BONDS

1. What are Bonds?

Bonds are debt obligations issued by corporations, states, municipalities and
government agencies. The insurer agrees to pay the holder interest on a semiannual
basis and then repay the principal when the bond maturesusually 20 to 35 years in
the future. nvestors can purchase bonds when originally issued, or later in the bond
mar!et. The face value "par value or denomination# of a corporate bond is typically
$%,000& a municipal bond is usually $5,000.
Bonds are called 'fi(ed)income' securities because they pay a fi(ed interest rateso
long as the company is solvent. *owever, bond values are not fi(edan important
fact overloo!ed by too many novice investors+ Bond prices are ,uite sensitive to
prevailing interest rates. They will fluctuate above or below their par "face# value, in
opposite directions to interest rates.
*istorically, bonds were considered a good and safe investment for retirees, widows,
orphans and institutional investors. nvestors bought bonds, clipped the coupons to
collect their interest every si( months and sleep well. Bonds still attract these types
of investors, but, because of -un! bonds and ta!eovers, the character of bonds
changed in the %./0s.
n earlier years, before 0B1s, -un! bonds and 2hapters 3 4 %% ban!ruptcies, strict
covenants of the bond contracts guaranteed bondholders their payment when due.
Today, these covenants may have broad interpretations that definitely are not
advantageous to the bondholder. Bondholders of ta!eover stoc!s sometimes have
watched the common shareholders clean up when a ta!eover is announced, while
their bonds drop to %0 or %5 percent of their original par value.
Big investment ban!s or bro!erage firms chasing big ta!eover fees are to blame.
They write the covenants to benefit their big clients, not you, the bondholder. Ban!s
tell their bro!erage clients how solid and safe they are, while their own bond
investment departments are assisting the ta!eover artists in deals that can drive the
bonds to near)5ero worth. 0isted below are some of e(amples of deals or situations
that were not in bond holders best interests6
7fter defaulting on over $2 billion in bonds, the 8ashington 9ower :upply
:ystem "8*119:# is planning to issue more bonds.
n the late %./0s ;<; =abisco issued bonds. 7 few months later, ;<;
management initiated a ta!eover plan with the assistance of :hearson)0ehman and
the bonds dropped %0 percent in value. nterestingly, :hearson was one of the
underwriters for the bonds.
8hen Te(aco went into ban!ruptcy "because of the 9en5oil lawsuit#, it delayed
ma!ing interest payments to the bond holders. The odd part is that once Te(aco
emerged from ban!ruptcy, its superior credit rating remained intact.

2. Definition of Terms
Par value: 7lso !nown as face value. The initial value of the bond. >ost corporate
bonds are traded in $%,000 denominations.
Coupon rate: The interest rate of the bond based on its par value& paid in
semiannual installments.
aturit! date: The date on which bond issuer agrees to repay the bond?s principal
amount, to redeem it.
Bond indenture: 7 long legal contract "often %00 pages or more# that covers every
detail regarding the bond issue. t spells out restrictions, collateral pledged, possible
early recalls, methods of repayment and other bond covenants.
Sellin" at Premium: Bonds selling for more than their par value.
Sellin" at Dis#ount: Bonds selling for less than their par value.
$ield: 9ercent annual interest rate paid on face value of bond, usually paid
semiannually.

%. What to &oo' for in a Bond
The first thing you must chec! in a bond is its rating by :tandard and 9oor?s, or
>oody?s. @ou will find these rating guides at libraries or your bro!er. :49?s highest
rating is '777,' while >oody?s uses '7aa&' both use '2' for the poorest rating. f the
rating is lower than :49 '7,' we recommend passing it up. nvestors who buy high)
yield, low),uality bonds because they yield %3 percent or more will be sorry during a
recession.
:ome bonds are insured against the issuer?s default. Averything else being e,ual, the
return from an insured bond is somewhat lower than from a same)rated non)insured
one. *owever, the bondholder is insured against loss of principal and interest if the
bond issuer defaults.
t is important to read the fine print and as! ,uestions about the bond issue.
7lthough a non)callable bond will have a lower yield than a callable bond, you usually
lose your gain if the bonds are called early. The following fictitious e(ample is based
on numerous real)life e(amples.
2ompany B@C issued a 30)year callable bond yielding %% percent. n three years,
interest rates dropped and the company decided to call the bonds. <ust before the
call, the bonds were trading at an / percent premium, "$%0/0 per $%000 of par
value#. Then the company redeemed the bonds par, $%,000. Bond holders too! an /)
point loss& if they held %0 bonds, they lost $/00.

