The Concise Encyclopedia of Economics

Bonds

by Clifford W. Smith
About the Author
Bond markets are important components of capital markets. Bonds are fixed-income securities—securities that promise the holder a specified set of payments. The value of a bond (like the value of any other asset) is the present value of the income stream one expects to receive from holding the bond. This has several implications:

    1. Bond prices vary inversely with market interest rates. Since the stream of payments usually is fixed no matter what subsequently happens to interest rates, higher rates reduce the present value of the expected payments, and thus the price.

    2. Bonds are generally adversely affected by inflation. The reason is that higher expected inflation raises market interest rates and therefore reduces the present value of the stream of fixed payments. Some bonds (ones issued by the Israeli government, for example) are indexed for inflation. If, for example, inflation is 10 percent per year, then the income from the bond rises to compensate for this inflation. With perfect indexation the change in expected payments due to inflation exactly offsets the inflation-caused change in market interest rates, so that the current price of the bond is unaffected.

    3. The greater the uncertainty about whether the payment will be made (the risk that the issuer will default on the promised payments), the lower the "expected" payment to bondholders and the lower the value of the bond.

    4. Bonds whose payments are subjected to lower taxation provide investors with higher expected after-tax payments. Since investors are interested in after-tax income, such bonds sell for higher prices.

The major classes of bond issuers are the U.S. government, corporations, and municipal governments. The default risk and tax status differ from one kind of bond to another.

U.S. Government Bonds

The U.S. government is extremely unlikely to default on promised payments to its bondholders. Thus, virtually all of the variation in the value of its bonds is due to changes in market interest rates. That is why analysts use changes in prices of U.S. government bonds to compute changes in market interest rates.

Because the U.S. government's tax revenues rarely cover expenditures nowadays, it relies heavily on debt financing. Moreover, even if the government did not have a budget deficit now, it would have to sell new debt to obtain the funds to repay old debt that matures. Most of the debt sold by the U.S. government is marketable, meaning that it can be resold by its original purchaser. Marketable issues include Treasury bills, Treasury notes, and Treasury bonds. The major nonmarketable federal debt sold to individuals is U.S. Savings Bonds.

Treasury bills have maturities up to one year and are generally issued in denominations of $10,000. They are sold in bearer form—possession of the T-bill itself constitutes proof of ownership. And they do not pay interest in the sense that the government writes a check to the owner. Instead, the U.S. Treasury sells notes at a discount to their redemption value. The size of the discount determines the interest rate on the bill. For instance, a dealer might offer a bill with 120 days left until maturity at a yield of 7.48 percent. To translate this quoted yield into the price, one must "undo" this discount computation. Multiply the 7.48 by 120/360 (the fraction of the 360-day year) to obtain 2.493, and subtract that from 100 to get 97.506. The dealer is offering to sell the bond for $97.507 per $100 of face value.

Treasury notes and Treasury bonds differ from Treasury bills in several ways. First, their maturities generally are greater than one year. Notes have maturities of one to seven years. Bonds can be sold with any maturity, but their maturities at issue typically exceed five years. Second, bonds and notes specify periodic interest (coupon) payments as well as a principal repayment. Third, they are frequently registered, meaning that the government records the name and address of the current owner. When Treasury notes or bonds are initially sold, their coupon rate is typically set so that they will sell close to their face (par) value.

Yields on bills, notes, or bonds of different maturities usually differ. Because investors can invest either in a long-term note or in a sequence of short-term bills, expectations about future short-term rates affect current long-term rates. Thus, if the market expects future short-term rates to exceed current short-term rates, then current long-term rates would exceed short-term rates. If, for example, the current short-term rate for a one-year T-bill is 5 percent, and the market expects the rate on a one-year T-bill sold one year from now to be 6 percent, then the current two-year rate must exceed 5 percent. If it did not, investors would expect to do better by buying one-year bills today and rolling them over into new one-year bills a year from now.

Savings bonds are offered only to individuals. Two types have been offered. Series E bonds are essentially discount bonds; they pay no interest until they are redeemed. Series H bonds pay interest semiannually. Both types are registered. Unlike marketable government bonds, which have fixed interest rates, rates received by savings bond holders are frequently revised when market rates change.

Corporate Bonds

Corporate bonds promise specified payments at specified dates. In general, the interest received by the bondholder is taxed as ordinary income. An issue of corporate bonds is generally covered by a trust indenture, which promises a trustee (typically a bank or trust company) that it will comply with the indenture's provisions (or covenants). These include a promise of payment of principal and interest at stated dates, and other provisions such as limitations of the firm's right to sell pledged property, limitations on future financing activities, and limitations on dividend payments.

