Corporate Bonds
WHAT IS IT?
A bond is the legal evidence of a long-term loan made by the bondholder to the corporation that issued the bond. Typically the loan must be repaid as of a specified date, referred to as the “maturity date.” Until the bonds are redeemed (i.e., paid off by the corporation), interest at a stated rate is paid, generally every six months, by the corporation to the bondholder. The interest rate paid on the bonds is usually fixed when the bonds are issued and does not change during the life of the bond.
An important subset of corporate bonds consists of so-called “high yield” issues, those that generally do not qualify for “investment grade” ratings by the major credit rating agencies. In Wall Street jargon, such issues are sometimes referred to as “junk” bonds.
ADVANTAGES
1. Income and principal are relatively safe. Semiannual interest payments and eventual repayment of the principal on an unsecured corporate bond (a “debenture”) are guaranteed by the general credit of the issuing corporation. Obviously, the security of both interest and principal are in direct proportion to the financial strength of the issuer. Income and principal payments on a secured bond are backed by specified collateral, such as real property owned by the corporation, as well as by the earning power and other assets of the firm.
Payment of both interest and principal to bondholders takes precedence over payment of dividends on either preferred or common stock. In the event of corporate insolvency or bankruptcy, holders of secured bonds generally will receive better treatment than unsecured creditors, general creditors, or stockholders.
2. Bonds normally pay interest income on a regular basis. Once issued, the amount and timing of bond payments cannot be changed by the issuing corporation regardless of its financial condition (unless it files a petition under the bankruptcy code). Unlike the payment of dividends on stocks, which is made at the discretion of the board of directors, interest payments on bonds are a nondiscretionary legal obligation. Because of this fixed commitment, it is possible for an investor, through careful selection of individual issues, to be assured of a regular income. For example, by selecting six bonds, each with a different semiannual payment date, an investor can receive an interest check every month.
3. Gain on the sale of a bond held for more than one year is eligible for long-term capital gain treatment. Likewise, if the bond is held to maturity, and the maturity value (par value) exceeds the price paid for a bond purchased on the market, the difference would be treated as a long-term capital gain. For example, if an investor had purchased an AT&T bond in 2006 at a price of $900, and the bond matures in 2012 at its par value of $1,000, the difference of $100 would be treated as a long-term capital gain.
The Tax Reform Act of 1984 changed the treatment of market discount on bonds issued after July 18, 1984 or purchased after April 30, 1993. When such a bond is purchased at a price less than the original issue price, the difference between the purchase price and the original issue price must be treated as interest income rather than capital gain. That income can be recognized on an annual basis, when the bond is sold, or when it matures. The law also provides for certain limits on the deductibility of interest expense incurred to purchase or carry market discount bonds.
In addition, if the original issue price of the bond is less than the maturity value, the excess of the maturity value over the original issue price must be included as interest income (i.e., original issue discount) as it accrues over the life of the bond.
4. Compared to many other investments, corporate bonds provide a high current rate of return on capital. Historically, the current yield on corporate bonds has ranged from 2% to 8% higher than the dividend yield on common stocks. In late 2003, the current yield on the Dow Jones Corporate Bond Index was approximately 6.13%, while the dividend yield on the Standard & Poor’s 500 Stock Average was 1.8%, and many public utility stocks paid dividends yielding about 4%.
5. High yield bonds provide a higher level of current income when compared to investment grade bonds (those issues rated BBB or higher by Standard & Poor’s, or Baa by Moody’s). They also have the potential for significant capital appreciation if a bond’s rating is upgraded at some future point in time.
DISADVANTAGES
1. While the interest payments on bonds are fixed as to the amount and almost certain to be paid, their purchasing power may be eroded by inflation.
The longer the period of time to maturity, the more likely that the purchasing power of each fixed dollar payment will decline.
For example, assume that an inflation rate of 3% annually exists and that an investor purchases a bond paying $80 each year. His “inflation-adjusted” interest income would be equivalent to $69.01 after five years and only $59.53 after 10 years. Examined another way, the investor’s income after five years would have to be $92.74 and after 10 years $107.51, to keep pace with a 3% annual inflation rate.
