Evaluating Popular
Investments
Lesson 4
Bond Characteristics
Bonds Characteristics
Aim:
 What are the important characteristics
of a bond that you need to know to
become an effective bond investor?
Do Now:
 Identify why people invest in bonds and
not stock.
Bonds Characteristics
 Do Now answer:
They want safety. They are willing to
trade the chance to go big (ie: invest in
a stock that soars) for the assurance
that they will be paid interest and their
money back when the bond’s term ends.
Rating Process For Bonds
 To assess a company’s risk of failing, bond investors
turn to the following three credit ratings agencies:
 Ratings are based the issuers financial strength which
indicates whether or not it will be able to make their principal
and interest payments to the bond holder on time
A “AAA” high grade bond offers more
security but a lower yield than a “C” bond
A “C” bond is more risky
but has a higher yield
STRONGEST
NON-INVESTMENT
GRADE
INVESTMENT
GRADE
CREDIT RATINGS*
WEAKEST
MOODY’S
STANDARD & POOR’S
FITCH
Aaa
AAA
AAA
Aa
AA
AA
A
A
A
Baa
BBB
BBB
Ba
BB
BB
B
B
B
Caa
CCC
CCC
Ca
CC
CC
C
C
C
C
D
D
*These credit ratings are reflective of obligations with long-term maturities.
Bond Characteristics
Debenture vs. Collateralized
 Debenture Bonds – An unsecured bond, meaning it is
not backed by any collateral. Collateral can be a real
asset (ex. Building) or a financial asset (ex. Loan or
Bond). Most bonds are debentures.
 Collateralized Bonds – Are backed by either a financial
asset or a real asset. In the case of bankruptcy, the
assets are sold and the proceeds are used to pay back
the holder of the collateralized bonds. Collateralized
bonds are safer than debenture bonds and, therefore,
offer lower yield (ie: coupon).
Bonds Characteristics
Currency Denomination
 Refers to the currency in which the bond is
issued and its coupon and principal payments
are paid.
 Large corporations that do business in many
countries may find it preferable to issue bonds in
one currency over another.
 The most common currencies are: U.S. Dollar,
Euros, and Japanese Yen
Redemption Characteristics
Callable Bonds
 When a bond is issued with a call option, the issuer has
the option to “call it in” (ie: retire the bond) before
maturity date at a set price, known as the call price,
that’s usually a little higher than face value.
 So that a bond isn’t called soon after the bond is bought
new, a certain number of years of call protection exist.
 Scenario: In 2014, XYZ Corp issues a 25-year 9% bond
that cannot be called until 2024. How many years of call
protection does the bond have?
 Answer: 10 years, from 2014 to 2024
Redemption Characteristics
Callable Bonds
 In what scenarios might a corporation be interested
in calling its bonds?
 Answer 1: It no longer needs the money!
 Answer 2: Dropping interest rates motivate the
corporation to refinance its debt.
 What do you suppose refinance means?
 Answer: Issuing news bonds at a lower rate
than the originals and using the money to
call in (ie: retire) the original bonds.
Redemption Characteristics
Convertible Bonds
 Gives the bondholder the option to exchange the
bond for a set number of shares of common
stock in the issuing company
Bond
Bondholder
Common
Stock
Redemption Characteristics
Convertible Bonds (example)
 ABC Corporation announces that it is offering a new 10year $1,000 face value bond with a coupon of 5%.
 To give investors a choice, it also offers a 10-year $1,000
face value bond that can be converted into 20 shares.
 Given that a fair rate on ABC’s ordinary bond is 5%,
should the coupon on the convertible bond be higher or
lower than 5%? Why?
 Answer: Lower. The ability to convert has value, so
investors will be willing to earn less interest!
Redemption Characteristics
Convertible Bonds (continued)
 Let’s say that the price of an ABC share is currently $30.
As we stated earlier, the bond may be converted into 20
shares.
 To see if it worthwhile to convertible the $1,000 bond to
stock, how do we compute what we’ll have by
converting?
 Answer: $30 share price x 20 shares = $600.
 With such a low figure, how can we say the ability to
convert is valuable?
 Answer: We have 10 years for the stock to go up!
Looking back… for the investor…
Upside
Downside
Owning
stock
May make a lot of money!
Not entitled to
receive
dividends; may
lose everything
if company fails
Owning
bonds
Entitled to regular payments What can be
and money back at
earned is
maturity; will receive some limited
money back if company fails
Redemption Characteristics
Convertible Bonds (continued)
 For the investors, which “downside” problem does a
convertible bond solve?
 Answer: The ability to make a lot of money! You
now have the upside of a stock with the downside
protection of a bond.
 So, what’s the catch?
 Answer: You’ll earn less interest every year than
with an ordinary bond. There is no guarantee the
stock will rise enough to make it worthwhile for
you to convert!
Redemption Characteristics
Convertible Bonds (continued)
 Looking at it from the corporation’s standpoint, why is it
tempting to issue convertible instead of ordinary bonds?
 Answer: The corporation has to pay less interest!
 What are the pros and cons for the corporation when a
conversion takes place?
