46. Bonds
Bonds are a method of borrowing by an entity. Usually a long-term obligation, a bond will
pay interest on the debt during the term of the bond, and at the end of a specified number
of years a bond will return the inverted dollars to the investor. Bonds may be bought and
sold after the initial issue of bonds has been made. Since the interest rate is fixed in
the bond agreement, the price of a bond will fluctuate in response to the
changes in interest rates.
A Look at Yield - Usually, when the stock market is up, the bond market shows poorly and
vice versa. Consequently, the stock market bears careful watching to see if it's the right
time to buy bonds. What you are
looking for in bonds is high yield. One thing to remember when thinking in terms of yield
is that during periods of restrictive government monetary policy, yields on all types of
corporate debt securities will go up, since a corporation will have to pay more to borrow.
Another thing to remember is that differing maturity times will affect yields. When money
is tight, there will probably be no difference between a short - and long - term bond; but
when money eases, investors, expecting interest rates to fall, like to invest in
longer-term securities. Demand thus pushes the price of the long-term bond up and yields
up since interest rates are constant.
Corporate Bonds
These are the common-type bonds with a fixed obligation to pay a certain sum at a certain
time (usually 5 or 10 years after issuance) and are sold generally in denominations of
$1,000. There are so-called "baby
bonds" sold in denominations of $500, but these are few and far between.
Bonds can be issued as coupon bonds with coupons attached, which are negotiable to the
bearer and are commonly known as bearer bonds, or as registered bonds. The latter is far
safer, since they are payable only to
the parties named but may possibly be sold at a slight discount, since they are
transferable only when the transfer has been made on the corporation's registry.
The ordinary bond is legally backed by a trust indenture, governed by a corporate (or in
some cases an individual) trustee, which handles a variety of administrative matters
including circumstances in the event of
default. In general, the trust indenture is an agreement between the corporation and the
trustee and is probably of little concern to you except for its informational value or if
you want to know how "safe" your
investment is.
WARNING: Ordinary bonds may be callable, i.e., the bonds can be retired before maturity.
This operates to the advantage of the corporation by allowing it to take advantage of
lower interest rates by calling back
higher paying bonds then issuing lower paying ones. The corporation might also switch from
long- to short-term obligations. Calls by a corporation for its bonds are perfectly legal
and should be understood to be a risk you are taking in losing a high yielding investment.
CONVERTIBLE BONDS: As a sweetener to investors, especially when money is tight, a
corporation may issue a bond that can be changed into stock or another security at a
certain conversion price. Convertibility may be
expressed in terms of the number of shares one bond of $1,000 par is convertible into or,
as is usual, it may be expressed in terms of a conversion price, or the amount of par
value or principal amount of bonds
exchangeable for one share of stock. An example would be a $1,000 par convertible into
common at $10 per share. This means the bond will be worth 100 shares at that price. If
the stock goes to $15, the $1,000 bond
is now worth $1,500. If the stock doesn't go above $10, the bondholder still has a fixed
interest rate. Consequently, the convertible bond has liquidity and the likelihood of
gain, but it should be pointed out that
there may be some risk factors involved since the company issuing a convertible bond
obviously has felt the need for some added incentives. Also, don't overlook the fact that
convertibles may not pay as high an
interest rate as the ordinary bond.
DEBENTURES: A debenture is a bond backed only by the general credit of a corporation
without specific real estate or property as collateral - really an IOU. Generally, only
large, well-established industrial
companies or utility companies use debentures.
Like convertible bonds, CONVERTIBLE DEBENTURES are commonly used by corporations and have
all the attractiveness and pitfalls of convertible bonds but with the added feature that
they are usually issued at a higher
yield. There are also subordinated debentures, junior to the primary debenture in the
event of insolvency, both types of debentures being junior to other bonds but not below
amounts due trade creditors.
There are various other types of bonds that one might consider when setting up an overall
financial plan. Among them are COLLATERAL TRUST BONDS, secured by the pledge of stocks or
bonds; MORTGAGE BONDS, detailing specific property to be mortgaged; FIRST MORTGAGE BONDS,
secured by property (sometimes after acquired); EQUIPMENT TRUST CERTIFICATES, on specific
equipment; UTILITY BONDS; and the like.