2. Interest payments are fixed when the bonds are issued. The dollar amount of these payments will not change even if the financial condition of the company or the economy improves. Since bondholders are creditors and not owners of the corporation, they do not share in the growth or prosperity of the company. This means that the fixed interest on bonds may be unattractive when compared with potentially increasing payments available from alternative
investments. For example, dividends from common stocks and rental income from real estate investments can increase substantially over time.
3. Inflation will also reduce the purchasing power of a bondholder’s principal. The longer the period of time the bondholder has to wait for repayment of principal, the more significant that effect may be. Assume that an investor purchases a bond for $1,000 and that the bond will mature in 10 years. At a 3% rate of inflation, the $1,000 repayment he will receive in 10 years would be equivalent to only $744.09 in current dollars.
4. Bond prices fluctuate with changes in current market interest rates. If interest rates paid on newly issued bonds increase, older bonds paying lower rates of interest will be less attractive to investors. In order to sell older bonds having lower interest rates, their price must be reduced. The effect of this decline in price is to make old bonds competitive with new ones in terms of their “yield to maturity.” (Yield to maturity is the average annualized rate of return that an investor will earn if a bond is held until it matures.)
For example, if market interest rates increase from 8% to 10%, a 20-year bond paying 8% will fall in price from $1,000 to $828. Why? Because, by purchasing new bonds investors can now earn 10% on every $1,000 they invest rather than 8%. Therefore, the price of the 8% bond must be lowered until it produces a yield to maturity equivalent to the yield on the new 10% bond.
Of course, the reverse is also true. If market interest rates fall, the price of previously issued bonds will rise. In this situation bondholders will demand a higher price for their bonds since they are more attractive than new issues with lower interest rates.
5. If the overall financial condition of the issuing corporation deteriorates, the resale price of their bonds is likely to fall. A decline in the financial strength of the corporation would be reflected in a lower credit standing for the firm and, therefore, a lower quality rating for the bond issue. The lower quality rating results in a perception of increased risk and diminished worth in the minds of investors. In return for this increased risk, potential buyers will demand a higher rate of return. Since interest payments cannot be increased, the only way to satisfy a potential buyer’s demand for a higher rate of return is for the seller to lower the price. An improvement in the issuer’s financial condition and credit rating will typically result in higher bond prices.
6. An investor’s ability to sell his bonds at a given time may be adversely affected by any one or more of the following factors:
a. The smaller the size of the issue, the less likely the bonds are to be actively traded.
b. The issue may be owned in large blocks by only a few large institutions, such as banks and pension funds, resulting in low levels of trading activity and a relatively restricted market.
c. If the quality rating of the issuer has declined since the bond was purchased, there may be fewer interested buyers. This, of course, makes a sale more difficult.
7. Today, most corporate bonds are issued as general credit obligations (“debentures”). Although such bonds provide a greater degree of security for investors than an equity (stock) investment, they still involve a greater degree of risk than a “secured” debt obligation, such as a mortgage. Bonds backed by real assets of the corporation provide an investor with the specific security of the mortgaged property.
Corporate bonds also are often issued in the form of “subordinated debentures,” which generally have security preference over only the equity of the issuing company. Such debentures are subordinated in security to all other creditors, including general creditors. Because of the higher risk associated with subordinated debentures, they usually will pay a higher interest rate than general credit obligations, and often are issued with warrants for the purchase of common stock of the issuing company, or are convertible into such stock.
8. High yield bonds typically involve additional risks, such as: (a) greater price volatility than investment grade bonds with similar maturities; (b) increased risk of default (failure to pay principal and/or interest as stated in the bond indenture); and (c) less liquid markets with higher bid-ask spreads than for ordinary bonds.
TAX IMPLICATIONS
1. Interest income paid on a regular basis is generally taxable when received at ordinary income rates.
2. Profits or losses on the sale or maturity of corporate bonds are treated as capital gains or losses (see the discussion of capital gains and losses in Chapter 43, “Taxation of Investment Vehicles”).