Potential lenders forecast the likelihood of default on a bond and require higher promised interest rates for higher forecasted default rates. One way that corporate borrowers can influence the forecasted default rate is to agree to restrictive provisions or covenants that limit the firm's future financing, dividend, and investment activities—making it more certain that cash will be available to pay interest and principal. With a lower anticipated probability of default, buyers are willing to offer higher prices for the bonds. Corporate officers must weigh the costs of the reduced flexibility from including the covenants against the benefits of lower interest rates.

Describing all the types of corporate bonds that have been issued would be difficult. Sometimes different names are employed to describe the same type of bond and, infrequently, the same name will be applied to two quite different bonds. Standard types include the following:

  • Mortgage bonds are secured by the pledge of specific property. If default occurs, the bondholders are entitled to sell the pledged property to satisfy their claims. If the sale proceeds are insufficient to cover their claims, they have an unsecured claim on the corporation's other assets.
  • Debentures are unsecured general obligations of the issuing corporation. The indenture will regularly limit issuance of additional secured and unsecured debt.
  • Collateral trust bonds are backed by other securities (typically held by a trustee). Such bonds are frequently issued by a parent corporation pledging securities owned by a subsidiary.
  • Equipment obligations (or equipment trust certificates) are backed by specific pieces of equipment (for example, railroad rolling stock or aircraft).
  • Subordinated debentures have a lower priority in bankruptcy than unsubordinated debentures; junior claims are generally paid only after senior claims have been satisfied.
  • Convertible bonds give the owner the option either to be repaid in cash or to exchange the bonds for a specified number of shares in the corporation.

Corporate bonds have differing degrees of risk. Bond rating agencies (for example, Moody's) provide an indication of the relative default risk of bonds with ratings that range from Aaa (the best quality) to C (the lowest). Bonds rated Baa and above are typically referred to as "investment grade." Below-investment-grade bonds are sometimes referred to as "junk bonds" (see Junk Bonds). Junk bonds can carry promised yields that are 3 to 6 percent (300 to 600 basis points) higher than Aaa bonds.

Municipal Bonds

Historically, interest paid on bonds issued by state and local governments has been exempt from federal income taxes. Because investors are usually interested in returns net of tax, municipal bonds have therefore generally promised lower interest rates than other government bonds that have similar risk but that lack this attractive tax treatment. In 1991 the percentage difference between the yield on long-term U.S. government bonds and the yield on long-term municipals was about 15 percent. Thus, if an individual's marginal tax rate is higher than 15 percent, after-tax return would be higher from munis than from taxable government bonds.

Municipal bonds are typically designated as either general obligation bonds or revenue bonds. General obligation bonds are backed by the "full faith and credit" (and thus the taxing authority) of the issuing entity. Revenue bonds are backed by a specifically designated revenue stream, such as the revenues from a designated project, authority, or agency, or by the proceeds from a specific tax. Frequently, such bonds are issued by agencies that plan to sell their services at prices that cover their expenses, including the promised payments on the debt. In such cases the bonds are only as good as the enterprise that backs it. In 1983, for example, the Washington Public Power Supply System (nicknamed WHOOPS by Wall Street) defaulted on $2.25 billion on its number four and five nuclear power plants, leaving bondholders with much less than they had been promised. Finally, industrial development bonds are used to finance the purchase or construction of facilities to be leased to private firms. Municipalities have used such bonds to subsidize businesses choosing to locate in their area by, in effect, giving them the benefit of loans at tax-exempt rates.

About the Author

Clifford W. Smith is the Louise and Henry Epstein Professor of Business Administration and Professor of Finance at the William E. Simon Graduate School of Business Administration, University of Rochester. He was previously editor of the Journal of Financial Economics, and associate editor of the Journal of Financial Engineering, the Journal of Risk and Insurance, and Financial Management.

Further Reading

Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 1991.

Peavy, John W., and George H. Hempel. "The Effect of the WPPSS Crisis on the Tax-Exempt Bond Market." Journal of Financial Research 10, no. 3 (Fall 1987): 239-47.

Sharpe, William F., and Gordon J. Alexander. Investments. 1990.

Smith, Clifford W., Jr., and Jerold B. Warner. "On Financial Contracting: An Analysis of Bond Covenants." Journal of Financial Economics 7, no. 3 (June 1979): 117-61.

Return to top