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Basic Finance Bootcamp Lesson #3: Introduction to Notes and Bonds

We were going to talk about preferred stocks today but I wanted to fix up the post a little so it would be more clear. So, instead, today we will skip ahead to an introduction to notes and bonds.

An Introduction to Notes and Bonds

In addition to issuing common or preferred equity to raise money, corporations often issue debt in the form of notes or bonds.  When you invest in a note or a bond issued by a corporation, you are lending the corporation money.  As a lender, you have a prior claim over both preferred and common shareholders in the event the firm goes belly up. In the case of both notes and bonds, the general pattern you will see is that the riskier the investment, the higher interest rate offered for your money. It makes sense–if you are taking a bigger risk, you should get paid more for the level of risk you are incurring. Alternatively, a very stable, safe investment is rewarded with less interest payout.

Insofar as the difference between a note and a bond is concerned, notes are sometimes issued with a shorter maturity than bonds, but this is not always the case, and from the perspective of the investor, there is really no difference, so we won’t belabor the matter here, and from this point on, we will use the term “bond” to mean either.

Bonds typically pay interest periodically—usually every 6 months—at a fixed annual rate that is called the coupon rate.  You will also receive the face value—also called the maturity value or the par value—of the bond when it matures.  There are some zero-coupon bonds that do not make interim interest payments.  In this case, the investor simply receives the face value of the instrument at maturity.

As a simple illustration of an interest-paying bond, assume you invest in a bond that has 20 years to maturity, a face value of $1,000, and a coupon rate of 6%.  This means you can expect to receive $60 (= 0.06 x $1,000) a year (which will usually be paid as $30 every six months) for as long as you hold the bond.  If you hold it until maturity, you will also receive the bond’s face value of $1,000.  However, you can always choose to sell the bond prior to its maturity date for whatever its market price is at that time.

Some bonds, such as mortgage bonds, are backed by one or more assets of the firm.  These are referred to as secured bonds and are less risky than unsecured bonds of the same corporation since the proceeds from the sale of the assets will be used to pay these bondholders before unsecured bondholders receive anything.  Unsecured bonds are called debentures.  Regardless of whether or not a bond is secured, the interest payments are legal obligations of the firm, and bondholders can force the firm into bankruptcy if the interest isn’t paid as promised according to schedule.

There are also bonds that are subordinated debentures.  These bondholders must wait until all the holders of bonds to which the bond is subordinate get paid.  For example, AFLAC has a subordinated debenture that pays a 5.5% coupon and matures on 9/15/2052.  The face value of the bond is $25, so the annual interest payment is $1.375 ($0.6875 every 6 months) per bond.  The bond indenture stipulates that it is subordinate to all current and future senior debt.  This means that in the event of default, these bondholders won’t be paid until all the bondholders of AFLAC’s current and future secured and unsecured debt are paid in full.

You can get an idea of the default risk–the risk that the firm will not be able to make the promised principal and interest payments–of a bond by looking at its rating.  Independent agencies such as Standard & Poor’s and Moody’s rate actively traded bonds based on their relative risk of default.  Standard & Poor’s uses all capital letters in its designations, while Moody’s uses a capital letter, followed by lower-case “a’s”.  To illustrate, the highest rating class is a “triple A,” designated as AAA by Standard and Poor’s and Aaa by Moody’s.

The rating classes progress downward to AA (Aa), A, BBB (Baa), BB (Ba), B and so on.  The lower the rating, the higher the default risk.  Bonds rated BBB (Baa) or above are considered “investment grade” and are considered to have only a moderate risk of default. The AFLAC subordinated debentures mentioned above are investment grade; both Standard & Poor’s and Moody’s give them a triple-B rating—that’s a BBB by Standard & Poor’s and a Baa by Moody’s.

The ratings agencies distinguish further among bonds by indicating whether they fall at the top, in the middle, or at the lower end of the rating class.  Standard & Poor’s uses a “+” to indicate the top and a “-” to indicate the bottom, with no designation for bonds that are in the middle of the class.  Moody’s uses the numerals “1,” “2” and “3”.  Both agencies rate the AFLAC subordinated debentures at the top of the BBB class; Standard & Poor’s gives it a BBB+ rating, and Moody’s rates it as Baa1.

Like preferred stock, some corporate bonds may be convertible to common stock and some may be callable.  These provisions are all spelled out in the bond indenture.  The AFLAC bond we’ve used in this discussion happens to be callable. If called, the bondholder will receive the face value of the bond, along with any accrued interest.

You can buy and sell corporate bonds through your broker.  Most brokerage firms have a team of fixed income specialists who can provide you with the specific details of a bond.  He can also help you find a corporate bond that matches some criteria that you may have.  For example, you could indicate that you’re interested in bonds that are rated AA or better and are non-callable.

Corporations aren’t the only issuers of notes and bonds.  The U.S. Treasury, U.S. government agencies, and state and local governments also issue debt to support their activities. These debt instruments can also be purchased through your broker, and much of the above discussion applies to them as well—although none of the federal or state and local government bonds can be converted to common stock, for obvious reasons, and all are unsecured debt instruments.  There are some other points you should understand about these government bonds, however.  We’ll cover those in a future blog post.

I hope that gives you a working knowledge for notes and bonds now. If anything is unclear, be sure to ask in the comments section. I want to make sure that everyone is caught up and able to follow my more sophisticated (and interesting) posts in the future.