Bonds

Characteristics of Bonds and Ownership

Issuing bonds comes with advantages and disadvantages for companies; issuing bonds provides capital but also accrues debt on financial statements.

At their most basic, bonds, or debt securities, are loans between a company and a group of investors. They are a way for companies to raise capital for initiatives such as expansion. It is typical to compare bonds to bank loans. Like an individual, a company can take out a loan from a bank. This will put cash into the company's bank account and at the same time place debt on its financial statement. Bonds are similar to these loans but with some added benefits. Bonds can be offered at a lower interest rate than loans. Because interest translates into expense for a company, paying a lower interest rate results in lower expense.

Bonds also have the capacity to raise a significant amount of capital relatively easily. The same bond type can be issued multiple times to a high number of investors. This significantly opens up the capital supply available to a company. It could be difficult to find a single bank to loan $100 million, for example, but selling one million bonds at $100 each makes acquiring funding possible.

Because bonds are a type of loan, the two components that determine a bond's value are the credit rating of the company, or the measurement of the likelihood that the company will default on its debt obligations, and the repayment amount, or the total amount that must be paid back. The credit rating and repayment amount are considered both before and at the time that the debt is paid back. The bond is issued at a specific amount, called the par value or face value. The face value is the principal amount that is returned to the lender at the end of maturity. A debt security that sells over its face value is a premium bond. A debt security that sells under the face value is a discount bond.

The payment associated with the interest rate is called a coupon payment, or a periodic payment from a bond that is outside of the payment at maturity, when the bond's value is paid. The coupon rate is generally expressed as a percentage. For example, if Megacompany Inc. issues a $1,000 par value bond that has a coupon rate of 10 percent, then it will pay $100 in interest annually, which will most likely be paid in $50 every six months. Some bonds are sold at a discount and do not pay interest. A zero-coupon bond is a debt security that is issued at a deep discount to its face value; it does not pay interest payments, but at maturity pays the full face value. This is one way for a company to raise capital and to defer all of the costs until the end of the maturity date.

The credit rating of the issuing organization is important. Standard & Poor's (S&P) and Moody's are two groups that analyze companies and give bond ratings. A bond rating is the credit rating of a bond based on the likelihood of default and other instrument-specific risks. A credit rating of BBB or higher is given to an investment-grade bond with good credit. A bond with a low credit rating for which investors can expect a high return on investment will have a C or D grade; thus, it is called a high-yield bond, or junk bond.

Bond Ratings

Bonds are rated by an independent agency, such as Moody's or Standard & Poor's, using the risk of default and the strength of the underlying asset in the analysis.