Long-term capital gains are generally taxable at a maximum rate of 15%. Capital losses may be used to offset only capital gains and up to $3,000 of ordinary income per year. Unused losses may be carried forward by individuals and applied against future income.
3. If a bond is sold at a loss and then repurchased, the investor may be subject to the “wash sale” rules.
4. Bonds held at death in the sole name of the investor will be subject to both federal estate tax and state death tax. (Under EGTRRA 2001, the estate tax is repealed for decedents dying after 2009. However, EGTRRA 2001 “sunsets” (i.e., expires) after 2010.[1.]) Fifty percent of bonds owned jointly between spouses will be includable in the gross estate of a decedent but will generate no federal estate tax upon the death of the first spouse because of the unlimited marital deduction.
5. Bonds issued with “original issue discount,” such as “zero coupon bonds,” yield taxable income to the bondholders with respect to the discount over the life of the bond. This occurs even though the discount “income” will not be received until the bond matures. (Original issue discount is discussed in detail in “Questions and Answers,” below.)
6. Special rules apply where bonds are purchased at a “market discount” (i.e., at a price below the original issue price and the maturity or face value). Generally, the amount of market discount need not be recognized as income until the bond is sold or matures. However, there is a limit on the deductibility of interest expense on debt incurred to purchase or carry market discount bonds. Such interest expense can be deducted to the extent there is interest income on the bond (including original issue discount) that is includable in income. Beyond that amount, interest expense may be deducted only to the extent it is more than the market discount allocable to the days the bond was held in the year. The amount of interest expense not currently deductible may be deducted in the year the investor disposes of the bond. (The interest disallowance rules do not apply if the investor elects to recognize a prescribed portion of the market discount as income each year until the bond matures.)
7. High yield bonds are treated similarly to other corporate debt instruments for income tax purposes. Interest income is subject to both federal and state income taxes and is taxed as “ordinary income,” such as wages. Gains and losses on high yield bond sales are also taxed like other capital transactions.
HOW DO I SELECT THE BEST OF ITS TYPE?
1. Investors interested in buying corporate bonds should consider the following:
a. Quality Rating of the Bond – as assigned by a professional appraisal service such as Standard & Poor’s Bond Guide or Moody’s Investors Service. These run from “AAA” (highest rating) to “D” (default), though conservative investors probably should not consider bonds rated lower than BBB. This rating is a current assessment of the creditworthiness of the issuer and is based on information furnished by the company or obtained by the rating service. The ratings take into consideration the nature and provisions of the obligation, likelihood of default, and protection afforded the holder in the case of bankruptcy.
b. Current Yield – the rate of return based on the current market price of the bond. This is obtained by dividing the annual interest amount by the current purchase price of the bond.
c. Yield to Maturity – the rate of return on a bond held to its maturity date and redeemed by the issuer at its par value. Yield to maturity includes any gain (or loss) if the bond was purchased below (or above) its par value.
2. A maturity date should be consistent with the investor’s projected cash flow or capital needs objectives.
3. It may be desirable to coordinate maturities with potential shifts in tax brackets. In other words, an investor should select maturities that delay the gain until he or she will be in a lower tax bracket or can utilize offsetting deductions.
4. Preference should be given to the larger issues of strong, well-managed corporations. The bonds of such firms are likely to be actively traded. This increased marketability will make the bonds easier and less costly to sell in a short time.
5. Bonds with shorter maturity dates will generally have greater price stability than longer-term bonds with the same quality rating (although the tradeoff may be a lower yield).
6. For high yield bonds, investors would be wise to:
(a) diversify their holdings across issuers and industry sectors—concentrating in only a few issues greatly increases the risk of holding junk bonds;
(b) adjust their portfolios over economic cycles—increasing holding during periods of economic expansion and reducing them as the economy slows or contracts; and
(c) monitor the rating agencies, which often put companies on a “credit watch” list prior to down-grading an issue.
For more Information:
Fixed Income and Bonds Investment Guide
Fixed-Income Securities and Derivatives Trading,Investment Bonds & Bond Trading, The Handbook of European Fixed Income Securities.
