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Understanding Bonds

Updated on September 7, 2009

A bond, in finance, a credit instrument that contains a promise to pay a specified sum of money at a fixed date in die future. The maturity date is usually 10 years or more from the time of issue. Interest is payable periodically at a fixed rate on specific dates throughout the life of the loan. In Europe, bonds are often called "stocks," and what are called stocks in the United States are usually termed "shares".

Usually negotiable, bonds are promissory notes that are typically issued in standard denominations by corporations or governmental bodies only. Corporation bonds are based on a trust indenture (also called a deed of trust), which is an agreement between the issuing corporation and a trustee (usually a bank or trust company). The trustee manages the indenture for the benefit of the bondholders and takes appropriate remedial action on behalf of the bondholders if the issuer violates the indenture terms. The debt and the remedial action are both enforceable at law.

Uses of Bonds

Bonds are employed to enlarge the immediate financial resources of the issuer. They are intended for borrowing large sums for relatively long periods of time. The loan is broken into convenient portions (most often $1,000 in the United States) in order to reach a wider market. A purchaser of several bonds may later dispose of as many as he wishes on the market. Thus both borrower and lender benefit through the use of standard-denomination, negotiable instruments.

Bond issues are ideally suited for financing the acquisition of durable, expensive, long-term assets such as buildings, real estate, machinery, and equipment. The costs of the assets are borne as the benefits from them are received. Thus governmental bodies need hot place a heavy immediate burden on the taxpayer, and corporate stockholders need not dilute their ownership control to finance expansion.

Types and Terminology

There are many varieties of bonds, each developed to serve a particular purpose. Bonds may be classified according to type of issuer, type of security of principal, or type of security of income.

In the United States, for example, public bonds are obligations of federal, state, county, or local governments or agencies. No collateral backing is provided, and therefore the credit rating of the borrower is most important. Public bonds may be backed by the "full faith and credit" of the issuer, in which case tax revenues provide the basis for payment; or they may be revenue bonds, which call for payment from the operations of a specific facility, such as a toll bridge.

Private corporate bonds are classified as railroad, utility, or industrial bonds, according to the business of the issuing corporation. When bond principal repayment is protected by pledged property, the bonds are termed secured. In case of default, the real estate, securities, or other collateral provides a basis for repaying bondholders. The holders of unsecured bonds, or debentures, have the same status as general creditors so far as loan principal is concerned.

Coupon bonds, also called bearer bonds, are negotiable to the bearer, and the attached coupons are negotiable promissory notes to pay interest on each payment date. Registered bonds bear the owner's name, which is also registered with the issuer, and an endorsement and change of registration are required to transfer ownership. A bond may be fully registered or registered as to principal only; in the latter case the bond carries bearer coupons for interest payment.

Promissory Notes

A promissory note, in law, a written evidence of indebtedness by which the maker agrees to pay to a named person or to the bearer a fixed sum of money at a specified time. Basically it is a contract, but it also falls within the legal classification of "commercial paper". A note may be, but is not necessarily, negotiable. The term "negotiable" is used to describe a written instrument which is transferable by endorsement and delivery, or by delivery alone.

Promissory notes, like bills of exchange, circulate in the commercial world as representatives of money, and can be used to pay debts, make purchases, or make remittances of money to foreign countries. The Uniform Negotiable Instruments Act, which was approved in 1896 and has subsequently been enacted in every American jurisdiction, defines a negotiable promissory note as "an unconditional promise in writing made by one person to another, signed by the maker engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to order or to bearer". In the absence of a special statutory provision to the contrary, the mere acknowledgment of a debt is not generally considered to be a promissory note.

Origin

The precise origin of bonds in a form similar to the modern credit instrument is obscure. In medieval Europe a debt was often secured by an individual "giving his bond". As early as the 12th century, records of negotiable credit instruments are found, and on occasion recourse could be had to the courts to enforce the payment of such debts. These were still direct personal debts, however. By the 16th and 17th centuries, public loans to kings and princes were common, but the debt instruments lacked enforceability at law because the debtor was also usually the law.

In the 17th century, bonds essentially similar to the modern version appeared in England, the Netherlands, and France. In each instance they were governmental or crown bonds. In England the records show that bonds of Charles II were hawked among the London nobility. It was not until the public issue of bonds by William III in 1693, however, that true enforceability of the debt was achieved. By that time Parliament's power was sufficient to assure payment to the lender. These bonds of William III are widely considered to be England's first modern issue.

On the Continent, the Antwerp Bourse was a major financial market and center in the 16th century, and royal bonds, city bonds, and even private bonds (royally guaranteed) were regularly traded there. As early as 1537 they were declared by imperial order to be formally binding, like commercial bills. Interest, howler, was paid in disguised form, because of the tenacious ban on usury. Lyon and Paris do not show bond dealings in crown debt until the late 17th century.

The development of bond financing to borrow money stemmed initially from a need for funds on the part of kings and governments, a decreasing power to tax indefinitely, and a necessity therefore to broaden the base of financial resources available to the crown. Thus the funded public debt and bond financing in the modern sense developed from the same historical and financial circumstances.

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    • AllSuretyBonds profile image

      AllSuretyBonds 6 years ago

      Great Hub. Very informative.

      Security is one of the major benefits for investing in a bond. If a company is liquidated, bondholders usually have priority over stockholders in a company’s capital structure and are more likely to receive payment. The percentage of this payment compared with the original investment is called the “recovery rate.” Even the holder of a low-rated bond is entitled to a share of a failing company’s assets ahead of preferred or common stockholders.

    • AllSuretyBonds profile image

      AllSuretyBonds 6 years ago

      Great Hub. Very useful and informative information.

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