Bond & Types of Bonds

A bond is a debt security. When investor purchase a bond, investor are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay investor a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures," or comes due.

A bond is a loan that pays interest over a fixed term, or period of time. When the bond matures at the end of the term, the principal, or investment amount, is repaid to the lender, or owner of the bond. Typically, the rate at which interest is paid and the amount of each payment is fixed at the time the bond is offered for sale. That's why bonds are known as fixed-income securities. That's one reason a bond seems less risky than an investment whose return might change dramatically in the short-term.

A bond's interest rate is competitive, which means that the rate it pays is comparable to what other bonds being issued at the same time are paying. It's also related to the cost of borrowing in the economy at large, so when mortgage rates are down, for example, bond rates also tend to be lower.

The Tenure of Bond : The life, or term, of any bond is fixed at the time of issue. It can range from short-term (usually a year or less), to intermediate-term (two to ten years), to long-term (30 years or more). Generally speaking, the longer the term, the higher the interest rate that's offered to make up for the additional risk of tying up investor’s money for so long a time. The relationship between the interest rates paid on short-term and long-term bonds is called the yield curve.

Making money with Bonds : Conservative investors use bonds to provide a steady income. They buy a bond when it's issued and hold it, expecting to receive regular, fixed-interest payments until the bond matures. Then they get the principal back to reinvest. More aggressive investors trade bonds, or buy and sell as they might with stocks, hoping to make money by selling a bond for more than they paid for it. Bonds that are issued when interest rates are high become increasingly valuable when interest rates fall. That's because investors are willing to pay more than the face value of a bond with an 8% interest rate if the current rate is 5%.

In this way, an increase in the price of a bond, or its capital appreciation, often produces more profits for bond sellers than holding the bonds to maturity. But there are also risks in bond trading. If interest rates go up, investor can lose money by selling an older bond, which is paying a lower rate of interest. That's because potential buyers will typically pay less for the bond than investor paid to buy it. The other risk bondholders face is rising inflation. Since the dollar amount investor earn on a bond investment doesn't change, the value of that money can be eroded by inflation. For example, if investor held a 30-year bond paying $5,000 annual interest, the money would buy less at the end of the term than at the beginning.

Convertible Bonds : A convertible bond is one which is convertible into the company's common stock. The conversion option to the bond is exercisable when and if the investor wants to do it. The conversion ratio varies from bond to bond. The terms of conversion are set forth in the indenture. The exact number of shares or the method of determining how many shares the bond is converted into is printed in the indenture.

Many times the indenture will tell investor how many shares of stock the bond is convertible into. For instance, it might say that it is convertible into 20 shares. Therefore, the conversion ratio is 20:1. Unfortunately, it's not always that easy. For instance, the indenture might state the conversion price. The conversion price is the price per share that the company is willing to trade their shares of stock for the bond. For example, if the indenture states that the conversion price is $50 per share, the bond is convertible into 20 shares of stock. Investor divide the par value (usually $1,000 for corporate bonds) by the conversion price. Occasionally, the indenture might state that the conversion ratio will change through the years. For example, the conversion price might be $50 for the first five years, $55 for the next five years, and so forth. There are also anti-dilutive features to the conversion feature. If the stock were to split 2 for 1, and the conversion ratio was 20 to 1 prior to the split, after the split, the conversion ratio would be 40 to 1. A stock dividend would also have the same effect. A stock split would also reduce the conversion price.

Because convertible bonds have a little something extra, the right to convert to common stock, that little something extra costs the bond holder. The bond will usually carry a slightly lower interest rate. If the stock price rises, the bond price will also rise. Since most convertible bonds are also callable, the company can force the bond holders to convert the bonds to common stock by calling the bonds. This is known as 'Forced Conversion'. When a bond is converted to common stock, the corporate debt is reduced. What was formerly debt has now been converted to equity. Of course, converting debt (bonds) into stock (equity) has the effect of diluting the equity. The company didn't get any larger with the additional stock. But each stockholder's piece of the pie got smaller. If the company's stock declines to a price which makes the convertible feature of the bond worthless, as long as the company is solvent, the bond will trade based on its yield - like any other bond. There is a price level to which a bond will fall and fall no further as long as the company can pay its interest and the principal upon maturity.

