Bonds

A form of debt issued by corporations, federal agencies, and local, state, and national governments, a bond is a financial security designed to pay back the bondholder on particular dates. Payments received by the bondholder typically consist of the repayment at the time of maturity of the principal amount borrowed as well as coupon payments (interest payments) made during the life of the bond (most commonly semi-annually, but often quarterly, monthly, or even once at the time the bond matures and the debt is retired). Because most bonds have a fixed interest payment that the bondholder receives, this form of debt security is also referred to as a fixed-income security.

Interest rates paid by the issuers of bonds can be fixed, can be paid at maturity, or can be variable as is the case with a step-up bond or a floating coupon level bond. The step-up coupon bond is the least complex of the variable rate bonds whereas a derivative bond (derivatives can be tied to an index such as an equity index or a consumer price index or determined by a mathematical equation that links the level of interest payments to an economic variable including market indices, single equities, or even commodity prices) can range from a simple structure to a very complex structure. An example of a fixed-coupon bond would be a bond with a $1,000 denomination (par value) that had a seven percent coupon paying semi-annu-ally with a final stated maturity date of January 15, 2020. In this example, every January 15th and every July 15th until and including January 15, 2020, the investor holding the bond would receive $35 such that his or her annual income from the bond would be $70 (7 percent of $1,000 par value or face value of the bond). In addition, upon maturity of the bond on January 15, 2020, the investor would receive not only the last interest payment of $35, but also the principal par value of the bond, which is typically $1,000.

Some bonds are issued without regular interest payments such that all of the interest is paid at the time the bond matures. These bonds are called zero-coupon bonds; they are issued (or sold) at a deep discount to their face value and they mature at par. The difference between the discounted price and the par value of the bond at maturity is considered accreted interest and represents the return to the investor over a specific time period. Consider the example of a zero-coupon bond that matures January 15, 2020. If the investor bought the bond when it was first issued on January 15, 2010, at a price of $300, then the investor would stand to gain $700 in accreted interest over 10 years time, or $70 a year. Comparing the zero-coupon bond to the previous 7 percent fixed-coupon bond shows that both bondholders would earn $70 per year. The advantage of the 7 percent coupon bond is that the [Page 167]bondholder actually receives current income of $70 each year throughout the life of the bond, whereas the zero-coupon bondholder has to wait to receive his or her income until the bond matures or until he or she sells the zero-coupon bond in the marketplace. The advantage of the zero-coupon bond is that it requires a much smaller initial investment, in this case $300 for the zero-coupon bond versus $1,000 for the 7 percent coupon bond.

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