(. ethods of )epa!ment
8hile most bonds pay interest semiannually, the principal is repaid in a single sum at
maturity. *owever, there are other methods of repayment6
Serial pa!ments: Bonds are paid off in installments over the life of the issue. Aach
bond has its own predetermined date of maturity and receives interest in a lump sum
at that time.
Sin'in"*fund provision: The corporation ma!es semiannual or annual contributions
to a fund administered by a trustee. The trustee goes into the mar!et and purchases
"retires# bonds from willing sellers. f no bondholders want to sell, a lottery system
can be used to determine which bonds will be redeemed.
Conversion: This allows bondholders to convert their bonds to common stoc!. The
bondholder decides, but incentives or penalties are used to encourage conversion.
This usually happens when interest rates drop.
Call feature: 7 call provision allows the corporation to call "redeem, pay off# the
bonds prior to maturity. The corporation usually pays a premium of 5 to %0 percent
over the par value. *owever, the issuing company may not be legally bound to pay a
premium and may call the bonds at par, as in the above e(ample. >ost bond
provisions or covenants for calls usually do not ta!e effect sooner than 5 to %0 years
after issue, but there are instances of companies calling the bonds within 2 years
after issue. 2orporations usually call the bonds after interest rates drop and they
want to retire the higher)rate bonds. Be sure to read all the fine print so you !now
when a company can call its bonds.

+. T!pes of Call Provisions
,reel! Calla-le: ssuer can retire the bond at any time. =o call protection, no
premium.
Non*#alla-le: 2annot be called until maturity date.
Deferred Call: 2annot be called until after a certain period, such as 5 to %0 years.

.. Bonds and /nterest )ates
Because bonds and interest rates move in opposite directions, investors should have
a basic understanding of how a bond?s worth varies with prevailing interest rates.
8hen interest rates drop, bond values increase. Bondholders who buy when interest
rates are high and then sell when they are low, will ma!e capital)gains profits.
2onversely, when interest rates rise, bonds lose value. Bondholders who buy when
interest rates are low and then sell when they are high, will suffer significant losses.
Thin! about it. f you hold ten $%,000)bonds that pay %0 percent, you will collect
$%000 interest per year. But if interest rates go up to %% percent, nine %% percent)
bonds will now pay about the same, $..0. :o if your %0 percent)bonds are long)
term, their mar!et value will drop to about $.00 each. 2onversely, if interest rates
drop to . percent one will need eleven $%,000 . percent)bonds to collect about the
same $%000 interest. :o the mar!et value of your bonds will increase to about
$%,%00 each.
The above figures are appro(imate because they neglect 'yield to maturity'a
$%,000 bond is still worth $%,000 when it matures no matter what you paid for it. Dor
long)term bonds, that does not change the numbers in the preceding paragraph very
much. "<ust another illustration that long)term bonds are not good inflation hedges
and are ris!ier.#
Dor shorter)term bonds, yield to maturity does ma!e a significant difference. A.g., if
your %0 percent bonds mature in 3 months, you do not care too much if interest
rates go to %% percentyou will soon get your money bac! and can reinvest at the
higher rate. :o one should always figure 'yield to maturity' for accurate evaluation of
bonds. Those calculations are beyond the scope of this tutorial. @ou can estimate
yield to maturity using 9resent Ealue table as discussed in Follars =ow versus Follars
0ater& or your bro!er or accountant "hopefully# can tell you the correct numbers.
The point of the above is that one should buy long)term bonds and hold them only if
interest rates are high. f you hold low)interest bonds, "or any interest)rate bonds at
all when interest rates are very low# you should be alert to sell them if you have
good reason to thin! interest rates will start rising in the near future. The reason is
simply that as interest rates increase, the value of all fi(ed)interest securities
decrease.

