers. Some benefit both parties.
We will discuss the following topics:
The first topic covers the life span of bonds.
BOND MATURITY
Unlike stocks, bonds have finite lifetimes. The issuers of bonds determine the lifetimes before they sell the bonds to investors. The date on which a bond comes due is called maturity or maturity date. Some people use the word "maturity" to refer to the lifetime itself. For example, they may say that a particular bond has a ten-year maturity.
Maturities range from one month to as long as fifty years. Some different maturity times for different bonds are as follows:
Corporate bonds -- 10 to 40 years
Municipal bonds -- 1 to over 20 years
Municipal notes -- 1 month to 1 year
U.S. Government agency bonds -- 3 years and over
U.S. Treasury bonds -- 10 to 30 years
U.S. Treasury notes -- 2 to 10 years
Our next topic is the issuer's privilege of cutting short a bond's maturity. This is Callability.
CALLABILITY
Callability is a bond issuer's privilege of redeeming its bonds early, before they are ready to mature. Corporations often call their bonds when interest rates are falling. When interest rates fall, they may want to replace any high-yielding bonds with newer, lower-yielding bonds. A callable bond specifies the call price in the bond. The call price is the price the issuer will pay if the bond is called.
Callability has some advantages for investors. The call price is always greater than the bond's face value because the issuing corporation adds a premium to it. Thus, the investor can profit from the early redemption.
The opposite of callability is the bondholder's right to redeem a bond early. This is the subject of the next screen.
PUT PROVISIONS
A put provision allows the bondholder to redeem a bond at its face value before it matures. Investors may do this when interest rates are rising and they can take advantage of higher rates elsewhere. They may not "put" their bonds whenever they choose, however. The issuer assigns dates for this provision, after which the bondholders can redeem the bonds.
Compared to callable bonds, "put bonds" are quite rare.
Read below to learn about bonds that can be converted into stock.
CONVERTIBILITY
Convertibility is the option of converting a bond into stock. Bonds with this feature are called convertible bonds. They give the investor the option to convert the bond into the issuing company's stock, generally the common stock.
Conversion must occur at specified times, at specified prices and under specified conditions. All of these must be set down in writing at the time of issue. Bonds can also be callable and convertible in one. By this provision, the company can force investors to convert their bonds to stock.
One advantage to the holder of a convertible bond is that he or she receives the low volatility of a bond and the ability to take advantage of the stock's growth.
One disadvantage is that convertible bonds offer lower interest rates than non-convertible bonds. Another is that they are not secured.
SECURED AND UNSECURED BONDS
Bonds may be secured or unsecured. To be secured is to be backed by collateral. The bond issuer must give this money or physical assets to investors if the bond defaults. A secured bond ensures the bondholder that the assets will be distributed to the bondholders upon default by the issuer. Corporate bonds and municipal bonds may be secured or unsecured. Federal government bonds, however, are unsecured.
Unsecured bonds are called debentures. Instead of securing them with some kind of collateral, the issuer "backs" them with its creditworthiness. Many consider the creditworthiness of the federal government to be the best there is. This is why U.S. Government securities are very popular among investors.
TAX-DEFERRAL FEATURES
The interest income on some bonds is either free of federal tax or can be deferred from tax until the bond matures.
Most municipal bonds (bonds issued by cities and states) pay interest that is federally tax-free. This feature makes them popular as bond investments. Although the interest income is tax-free, you will have to pay tax on any capital gains when you sell a municipal bond. If a municipal bond is issued at a discount, however, the difference between the discount and the face value is considered interest income.
Some bonds have a tax-deferral option. These bonds are sold at discounts. As they move toward maturity, the bondholder can pay taxes on the yearly increases in their value. However, the investor can defer paying income tax until the bonds mature. With the Series EE bond (a type of savings bond), he or she may even defer it longer than this if he or she exchanges the bond at maturity for a Series HH bond, another type of savings bond.
INTEREST AND YIELDS
Besides returning the principal, most bonds guarantee payment of interest at a specified rate. The rate of interest on the face amount (par) is referred to as the coupon rate or interest rate.
The yield refers to the rate the bondholder receives as a percentage of the investment. If the bondholder pays the face amount (par) for the bond, the coupon rate and yield are the same. In this example, the coupon rate is the "nominal yield."
The current yield is the yearly interest payment relative to its price in the secondary market. To calculate the current yield, divide the annual interest payment by the current market value.
The yield-to-maturity is the fully annual compounded rate of return paid out over a bond's life, including appreciation/depreciation and earnings. You would have to receive this rate on an investment today to equal the future returns on the bond.
The yield-to-call is the annual rate you would have to receive on an investment today to give you the future returns on the date a callable bond is called.
DISCOUNTS AND PREMIUMS
Bonds are not always sold at face value (par). Some bonds are sold for more or less than their face values: these bonds are sold at premiums or discounts.
Bonds can be discounted by their issuing companies or when bondholders sell them to others on the secondary market. When interest rates in the market rise, a bond's fixed interest payments are less attractive (the coupon rate is too low). To induce an investor to purchase a bond with a low coupon rate, the bond price must be lowered until the current yield equals the market rate.
Discounted bonds that do not pay interest are called zero-coupon bonds. Here is how they work: let us say you buy a $1,000 bond for only $300. When the bond matures, you are given $1,000. The $700 difference will be treated as "interest" for tax purposes.
A premium is an increase in price. When interest rates decrease, bonds with high interest rates are in demand. Investors who want to buy these bonds will offer to buy them at premiums.
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