Companies cannot always secure sufficient long-term financing from a bank or from private investors. Instead, large companies may borrow money by issuing bonds to interested investors. The company is called the bond issuer since it issues the bond. The bondholder is the investor who purchases the bond. There a number of complexities involved with bonds but essentially, it is a contract, whereby a bondholder loans money (the principal) to a bond issuer. In return, the bond issuer promises to provide regular interest payments to a bondholder and after a set time (when the bonds mature), the principal is returned to the bondholder. Bond investors are, often, large organizations such as pension funds but can also include smaller institutions or individuals. There are several types of bonds:
- Term bonds mature on a specific date, whereas serial bonds are a set of bonds that mature at different intervals.
- Companies may issue secured or mortgage bonds whereby they put up specific assets as collateral (like loans) in the event that it defaults on interest or principal repayments.
- Unsecured or debenture bonds are backed only by the bondholder’s faith in the company’s good reputation.
- Bonds may have a callable feature whereby the company has the right to buy back the bonds before maturity at a set or “call” price.
- If the bonds are convertible, bondholders have the option of converting or exchanging the bonds for a specific number of stocks of the company’s common stock.
- Registered bonds list the bondholders as registered owners who receive regular interest payments on the interest payment dates.
- Coupon bonds, on the other hand, contain detachable coupons that state the amount and due date of the interest payment. These coupons can be removed and cashed by the holder.
An organization that issues bonds faces the challenge of competing with other investments in the market. Specifically, a bond is an interest-bearing investment vehicle whereby money is received from investors in exchange for interest payments.
For example, a 5% interest rate on a bond means that 5% annual interest on the principal balance outstanding will be paid back to the investor. A company that has issued a five-year bond, with annual interest of 10% (payable twice per year) and having a $100,000 principal value, is obligated to make semi-annual (twice per year) interest payments to bondholders totaling $5,000 ($100,000 x 10% x ½). The interest rate on a bond must compete with market interest rates in general – that is, investors can earn interest through a number of other investments on the market, including bonds issued by other companies and organizations.
That is why companies generally issue bonds at the going market interest rate. For example, if the market rate is 10%, the company is likely to issue the bond with a 10% interest rate; this is known as issuing a bond at par. Since it takes time to arrange the printing and distribution of bonds, however, rates of existing bonds can differ significantly from current market rates.
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