0. $ield Curves: /nterest )ate 1ersus Time to aturit!
7 yield curve plots interest rates paid on bonds "or other securities# against the life,
or time to maturity, of the securities. "Barrons and the 8all :treet <ournal both
publish yield curves.# =ormally, the yield curve slopes upward, meaning that long)
term bonds pay higher interest rates than shorter)term ones. Thirty)year treasury
bonds pay higher rates and are on the upper end of the curve& .0)day T)Bills usually
pay lower interest rates and are on the low end of the curve. The reason for this is
that ris!s increase as times)to)maturity increase and borrowers must pay higher
rewards for higher ris!s. Gsually, the economy and interest rates do not change
much within a few months... the life span of a T)Bill. But a lot can happen in a few
years, not to mention thirty yearsdouble)digit inflation, double)digit interest rates,
ma-or ban!ruptcies, wars, recessions, :40 failures and mar!et crashes. 7n(iety over
those painful events will drive down the worth of long)term fi(ed)income securities.
0ong)term bonds have higher ris!s than short)term bonds because they are more
vulnerable to price decreases if interest rates rise. 7lso, long)term industrial bonds
allow companies issuing the bonds more time to run into financial problemsthus
increasing long)term ris!s. ;ational investors will not buy longer)term bonds or
treasuries unless they are compensated by appropriately higher yields.
7t times, short)term rates may move higher than long)term rates, creating an
abnormal 'inverted' yield curve. That situation has historically forecast recessions or
bear mar!ets. 8hen that happens, smart bond investors usually sell their cyclical
stoc!s "chemicals, paper, autos and machinery stoc!s# and buy bonds. 7s noted
before, once long)term rates start to drop, bond values begin to rise.

2. uni#ipal and Ta3*free Bonds
:tate, local, city and county governments issue general obligation bonds, revenue
bonds and industrial revenue bonds. They carry lower interest rates than corporate
bonds because they are not sub-ect to federal income ta(es. These include6
4eneral O-li"ation Bonds: Bonds issued for general purposes such as building
highways, roads and schools. The bonds are repaid by ta(ing the populace who will
benefit from the item being financed.
)evenue Bonds: Bonds issued to build revenue)generating facilities li!e toll roads,
bridges, home mortgages and college dormitories. The pro-ects generate funds to
pay principal and interest on the bonds.
Spe#ial Ta3 Bonds: :hort)term bonds used by municipalities that may have a
budget shortfall, or are waiting for ta( revenues to be received. These bonds help
'tide over' the issuing municipality and are repaid through general ta(ation.
/ndustrial )evenue Bonds: Bonds usually issued by a municipality to assist a large
company in placing a plant or building in the municipality. The town e(pects that the
new facility will employ local wor!ers. The bonds are repaid by general ta(ation.

5. Corporate and Converti-le Bonds
Corporate Bonds: Bonds issued by corporations. They are long)term debt "long)
term liability# for a corporation and show on its balance sheet as such. The better the
company?s credit or bond rating, the lower the ris! and lower the return to
bondholders.
Converti-le Bonds: Bonds that may be converted to "e(changed for# shares of the
corporate issuer?s common stoc! at a specified share price. f the stoc! appreciates
in value, the holder receives shares worth more than the face value of the bond.
2onvertibles offer higher income than the dividends of most common stoc!s, but
offer lower yields than most non)convertible bonds.

16. 7ero Coupon Bonds
'Ceros' are bonds issued at a deep discount from their face value. They are called
'5eros' since no interest at all is paid until maturity. Bondholders redeem them at
face value when they reach maturity. The e(cess of the redemption amount over the
original low purchase price compensates the buyer for both principal and interest. Dor
e(ample, if you buy a $%0,000 %5)year 5ero you may pay only $%,200 for the bond
and in %5 years it is worth $%0,000. "That sounds great, but $%,200 invested at %%
percent with all interest re)invested will grow to about $%0,000 in %5 years.# The
$/,/00 'profit' is the compound interest accrued on $%,200 over the life of the bond.
1n 5eros, the ;: re,uires investors to pay ta(es each year on the accrued interest
even though the ta(payer received no interest whatsoever during those years. "7nd
you thought the government put fraud artists in -ail instead of in the ;:+ 7ctually,
you must blame it on 2ongressnot the ;:#. The ta( can be postponed by using
5eros in ;7s and childrens? custodian accounts.
Ceros fluctuate in value more dramatically then regular bonds, so you should not
purchase 5eros unless you plan on holding them until maturity. 7lso you want to
avoid purchasing 5eros that are callable. Best bets for safety are 5ero)coupon G.:.
Treasuries, they are non)callable.
Ceros, unli!e stoc!s but li!e other bonds, are a poor hedge against inflation. Because
the bonds do not mature for many years, you can lose significant purchasing power
with inflation or interest rate increase. nvestors who bought H percent bonds 25
years ago were big losers during the high)interest)rates seventies.
8hen interest rates increase, some investors try to sell their 5eros, but they will get
less than what they paid for the bond. The best time to buy 5eros, or any other
bonds for that matter, is when interest rates are high and you e(pect them to drop.
8hen interest rates drop, bond values increase. *owever, the chances of reliably
predicting interest rates is about the same as winning the lottery. 9rudent investors
should be wary of speculation unless they can afford the losses.

