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Bonds as an Investments

Fixed - Income Securities - Bonds

Unlike equity securities, the cash flows to fixed-income securities are fixed or specified in advance and are a contractual obligation. The cash flows are the interest payments, generally paid semiannually, and the repayment of principal at maturity. Thus, a $ 2,000 10-year 12 % bond will make 20 semiannual payments of $120, plus one payment of $2,000 at the end of 10 years. Purchase of a bond is considered a form of lending. The investor must still bear credit risk which is the risk that the issuer will default by failing to meet some or all of the obligations. Bonds are often separated by issuer into governments, municipals, and corporates.

Government Bonds

Government bonds are securities issued by the U.S. Treasury and by US. government agencies. Treasury securities are backed by the full faith and credit of the United States government, and are considered to have no credit risk. Treasury securities enjoy one of the most active markets, and are highly liquid. The market is an over-the-counter market where government securities dealers stand ready to buy or sell, providing continuous quotes.

Agencies are bonds issued by government agencies, with fixed interest payments and maturity value. These securities are technically are not directly obligations of the U. S. government. Nonetheless, it is widely assumed that the U.S. government would support the obligation, and the bonds are considered to have very low credit risk.

Municipal Bonds

Municipal bonds are issued by state and local governments, with fixed interest payments and maturity values. Interest payments on municipal bonds are exempt from federal taxes, and from state and local taxes within the state of issue (but not in other states). Because of this tax exempt feature, these bonds tend to have a lower yield than taxable bonds. Capital gains on municipal bonds are fully taxable. It is important to recognize, however that not all bonds issued by state and local governments qualify for this tax treatment, and the investor is advised to use caution.

General obligation bonds are supported by the full faith and credit of the issuer. In reality, this means that the bonds ultimately rely on the taxing power of the municipality. Revenue bonds issued to finance a particular project, such as a sewer line or bridge. The credit risk of a particular issue depends on the viability of the project being financed. Various maturities are available, usually up to 30 years. Municipals are sometimes issued as serial bonds.

Corporate Bonds

Corporates are simply bonds issued by corporations, typically with fixed interest payments and maturity. The credit risk of a corporate bond is a reflection of the viability of the issuer, and variations are wide. Beyond the credit risk there are a number of characteristics and arrangements which affect the risk of the bond. These characteristics and arrangements are spelled out in the indenture, or legal agreement under which the bond is issued.
One important characteristic of a corporate bond is the collateral.

Mortgage bonds

Are secured by a claim on a specific asset, usually real property. They may be: open end, limited open end, or closed end, depending on the extent to which the collateral can be used as security for other issues./p>

Equipment trust certificates are a variation of mortgage bond using equipment as security, while collateral trust certificates use securities of other entities as security. In bankruptcy, the asset would be sold and the proceeds used to pay the claims of the mortgage bondholders. Any excess proceeds would go the claimants of next highest priority. If the proceeds were insufficient, the mortgage bondholders claims for the balance would simply be joined to the holders of debentures. Debentures are secured by a general, nonspecific claim on the firm's assets. In some cases the security of mortgage bonds or debentures may be augmented by the existence of subordinated debentures. In case of bankruptcy the holders of subordinated debentures must subordinate their claims to another specific class of bonds, and will receive payments only after the claims of the other class have been met in full.

Callable bonds

This is a bonds that can be repurchased by the firm at its option. The call price at which the forced repurchase is carried out includes a call premium, which is often equal to one year's interest. The call premium may vary over the life of the bond, typically becoming smaller as maturity nears. The premium may also vary in size depending on the reason underlying the call. This feature is to the benefit of the firm, primarily if the firm desires to refund the issue by replacing it with an issue with lower interest cost. Despite the attraction of receiving the call premium, the investor faces the prospect of being forced to replace the investment with a security of lower yield. This will be the case since the firm will only recall the issue when recall is to its advantage — i.e., when yields are low. Further, the call price becomes in effect an upper limit to the price of the bond. Since this feature is disagreeable to investors, callable bonds typically have a higher yield than similar non-callable bonds. Bonds are often call protected for a certain period to make the feature more acceptable to investors and allow issue at a lower yield. At the other extreme is the putable bond, which may be sold back to the issuer at the option of the investor. This feature is attractive to investors.

The maturity date of a bond issue is a time of some concern. While the firm may be able to make the periodic interest payment, the repayment of principal at maturity may be beyond the ability of the firm. Normally, an issue will simply be replaced by a new issue, but this may prove difficult or impossible. A sinking fund is a way of avoiding this end of life crisis. Originally, a sinking fund requirement actually created a fund to which the firm made payments, so that all or at least a portion of the maturity payments, were available. At present, however, the sinking fund usually requires that a certain number of bonds be retired each year. If the bonds are selling below the call price, the requirement will be met through purchase on the open market If the bonds are above the call price, they will be called. Often the call premium for purchases to meet sinking fund requirements are less than call premiums for refunding. This feature is thus a mixed blessing for investors. On the one hand the possibility of end of life crisis is lessened, the average life of the issue is shortened, and it is also thought that sinking fund repurchases will support the value of the bonds. On the other hand, the investor faces the possibility of call at a reduced premium. The effect is similar to that of municipal serial bonds.

Convertible bonds are bonds that can be converted into the common stock of the issuing firm. Zero coupon bonds are bonds mat have ho interest payment, but instead provide a return by being sold at a discount. In fact, there are a large variety of other characteristics that have been written into the bond indenture, the agreement under which the bond is issued, and the instrument is very flexible.

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