The yield curve

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield. The yield curve is drawn against two axes, the vertical showing yield (expressed in percentage points) and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that i…

Types of bonds

An increasing variety of bonds is available in the marketplace. In some cases, an issuer agrees to design a bond with the specific characteristics required by a particular institutional investor. Such a bond is then privately placed and is not traded in the bond markets. Bonds that are issued in the public markets generally fit into one or more of the following categories.

Straight bonds 

Also known as debentures, straight bonds are the basic fixed-income investment. The owner receives interest payments of a predeterm inedamount on specified dates, usually every six months or every year following  the date of issue. The issuer must redeem the bond from the owner at its face value, known as the par value, on a specific date.

Callable bonds

The issuer may reserve the right to call the bonds at particular dates. A call obliges the owner to sell the bonds to the issuer for a price, specified when the bond was issued, that usually exceeds the current market price. The difference between the call price and the current market price is the call premium. A bond that is callable is worth less than an identical bond that is non-callable, to compensate the investor for the risk that it will not receive all of the anticipated interest payments.

Non-refundable bonds

These may be called only if the issuer is able to generate the funds internally, from sales or taxes. This prohibits an issuer from selling new bonds at a lower interest rate and using the proceeds to call bonds that bear a higher interest rate.

Putable bonds
Putable bonds give the investor the right to sell the bonds back to the issuer at par value on designated dates. This benefits the investor if interest rates rise, so a putable bond is worth more than an identical bond that is not putable.

Perpetual debentures
Also known as irredeemable debentures, perpetual debentures are bonds that will last forever unless the holder agrees to sell them back to the issuer.

Zero-coupon bonds
Zero-coupon bonds do not pay periodic interest. Instead, they are issued at less than par value and are redeemed at par value, with the difference serving as an interest payment. Zeros are designed to eliminate reinvest-ment risk, the loss an investor suffers if future income or principal payments from a bond must be invested at lower rates than those available today. The owner of a zero-coupon bond has no payments to reinvest until the bond matures, and therefore has greater certainty about the
return on the investment.

Convertible bonds

Under specified conditions and strictly at the bondholder’s option, convertible bonds may be exchanged for another security, usually the issuer’s common shares. The prospectus for a convertible issue specifies the conversion ratio, the number of shares for which each bond may be exchanged. A convertible bond has a conversion value, which is simply the price of the common shares for which it may be traded. The buyer must usually pay a premium over conversion value, to reflect the fact that the bond pays interest until and unless it is converted. Convertibles often come with hard call protection, which prohibits the issuer from calling the bonds before the conversion date.

Adjustable bonds

There are many varieties of adjustable bonds. The interest rate on a floating-rate bond can change frequently, usually depending on short term interest rates. The rate on a variable-rate bond may be changed only once a year, and is usually related to long-term interest rates. A step-up note will have an increase in the interest rate no more than once a year, according to a formula specified in the prospectus. Inflation indexed bonds seek to protect against the main risk of bond investing: the likelihood that inflation will erode the value of both interest payments and principal. Capital-indexed bonds apply an inflation adjustment to interest payments as well as to principal. Interest-indexed bonds adjust interest payments for inflation, but the value of the principal itself is not adjusted for inflation. Indexed zero-coupon bonds pay an inflation-adjusted principal upon redemption.

Enhancing security

An issuer frequently takes steps to reduce the risk bondholders must bear in order to sell its bonds at lower interest rate. There are three common ways of doing this:

 Covenants are legally binding promises made at the time a bond is issued. A simple covenant might limit the amount of additionaldebt that the issuer may sell in future, or might require it to keep a certain level of cash at all times. Convenants are meant to protect bondholders not only against default, but also against the possibility that management’s future actions will lead ratings agencies to downgrade the bonds, which would reduce the price in the secondary market.

 Bond insurance is frequently sought by issuers with unimpressive credit ratings. A bond insurer is a private firm that has obtained a top rating from the main ratings agencies. An issuer pays it a premium to guarantee bondholders that specific bonds will be serviced on time. With such a guarantee, the issuer is able to sell its bonds at a lower interest rate. Bond insurance is a particularly popular enhancement for municipal bonds in the United States. Its popularity also has increased in Europe; there were $14 billion of insured bonds issued outside the United States in 2004. Sinking funds ensure that the issuer arranges to retire some of its debt, on a prearranged schedule, prior to maturity. The issuer can do this either by purchasing the required amount of its bonds in the market at specified times, or by setting aside money in a fund overseen by a trustee, to ensure that there is adequate cash on hand to redeem the bonds at maturity.

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