WHAT IS IT?
A bond is the legal evidence of a long-term loan made by the bondholder to the corporation that issued the bond. Typically the loan must be repaid as of a specified date, referred to as the “maturity date.” Until the bonds are redeemed (i.e., paid off by the corporation), interest at a stated rate is paid, generally every six months, by the corporation to the bondholder. The interest rate paid on the bonds is usually fixed when the bonds are issued and does not change during the life of the bond.
An important subset of corporate bonds consists of so-called “high yield” issues, those that generally do not qualify for “investment grade” ratings by the major credit rating agencies. In Wall Street jargon, such issues are sometimes referred to as “junk” bonds.
ADVANTAGES
1. Income and principal are relatively safe. Semiannual interest payments and eventual repayment of the principal on an unsecured corporate bond (a “debenture”) are guaranteed by the general credit of the issuing corporation. Obviously, the security of both interest and principal are in direct proportion to the financial strength of the issuer. Income and principal payments on a secured bond are backed by specified collateral, such as real property owned by the corporation, as well as by the earning power and other assets of the firm.
Payment of both interest and principal to bondholders takes precedence over payment of dividends on either preferred or common stock. In the event of corporate insolvency or bankruptcy, holders of secured bonds generally will receive better treatment than unsecured creditors, general creditors, or stockholders.
2. Bonds normally pay interest income on a regular basis. Once issued, the amount and timing of bond payments cannot be changed by the issuing corporation regardless of its financial condition (unless it files a petition under the bankruptcy code). Unlike the payment of dividends on stocks, which is made at the discretion of the board of directors, interest payments on bonds are a nondiscretionary legal obligation. Because of this fixed commitment, it is possible for an investor, through careful selection of individual issues, to be assured of a regular income. For example, by selecting six bonds, each with a different semiannual payment date, an investor can receive an interest check every month.
3. Gain on the sale of a bond held for more than one year is eligible for long-term capital gain treatment. Likewise, if the bond is held to maturity, and the maturity value (par value) exceeds the price paid for a bond purchased on the market, the difference would be treated as a long-term capital gain. For example, if an investor had purchased an AT&T bond in 2006 at a price of $900, and the bond matures in 2012 at its par value of $1,000, the difference of $100 would be treated as a long-term capital gain.
The Tax Reform Act of 1984 changed the treatment of market discount on bonds issued after July 18, 1984 or purchased after April 30, 1993. When such a bond is purchased at a price less than the original issue price, the difference between the purchase price and the original issue price must be treated as interest income rather than capital gain. That income can be recognized on an annual basis, when the bond is sold, or when it matures. The law also provides for certain limits on the deductibility of interest expense incurred to purchase or carry market discount bonds.
In addition, if the original issue price of the bond is less than the maturity value, the excess of the maturity value over the original issue price must be included as interest income (i.e., original issue discount) as it accrues over the life of the bond.
4. Compared to many other investments, corporate bonds provide a high current rate of return on capital. Historically, the current yield on corporate bonds has ranged from 2% to 8% higher than the dividend yield on common stocks. In late 2003, the current yield on the Dow Jones Corporate Bond Index was approximately 6.13%, while the dividend yield on the Standard & Poor’s 500 Stock Average was 1.8%, and many public utility stocks paid dividends yielding about 4%.
5. High yield bonds provide a higher level of current income when compared to investment grade bonds (those issues rated BBB or higher by Standard & Poor’s, or Baa by Moody’s). They also have the potential for significant capital appreciation if a bond’s rating is upgraded at some future point in time.
DISADVANTAGES
1. While the interest payments on bonds are fixed as to the amount and almost certain to be paid, their purchasing power may be eroded by inflation.
The longer the period of time to maturity, the more likely that the purchasing power of each fixed dollar payment will decline.
For example, assume that an inflation rate of 3% annually exists and that an investor purchases a bond paying $80 each year. His “inflation-adjusted” interest income would be equivalent to $69.01 after five years and only $59.53 after 10 years. Examined another way, the investor’s income after five years would have to be $92.74 and after 10 years $107.51, to keep pace with a 3% annual inflation rate.