11. T!pes of 7ero Coupon Bonds
Corporate 7eros: Iuite ris!y because you buy the bond at a discount& if it defaults
before maturity, you usually get nothing. 7 regular corporate bond usually ma!es at
least some interest payments before default. The advantage is that higher interest
rates compensate you for assuming additional ris!.
uni#ipal 7eros: Ceros issued by state and local governments. They are e(empt
from federal ta(es and e(empt from state ta(es in the state that issued them. These
bonds can have call provisions.
4overnment 7eros: The G.:. government offers Treasury 5eros called :T;9: "for
:eparate Trading of ;egistered nterest and 9rincipal :ecurities#. >errill 0ynch
originally developed these products and called them TJ;s "for Treasury nvestment
Jrowth ;eceipts#. :almon Brothers developed similar ones called 27T: "for
2ertificates of 7ccrual on Treasury :ecurities#. To cover paybac!s, >0s and :Bs
purchase government bonds and place them in irrevocable trusts.

12. )eturns ,rom 7eros
f you invest $2,000 in a 5ero coupon bond that has semiannual compounding, your
investment will be worth the following amounts "before ta(es# after the
corresponding number of years since issue6
aturit! 28 168 128
5 years $2,.K0 $3,25/ $3,5/2
%0 years $H,3/2 $5,30K $K,H%H
%5 years $K,H/K $/,KHH $%%,H//
20 years $.,K02 $%H,0/0 $20,532
But remember, if you invest in a 5ero, you need to hold it until it matures. f you try
to sell before maturity, you may sell at a poor price. 1nly very e(perienced investors
should use 5eros as a short)term investment.

1%. 9i"h $ield :;un'< Bonds
*igh @ield '<un!' bonds were invented to enable smaller companies or big investors
to use bonds and bond mar!ets to finance ta!eovers. The original concept was good
and legal& but unbelievably greedy bro!ers and arbitrageurs, aided by big investment
firms, e(ploited and corrupted it. They used illegal inside information, deliberately)
planted misinformation and mar!et rigging to ma!e millions and millions of dollars
while, in some instances, destroying profitable old companies. :ome of these
multimillionaires are now in the penitentiary. Gnfortunately, greed is still rampant.
The -un! bond mar!et grew e(ponentially. Furing the %..0).% recession many of
these bonds defaulted, helping ban!rupt the :40s throughout the G.:. and helping to
saddle G.:. ta(payers with a trillion dollar national deficit.
8hen the bonds defaulted, many investors complained that their bro!ers said they
would get a %K percent yield. They chose to ignore the a(iom that high ris!s
inevitably accompany high rewards. There are no free lunches, no guarantees.
8e recommend avoiding -un! bonds. *owever, if you must buy them, at least buy a
-un! bond fund& with a fund you have more diversification. n the -un! bond fund you
may lose only 25 percent of your principal versus %00 percent in an individual bond.
8e feel that investors have superior and safer opportunities in undervalued common
stoc!s or stoc! mutual funds.
7 research study completed in mid)%./. by *arvard professor Fr. 9aul 7s,uith found
that an incredible 3H percent of all high yield bonds defaulted. *e started with bonds
issued in %.33 and assumed that if a hypothetical investor bought every high yield
bond issue between %.3/ and %./K, 3H percent of the bonds would have defaulted
by =ovember %.//. 9rofessor 7s,uith also found that the ,uality of bond issues has
decreased over time with higher ,uality issues in the early %./0s versus the late
%./0s.

1(. Bond utual ,unds
>any investors choose bond mutual funds over bonds. These funds offer
diversification and professional management. >any turned to bond funds after the
1ctober %./3 crash, in search of lower)ris! investments. <un! bond advertisements
of %3 percent yields enticed some of them. Gnfortunately, those were not lower ris!.
>any investors did not understand that the values of the funds fluctuate li!e regular
bonds, because both are tied closely to the mar!et.
f an investor holds a bond to maturity she will eventually recover the entire face
value of the bond, assuming it does not default. *owever, bond funds values
fluctuate because some bonds do default and because the fund constantly adds new
bonds as the fund e(pands and replaces retired bonds with new bonds. 7n investor
may get scared when the value of the bond shares drops "e.g., because of higher
interest rates# and bail out. f so, he will not recover his original principal. *e will
have a capital loss.
:ee also the mutual fund section for more information on bond mutual funds.