Municipal Bonds
Municipal bonds are, as the name implies, bonds issued by municipalities. However,
municipal bonds are issued not only by cities, towns, and villages, but by states,
territories and possessions of the United States,
schools, hospitals, street and highway departments, port authorities, etc. The most
obvious advantage of municipal bonds is that they are exempt from federal income tax and
from most state and local taxes. Today there is a tremendous market for municipals, which
were once considered to be tools merely for individuals in high income tax brackets, since
the yield on municipals is generally lower than that on other bonds.
The number of different tax-exempt issues is vast, since there are over 100,000
governmental units that can issue them. Generally, they fall into the following
categories.
GENERAL OBLIGATION BONDS: These are obligations that are backed by the full taxing power
of the political unit issuing them. Because of this, they generally have the highest
rating.
REVENUE BONDS: These are obligations that are secured by the revenues of a particular
project, such as a toll highway, a bridge, or a sewer system. If the project fails to
return the necessary money, the bonds will be defaulted.
SPECIAL ASSESSMENT BONDS: Special assessments are levied against property owners for
improvements benefiting them directly, such as new streets. To raise the money initially,
a bond issue may be floated,
secured by the levies that will be made.
HOUSING AUTOORITY BONDS: These raise funds for housing projects and can be either general
obligation bonds or revenue bonds. They are in a separate category because, when they are
issued pursuant to a contract with the Federal Public Housing Authority, they are backed
by the U.S.
INDUSTRIAL DEVELOPMENT BONDS: Interest on these bonds is exempt only if it relates to an
issue of $10 million or less. Industrial development bonds include issues that (a) are to
be used in a trade or business by a taxable person (i.e., a person or entity other than a
governmental unit or a tax-exempt charitable, religious, or educational organization) and
(b) are secured by an interest in property used in a trade or business. The rule applies
both to general obligation bonds that are guaranteed by the state or local government and
to revenue bonds.
MORAL OBLIGATION BONDS: These are bonds that are not debts of the state of issue but that
are guaranteed by the "moral obligation" of the state in the event that the
issuing authority defaults. These are not
rated as highly as general obligation bonds but may be more highly rated than other types.
It is not clear how significant the "moral obligation" guarantee really is.
INVESTMENT PITFALLS OF TAX-EXEMPTS: Before jumping into tax-exempts as "sure
things", remember that tax-exempt bonds involve two risks: price fluctuation and
unmarketability. While defaults in tax-exempts are
extremely rare, their prices do fluctuate with changes in the prevailing interest rates.
This does not matter if you intend to hold the bond until its maturity, but if you do not,
you must exercise care in choosing the
time to buy.
Unmarketability is a common problem for bonds issued by small taxing districts. If you
have to sell such bonds, the bond dealer may impose an extra charge because of the risk
that he or she may not be able to resell
them. Conversely, you often can pick up these same bonds at a discount--but you should be
prepared to hold them indefinitely.
U.S. Savings Bonds
Series EE and HH are offered as substitutes for the old Series E and H bonds. An investor
who buys EE bonds has the choice of reporting the interest and paying tax on it every year
or postponing payment of tax on
the increment until he or she redeems the bond. Normally, an investor will want to elect
to defer paying the tax on the increases in value of the bonds until he or she finally
cashes them in (which can include the
original term of the bonds and the extended terms that have been tacked onto them). That
will often defer the income until after retirement when the investor's tax rates may be
lower.
On the other hand, if the bonds are bought for a child, an election to report the interest
currently will save taxes if the child has little or no other income.
Series HH bonds pay semiannual interest. EE bonds can be swapped for HH bonds without
picking up the increase in value of the EE bonds as income. That increase is postponed
until the HH bonds are finally cashed
in. If an investor has Series E bonds issued before 1980, these too may be swapped for
Series HH bonds.
Series EE bonds are issued at 50% of their face amount. The smallest denomination is $50
($25 cost), and the largest is $1,000 ($500 cost). The maximum amount of Series EE bonds
that can be purchased in any one year is $30,000 in face amount ($15,000 cost). The limit
for Series HH bonds, which are issued for their face amount, is $20,000 in any one year.
Tax reference verification 1-800-829-1040
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