2. Interest payments are fixed when the bonds are issued. The dollar amount of these payments will not change even if the financial condition of the company or the economy improves. Since bondholders are creditors and not owners of the corporation, they do not share in the growth or prosperity of the company. This means that the fixed interest on bonds may be unattractive when compared with potentially increasing payments available from alternative
investments. For example, dividends from common stocks and rental income from real estate investments can increase substantially over time.
3. Inflation will also reduce the purchasing power of a bondholder’s principal. The longer the period of time the bondholder has to wait for repayment of principal, the more significant that effect may be. Assume that an investor purchases a bond for $1,000 and that the bond will mature in 10 years. At a 3% rate of inflation, the $1,000 repayment he will receive in 10 years would be equivalent to only $744.09 in current dollars.
4. Bond prices fluctuate with changes in current market interest rates. If interest rates paid on newly issued bonds increase, older bonds paying lower rates of interest will be less attractive to investors. In order to sell older bonds having lower interest rates, their price must be reduced. The effect of this decline in price is to make old bonds competitive with new ones in terms of their “yield to maturity.” (Yield to maturity is the average annualized rate of return that an investor will earn if a bond is held until it matures.)
For example, if market interest rates increase from 8% to 10%, a 20-year bond paying 8% will fall in price from $1,000 to $828. Why? Because, by purchasing new bonds investors can now earn 10% on every $1,000 they invest rather than 8%. Therefore, the price of the 8% bond must be lowered until it produces a yield to maturity equivalent to the yield on the new 10% bond.
Of course, the reverse is also true. If market interest rates fall, the price of previously issued bonds will rise. In this situation bondholders will demand a higher price for their bonds since they are more attractive than new issues with lower interest rates.
5. If the overall financial condition of the issuing corporation deteriorates, the resale price of their bonds is likely to fall. A decline in the financial strength of the corporation would be reflected in a lower credit standing for the firm and, therefore, a lower quality rating for the bond issue. The lower quality rating results in a perception of increased risk and diminished worth in the minds of investors. In return for this increased risk, potential buyers will demand a higher rate of return. Since interest payments cannot be increased, the only way to satisfy a potential buyer’s demand for a higher rate of return is for the seller to lower the price. An improvement in the issuer’s financial condition and credit rating will typically result in higher bond prices.
6. An investor’s ability to sell his bonds at a given time may be adversely affected by any one or more of the following factors:
a. The smaller the size of the issue, the less likely the bonds are to be actively traded.
b. The issue may be owned in large blocks by only a few large institutions, such as banks and pension funds, resulting in low levels of trading activity and a relatively restricted market.
c. If the quality rating of the issuer has declined since the bond was purchased, there may be fewer interested buyers. This, of course, makes a sale more difficult.
7. Today, most corporate bonds are issued as general credit obligations (“debentures”). Although such bonds provide a greater degree of security for investors than an equity (stock) investment, they still involve a greater degree of risk than a “secured” debt obligation, such as a mortgage. Bonds backed by real assets of the corporation provide an investor with the specific security of the mortgaged property.
Corporate bonds also are often issued in the form of “subordinated debentures,” which generally have security preference over only the equity of the issuing company. Such debentures are subordinated in security to all other creditors, including general creditors. Because of the higher risk associated with subordinated debentures, they usually will pay a higher interest rate than general credit obligations, and often are issued with warrants for the purchase of common stock of the issuing company, or are convertible into such stock.
8. High yield bonds typically involve additional risks, such as: (a) greater price volatility than investment grade bonds with similar maturities; (b) increased risk of default (failure to pay principal and/or interest as stated in the bond indenture); and (c) less liquid markets with higher bid-ask spreads than for ordinary bonds.
TAX IMPLICATIONS
1. Interest income paid on a regular basis is generally taxable when received at ordinary income rates.
2. Profits or losses on the sale or maturity of corporate bonds are treated as capital gains or losses (see the discussion of capital gains and losses in Chapter 43, “Taxation of Investment Vehicles”).
