Private enterprises, local, state and federal governments require financial resources to pay for essential operations, build structures and finance other needs. To obtain large amounts of capital, these entities take out loans by issuing IOUs called bonds. Investors purchase bonds in return for interest payments made at specified intervals over a predetermined period such as ten years. As part of your due diligence when purchasing bonds for your portfolio, you must understand the four primary bond characteristics – issuer, par value, interest rate and maturity date, contained in a legal contract called a trust indenture.
Corporations with bond issues that exceed $5,000,000 must follow the Trust Indenture Act of 1939 (the Act), which requires issuers to assign a trustee — bank or trust company, to work in the interest of bondholders. The regulation excludes issues for municipal bonds and government bonds. A trustee’s duties include an obligation to file a lawsuit if the issuer fails to meet its responsibilities. Issuers must make trust indentures available to bond investors.
Trust indenture contracts outline rules for bond offerings, including responsibilities and procedures for resolving disputes. Some contracts may also include information on the issuer’s resources for repayment of debt obligations. Making the best choice for personal investment objectives requires investors to compare details and characteristics contained in each trust indenture. Essential knowledge for investors includes information about four characteristics: 1) issuer, 2) par value, 3) interest rate and 4) maturity date.
The creditworthiness of an issuer has a direct bearing on a bond’s value. To protect your principal, learn about the issuer’s financial stability. For example, investing in the high-yield corporate bonds presents a higher risk than putting your money in Treasury notes. The business enterprise will need to make profits to meet it debt payment obligations. There is always a risk that the business will not earn the profits necessary to pay back the principal and interest. The government can always raise tax revenues to repay its debt security obligations.
2) Par Value
An investor buys a newly issued bond at face value or par value. Sometimes called the “principal,” face value represents the amount of money the investor receives back when the bond matures. The par value of the bond does not represent the price of the instrument because the price fluctuates according to market conditions.
Sometimes, a bond trades at a price higher than its par value or at a “premium.” A bond can also sell below its par value or at a “discount.” Most corporate bonds have a par value of $1,000. Government bonds can have higher face value amounts.
3) Interest Rate
Issuers pay interest on a monthly, quarterly, semiannually or annual basis. Most entities pay makes interest payments on a semiannual basis. The interest rates paid on bonds depend on the bond’s par value. For example, a bond with a par value of $1000 and coupon (yield or interest rate) of 8 percent, pays $80 a year in interest.
Bonds that pay a fixed percentage coupon for the life of the bond are called fixed-rate bonds. However, some bonds have an adjustable coupon (floating-rate bond). A floating-rate bond periodically resets the interest rate based on an index, such as Treasury bills, Feds funds or prime rate. Coupon refers to the actual coupons that accompany some bonds, which bondholders remove and redeem for interest payments.
4) Maturity Date
Generally, issuers make a bond’s maturity date (call date) from one day to 30 years or longer. The maturity date denotes the point at which the issuer must repay the par value or principal to the investor and make any remaining interest payments. Bonds with longer maturity dates tend to fluctuate in value, which presents a higher risk to investors. Therefore, these bonds tend to have higher coupon rates.
The issuer, par value, interest rate and maturity date are the most basic information to start investing in bonds. Most investors, however, invest in bonds through purchase of bond mutual funds rather than investing in individual bonds. Even so, understanding average values for issuer credit rating, par value, interest rate and maturity date is important to assessing risk and return characteristics for the mutual fund.