Capital Sources for Business: Bonds

A bond is a type of loan. Bonds are certificates of debt that is issued by a government or corporation in order to raise money with a promise to pay a specified sum of money at a fixed time in the future and carrying interest at a fixed rate. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). The main types of bonds are corporate bond, municipal bond, Treasury bond, Treasury note, Treasury bill, and zero-coupon bond. It is a tradable debt instrument that might be sold at above or below par (the amount paid out at maturity), and are rated by bond rating services to specify likelihood of default. Bonds are relatively more secured than equity and has priority over shareholders if the company becomes insolvent and its assets are distributed.

There is no legal distinction between a debenture and a bond except that a debenture could be either secured or unsecured, whereas a bond is secured. The term bond is usually applied to public sector debt offerings.

Features of a Bond

A bond is a marketable debt instrument. The length of time before it matures is called term to maturity, usually greater than a year. Those with term to maturity of less than a year are called money market instruments, and those with term greater than one year are called capital market instruments.

The issuer generally pays a fixed rate of interest on the principal (face value). The rate of interest is called coupon rate, and the amount itself is called coupon. The coupon can be paid annually or semi-annually.

Long-term debt instruments share several common features.

  1. Stated maturity: This is the date by which the borrower must repay the money it borrowed.
  2. Stated principal amount: This is the amount the borrower must repay.
  3. Stated coupon rate of interest: The interest rate may be a fixed rate, or it may be a variable rate that is adjusted according to a specified formula.
  4. Mandatory redemption (or sinking fund) schedule: Some bonds contain a sinking fund, whereas others are repaid in a single sum at maturity. A sinking fund involves a sequence of principal repayments prior to the maturity date. Bonds are redeemed in cash at their face amount or else through capital market purchases.
  5. Optional redemption provision: The issuer has the right to call the issue (or some portion of it) for early redemption. A schedule of optional redemption prices is specified at the time of issue. Callable bonds usually provide for a grace period immediately following issuance. Bonds are noncallable during this period. Many long-term issues contain a weaker provision. The bonds are only nonrefundable. During the nonrefundable period, the issuer cannot use the proceeds from a new debt issue that ranks senior to, or on a par with, the outstanding debt to refund it.
  6. Protective Covenants: Covenants impose restrictions on the borrower. They are designed to protect the bondholders.

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