Long-term capital gains are generally taxable at a maximum rate of 15%. Capital losses may be used to offset only capital gains and up to $3,000 of ordinary income per year. Unused losses may be carried forward by individuals and applied against future income.
3. If a bond is sold at a loss and then repurchased, the investor may be subject to the “wash sale” rules.
4. Bonds held at death in the sole name of the investor will be subject to both federal estate tax and state death tax. (Under EGTRRA 2001, the estate tax is repealed for decedents dying after 2009. However, EGTRRA 2001 “sunsets” (i.e., expires) after 2010.[1.]) Fifty percent of bonds owned jointly between spouses will be includable in the gross estate of a decedent but will generate no federal estate tax upon the death of the first spouse because of the unlimited marital deduction.
5. Bonds issued with “original issue discount,” such as “zero coupon bonds,” yield taxable income to the bondholders with respect to the discount over the life of the bond. This occurs even though the discount “income” will not be received until the bond matures. (Original issue discount is discussed in detail in “Questions and Answers,” below.)
6. Special rules apply where bonds are purchased at a “market discount” (i.e., at a price below the original issue price and the maturity or face value). Generally, the amount of market discount need not be recognized as income until the bond is sold or matures. However, there is a limit on the deductibility of interest expense on debt incurred to purchase or carry market discount bonds. Such interest expense can be deducted to the extent there is interest income on the bond (including original issue discount) that is includable in income. Beyond that amount, interest expense may be deducted only to the extent it is more than the market discount allocable to the days the bond was held in the year. The amount of interest expense not currently deductible may be deducted in the year the investor disposes of the bond. (The interest disallowance rules do not apply if the investor elects to recognize a prescribed portion of the market discount as income each year until the bond matures.)
7. High yield bonds are treated similarly to other corporate debt instruments for income tax purposes. Interest income is subject to both federal and state income taxes and is taxed as “ordinary income,” such as wages. Gains and losses on high yield bond sales are also taxed like other capital transactions.
HOW DO I SELECT THE BEST OF ITS TYPE?
1. Investors interested in buying corporate bonds should consider the following:
a. Quality Rating of the Bond – as assigned by a professional appraisal service such as Standard & Poor’s Bond Guide or Moody’s Investors Service. These run from “AAA” (highest rating) to “D” (default), though conservative investors probably should not consider bonds rated lower than BBB. This rating is a current assessment of the creditworthiness of the issuer and is based on information furnished by the company or obtained by the rating service. The ratings take into consideration the nature and provisions of the obligation, likelihood of default, and protection afforded the holder in the case of bankruptcy.
b. Current Yield – the rate of return based on the current market price of the bond. This is obtained by dividing the annual interest amount by the current purchase price of the bond.
c. Yield to Maturity – the rate of return on a bond held to its maturity date and redeemed by the issuer at its par value. Yield to maturity includes any gain (or loss) if the bond was purchased below (or above) its par value.
2. A maturity date should be consistent with the investor’s projected cash flow or capital needs objectives.
3. It may be desirable to coordinate maturities with potential shifts in tax brackets. In other words, an investor should select maturities that delay the gain until he or she will be in a lower tax bracket or can utilize offsetting deductions.
4. Preference should be given to the larger issues of strong, well-managed corporations. The bonds of such firms are likely to be actively traded. This increased marketability will make the bonds easier and less costly to sell in a short time.
5. Bonds with shorter maturity dates will generally have greater price stability than longer-term bonds with the same quality rating (although the tradeoff may be a lower yield).
6. For high yield bonds, investors would be wise to:
(a) diversify their holdings across issuers and industry sectors—concentrating in only a few issues greatly increases the risk of holding junk bonds;
(b) adjust their portfolios over economic cycles—increasing holding during periods of economic expansion and reducing them as the economy slows or contracts; and
(c) monitor the rating agencies, which often put companies on a “credit watch” list prior to down-grading an issue.
For more Information:
Fixed Income and Bonds Investment Guide
Fixed-Income Securities and Derivatives Trading,Investment Bonds & Bond Trading, The Handbook of European Fixed Income Securities.
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