A bond is a long-term debt instrument with a final maturity generally being 10 years or more. If the security has a final maturity shorter than 10 years it is usually called a note. To fully understand bonds, we must be familiar with certain basic terms and common features.
Par value for a bond represents the amount to be paid to the lender at the bondâ€™s maturity. It is also called face value or principal. Par value is usually $1,000 per bond (or some multiple of $1,000). With the major exception of a zero-coupon bond, most bonds pay interest that is calculated on the basis of the bondâ€™s par value.
The stated rate of interest on a bond is referred to as the coupon rate. For example, a 13% coupon rate indicates that the issuer will pay bondholders $130 per annum for every $1,000-par-value bond that they hold.
Bonds almost always have a stated maturity. This is the time when the company is obligated to pay the bondholder the par value of the bond.
Trustee and Indenture
A company issuing bonds to the public designates a qualified trustee to represent the interests of the bondholders. The obligations of a trustee are specified in the Trust indenture act of 1939, administered by the Securities and Exchange Commission (SEC). The trusteeâ€™s responsibilities are to authenticate the bond issueâ€™s legality at the time of issuance, to watch over the financial condition and behavior of the borrower, to make sure that all contractual obligations are carried out, and to initiate appropriate actions if the borrower does not meet any of these obligations. The trustee is compensated directly by the corporation, a compensation that adds to the effective costs of borrowing.
The legal agreement between the corporation issuing the bonds and the trustee, who represents the bondholders, is defined in the bond indenture. The indenture contains the terms of the bond issue as well as any restrictions placed on the company. These restrictions, known as protective covenants, are very similar to those contained in a term loan agreement. The terms contained in the indenture are established jointly by the borrower and the underwriter along with the trustee.
The creditworthiness of a publicly traded debt instrument is often judged in terms of the credit ratings assigned to it by investment rating agencies. The principal rating agencies are Moodyâ€™s investor Service(Moodyâ€™s) and Standard & Poorâ€™s (S&P) the issuer of a new corporate bond contracts with the agency to evaluate and rate the bond, as well as to update the rating throughout the bondâ€™s life. For this service, the issuer pays a fee. In addition, the rating agency charges subscribers to its rating publications.
Based on their evaluation of a bond issue, the agencies give their opinion in the form of letter grades, which are published for use by investors. In their ratings, the agencies attempt to rank issues according to the perceived probability of default. The highest grade issues, whose risk of default is felt to be negligible, are rated triple â€“ A , followed by double â€“ A, single â€“ A, B â€“ double â€“ A (Moodyâ€™s) or triple â€“ B (S&P), and so forth through C and D, which re the lowest grades of Moodyâ€™s and S&P, respectively. The first four grades mentioned are considered to represent investment â€“ quality issues, whereas the other rated bonds are considered speculative.
If the corporation defaults under any of the provisions of the indenture, the trustee, on the behalf of the bondholders, can take action to correct the situation. If not satisfied, the trustee can then call for the immediate repayment of all outstanding bonds.