1+. 9o= to Bu! Bonds
nvestors can buy bonds from a full service or most discount bro!ers. f you buy a
new issue bond you will not pay a commission, but you will when you sell it. @ou also
will pay a commission for bonds listed on the e(change "after issue#. @ou can buy
G.:. Jovernment bonds, bills and notes from your ban! or a Dederal ;eserve ban! or
branch with little or no commission.
1.. Bond 1aluation
nvestors need to understand the pricing and yield of bonds before they purchase.
>ost bonds are in $%,000 denominations and are ,uoted as a percent of par "face
amount#. :ay that 7B2 2orp. / %L2 percent bonds maturing in the year 200% are
,uoted at .H. The price is .H percent of par, or $.H0, so the current yield at .H
would be /5L.H0, or ..0H percent. "2urrent percent yield e,uals %00 times the
annual interest dollars, divided by what you pay for the bond6 %00 ( $/5 L $.H0 M
..0H percent#. *owever, remember that current yield, 2@, is not the same as yield to
maturity, @T>. f a bond is selling below par, its @T> will be higher than its 2@,
because eventually you get bac! the full par value. f it is selling above par, its @T>
will be lower than its 2@.

10. The Bond ar'et as a Predi#tor of the Sto#' ar'et
The bond mar!et acts as an indicator of the direction of the stoc! mar!et. 0isted
below are three ways you can use the bond mar!et to predict the stoc! mar!et6
n a down or bear mar!et, watch for rising bond prices& this may signal start
of a bull mar!et or rally.
7 drop in high grade bond prices "same as increase in bond yields#. n the
mar!et declines of %.3H and %./3, 777 bond yields increased before the
mar!et dropped.
Fecline in high)yield, -un! or second)grade bond prices. This may signal that
speculators are moving out of the bond mar!et.

12. Se#urit! )epa!ment Priorities of Bonds
There are two types of security provisions for bonds, unsecured claims and secured
claims. Gnsecured debt is not secured by assets. :uch long)term, corporate bonds
are also called debentures. Gnsecured debt also has senior and -unior classes.
Febentures are essentially promissory notes to the bondholders.
n a secured claim, the company pledges specific assets "usually hard assets li!e
plant and e,uipment# to protect the bondholder from default. 8hen a company does
default, assets usually are not sold off. n most cases "2hapter %% ban!ruptcy# the
company is re)organi5ed and new securities are issued to satisfy bondholders claims.
The new issues will li!ely be worth a fraction of the original bonds and the
bondholders ta!e it in the nec!. n the past, assets were sold off and money set
aside to pay off bondholdersbut not anymore+
:ecured debt has different classes, senior)secured debt and -unior)secured debt. The
following chart shows the priority of claims for investors6
:ecured Febt6 :enior has first claim on assets pledged& <unior has second
claim.
Gnsecured Febt6 2laims below secured debt.
Febentures6 *olders do not receive payment until senior holders are paid in
full.
9referred :toc!6 9riority of claims are below unsecured debt.
2ommon :toc!6 0ast in line. 9robably no recovery.

15. Disadvanta"es and &imitations of Bonds
2ompared to common stoc!s, bonds do not offer a good hedge against inflation.
7nother drawbac! is that bonds come in large denominations of $%,000 per issue "or
$5,000 for municipals#. t used be that Bonds were relatively conservative
investments that investors could buy, clip the coupons and ignore until maturity. But
this has changed because of ta!eovers and litigation.
>ost ta!eovers are funded by high yield or -un! bonds. The companies issuing bonds
insert loopholes in the covenants. These escape clauses allow great leeway for the
companies or ta!eover artists to abuse the bondholders. Dew investors or bro!ers
understand, or even read, the comple( legal and financial details in the %00N page
contracts.
8hen the highly leveraged companies start having cash flow problems, they fall bac!
on the provisions of the covenants as an escape hatch. 7 company may decide to
'restructure' overnight so the high grade senior debt becomes lower grade -unior
debt. n plainer Anglish, the bonds become worthless.