 Pro: Interest is no longer due and there’s no maturity
date payment to worry about.
 Con: Existing shareholders will become upset
because they are being diluted.
Redemption Characteristics
Are There Callable Convertible Bonds?
 Is it possible for a bond to have both features?
 Answer: Yes.
 Remember the ABC Corporation with the $30 share
price? It issued a 10-yr bond convertible to 20 shares.
 Fast forward to the 6th year of the bond. The stock
has risen to $80 per share! The company announces
that in 30 days, it will call the bond. What will
bondholders do?
 Answer: Convert their bond really fast!
Redemption Characteristics
Callable Convertible Bonds
 The corporation knows this will be the response of
its bondholders. Therefore, this is known as a …
 Answer: … forced conversion.
 Here’s another question: Why haven’t bondholders
converted already if it’s clear that 20 shares are now
worth more than one bond?
 Answer: Its safer to keep the bond. They can
convert just before they’re ready to sell out of the
investment!
Redemption Characteristics
Sinking Fund Bonds
 A means of repaying funds that were
borrowed by requiring the issuer to begin
setting aside money in advance of the
maturity date
• The issuer makes periodic payments to a
trustee who retires part of the issue by
purchasing the bonds in the open market
Coupon Structure
The coupon structure is the interest rate stated on
a bond when the bond is offered. It is the
percentage of the bond principal value that will be
paid, usually semi-annually or annually, as the
coupon payment to the owner of the bond.
Example: XYZ Corp issued a $1,000 6% bond
that’s due in the year 2030. Each year the
company must pay $1,000 * 6% = $60 in interest
to the holder of the bond.
Coupon Structure
Fixed Rate Bond
 The majority of bonds are fixed rate, such as in
our example. The fixed rate was 6% per year.
 The coupon rate does not fluctuate, ever!
Floating Rate Bond
 Bonds that have a coupon rate that is adjusted
periodically, or “floats”, in conjunction with a
short term rate, such as LIBOR (London InterBank Offer Rate).
Payment of Principal
The bond’s principal can be repaid with a “balloon
payment” or through amortization.
Balloon Payment
 Simply means that if a company issued, say, 10year bonds and borrowed a total of $100 million
when the maturity date arrives a decade later, it
owes back the $100 million at that time
 Each year during the term of the bond, the
issuer pays just interest to the bondholders.
 The vast majority of bonds are of this type!
Payment of Principal
Amortization
 The process by which the principal balance
gradually declines over time and is at zero by the
time the maturity date arrives
 Each year, the issuer pays interest plus additional
money that pays off part of the principal borrowed
 In the beginning, the majority of the fixed payment
is interest. As the payments continue, a larger
portion of the payment pays the principal and a
smaller portion is needed to pay the interest.
 Usually seen in car and home loans, not bonds.
Payment of Principal
Example:
$10,000
loan paid
off in
equal
monthly
payments
of $860.66
over one
year.
Term
What is the normal range of bonds terms?
 The most common number of years representing the
longest term offered is 30 years.
 On the short side:
 we will see in a later lesson that the U.S.
Government offers several different bond terms
that are all under one year!
 Corporations issue bonds, called Commercial
Paper, that have terms from 1 to 270 days. They
can be used to raise cash to pay bills, buy
inventory, allow their customers pay for a
purchases over time, etc.
Lesson Summary 1 of 2
1. How do we get a sense of the risk of buying
the bonds of a particular company?
2. Why is a collateralized bond safer for the
investor than a debenture?
3. How can a bond issuer give itself the ability
to retrieve its bonds before the maturity date?
4. What can investors do to gain the safety of
bonds but with potential upside of owning
stock at the same time?
5. How can bond investors ensure that the
issuer will have the money needed to redeem
the bonds at maturity?
Lesson Summary 2 of 2
6. What are the two types of coupon structures,
and which is by far the most common?
7. What are the two types of repayment
structures, and which is by far the most
common?
8. What is the general term range available to
investors?
9. What are the important characteristics of a
bond that you need to know to become an
effective bond investor?
Web Challenge #1
Q: Why do companies issue mortgage bonds?
• A: The make potential bond investors feel
much safer. In case the company goes
under, there’s a specific asset that will be
sold to ensure repayment!
• Also, because there’s less risk, the investor
will be willing to accept a lower coupon rate.
•
Challenge: Research three companies that
have issued mortgage bonds in the last year.
What assets were pledged? Look for any
indication as to why they decided to issue them
instead of ordinary debentures.
Web Challenge #2
Challenge: We said earlier that the coupon rate
is almost always fixed. Floating rate bonds are
much rarer. Research three companies that
have issued floating rate bonds in the last year.
Read the article for clues as to why it chose to
go this unusual route. Why did it?
Extra: What is the biggest risk to a company of
issuing a floating rate bond?
Web Challenge #3
Challenge: Find a company that intends to
issue a convertible bond. Record:
 The company’s current share price
 The conversion price that the author of the
article has already calculated
 How much higher the share price has to go
to make it worthwhile to convert the bond
into shares of stock
 Do you think the stock can get there given
the term of the bond?