Corporate Bonds : Corporate bonds are debt obligations issued by corporations as an alternative to issuing stock when raising capital. The corporation promises to repay the loan at a specified future date and makes semi-annual interest payments to the investor at a fixed rate. Because bonds are senior to stock, interest and principal are paid to bondholders before dividends are paid to stockholders.

Benefits of corporate bonds - Whether investor are purchasing corporate bonds to diversify investor’s portfolio or buying them because investor’s investment strategy calls for higher returns than Treasuries offer, investor can take advantage of:

Flexibility - Investors have the option to select from a wide range of corporate bonds -- ranging from specific industries to particular coupons, maturities and ratings.

Dependable Income - Corporate bonds pay interest semi-annually until maturity or until they are called. Investors / owners will know when to expect your payments and how much they'll be.

Diversification - Many people buy bonds to diversify their portfolios. Because there are so many different corporate bonds, you can structure your portfolio according to your particular investment strategy. Of course, your mix of bonds and stock will depend on your investment objectives.

Liquidity - If you need cash you can sell your bonds any time prior to maturity in the secondary market. Some bonds trade more actively than others and may be easier to sell. Because bond prices and interest rates move in opposite directions, you may receive more or less than your original investment if you sell. Of course, if you hold your corporate bond until maturity, the issuer promises to pay back the full face value.

High Returns - Corporate bonds offer higher yields than Treasury bonds of similar maturities and may be appropriate for investors who are willing to trade off some security for potentially higher returns. Usually, bonds with higher yields have lower credit ratings. And some bonds are callable, which limits your ability to lock in the high yield for the full term.

Extendible/Retractable Bonds - Extendible and retractable bonds have more than one maturity date. An extendible bond gives its holder the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. Investors use extendible/retractable bonds to modify the term of their portfolio to take advantage of movements in interest rates. The characteristics of these bonds are a combination of their underlying terms. When interest rates are rising, extendible/retractable bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with their longer terms.

Extendible Bonds - An extendible bond provides its owner the right to "extend" its initial maturity at a specific date or dates. The investor initially purchases a shorter term bond combined with the right to extend its term to a longer maturity date. An investor purchases an extendible bond to have the ability to take advantage of potentially falling interest rates without assuming the risk of a long term bond. As interest rates fall, the price of a shorter term bond rises less than the price of a longer term bond. This means the extendible bond begins to behave or "trade" as a longer term bond. On the other hand, if interest rates rose, the extendible bond would behave as a shorter term bond.

Retractable Bonds - With a retractable bond, an investor owns a longer term bond with the right to "retract" it at a specific date. Consider an investor that believes that interest rates will rise and bond prices will fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer term retractable bond which behaves initially as a similar term long term bond. As interest rates rise the bond falls in price. Once its price is low enough, it will begin to behave as a short term bond and its price fall will be much less than a normal long term bond. At worst, the investor can retract it at the retraction date and receive the par amount back to reinvest.

Pricing Extendible/Retractable Bonds : Usually, the extension or retraction feature means that the price of an extendible/retractable bond is higher and the interest rate lower than other similar term bonds. The motivation of the issuer is obvious, having to pay a lower interest rate than would otherwise be the case. The investor's motivation comes from the "defensive" feature of these bonds. The investor gains the potential upside of a longer term bond with the price risk of a shorter term bond. Looking at it another way, the investor can lock in a longer term interest rate with the option to shorten at his or her discretion.

Originally, these bonds were created as "sweeteners" as a way to sell bonds more easily. The market conditions were not conducive to issuing longer term bonds or the issuer wanted a lower interest rate than was available at that time. Adding the extension or retraction feature made it easier to sell the issue or cheaper for the issuer. At that time, the "rule of thumb" was that these bonds should be issued .2% less in yield than a normal bond of the same issuer.

More recently, with the development of options and swap markets, these bonds are priced using option pricing techniques. These view extendible and retractable bonds as a combination of a normal bond and a "call option" (extendible) or "put option" (retractable). "Option Adjusted Spread" (OAS) analysis uses statistical "decision trees" to assess the worth of these options given historical patterns of interest rate movements.