What is a Bond?

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A bond is a legal obligation of an enterprise. It gives the holder a claim that is sometimes secured by a lien on the enterprise’s assets (in the same way that a mortgage is secured by a lien on a house). If the claim is unsecured, the bondholder has the right to a share of the enterprise’s unsecured assets, along with other unsecured creditors. Most publicly-traded corporate bonds are unsecured.

In contrast, common shareholders have an interest in the net assets of a corporation Since shareholders do not have a contractual claim, the corporation has a fiduciary duty to conduct its affairs in the best interests of its shareholders. Should the corporation fail in that duty, shareholders typically suffer substantial losses. In a bankruptcy filing, shareholders usually recover little of their original investment and often suffer a total loss.

Besides the requirement to pay interest and principal on a timely basis, many bonds place restrictions on a company’s actions. These are known as covenants.

Covenants take many forms. For example, they can limit a company’s ability to incur debt, merge with others or pay dividends to shareholders. They may also require the company to maintain a minimum level of net worth.

If a company fails to correct a covenant breach within a specified time period, then bondholders usually have the right to accelerate the repayment of principal (and any interest due). In theory, the right to accelerate allows bondholders to maximize their recovery by preventing any further erosion in the company’s value,

In practice, the restrictiveness of covenants is usually a function of the relative bargaining powers of a company and bondholders at the time that bonds are issued. Financially weaker companies are usually saddled with more restrictions.

It is useful for investors to become familiar with all of a bond’s terms, including the covenants. However, in my experience, the only protection that has proven its value consistently over time is a security interest (i.e. a lien against some or all of the assets of a company). Alternatively, a pledge by a company not to grant liens to other creditors – i.e. a “negative pledge” – is also valuable.

KEY TERMS:

Par Value: Also known as face value, this is the contractual amount of principal due at maturity. It is almost always equal to $1,000 per bond.

Bond prices are usually quoted as a percent of par value (i.e. par value is 100). So a bond price of 98 equals 98% of par or $980 per bond.

Basis Point: 1/100% or 0.01%. 2% equals 200 basis points.

Yield-to-maturity: The annualized total return on a bond held to maturity. It is equal to the discount rate which equates the contractual cash flows on the bond to its price. By convention, it is equal to the semi-annual yield multiplied by two. (This is because most bonds pay interest on a semi-annual basis.)

Yield-to-call: The total return on a bond calculated to the date that a company can exercise its option to call the bond (i.e. retire it before it matures). Companies will seek to call a bond if they can refinance at a lower contractual interest rate. Usually, however, by the terms of a bond, the company must pay a premium to the bondholder to exercise its call option.

Yield-to-worst: This is equal to the lower of either the yield-to-maturity or yield-to-call. If the yield-to-worst equals the yield-to-call, the bond market implicitly assumes that the bond will be called.

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Originally published February 28, 2008. Update May 8, 2014.

Stephen P. Percoco
Income Builder
P.O. Box 1543
Linden, NJ  07036
(908) 448-2246
incomebuilder@larkresearch.com

© 2014 Lark Research, Inc. All Rights Reserved. Information is carefully compiled but not guaranteed to be free from error. Specific reference to any specific security should never be construed as a solicitation to either buy or sell. Reproduction without permission from the publisher is prohibited.