Bond Basics for Investment Banking - dummies

Bond Basics for Investment Banking

By Matt Krantz, Robert R. Johnson

A bond is a financial security recognizing that an investor is loaning money to a corporation. For investment bankers, it’s really just an IOU. In return for the bondholder’s money, the corporation is obligated to make periodic interest payments to the bondholder and to repay the loan when the term of the loan ends.

The basic terms of the bond include the bond’s maturity (the original length of the loan), the coupon rate of interest (the rate of interest on the bond), and the denomination of the bond (the amount of the loan).

All the basic terms of the bond are detailed in the bond indenture, which is a legal document that lays out all the rights of the bondholder and the obligations of the issuer. The terms of a bond issue represent a compromise between the interests of the firm and the interests of the bond investor — each of them gives up something in order to get something in return.

The firm wants to pay the lowest interest rate possible and have the most business flexibility. On the other hand, the investor wants the highest interest rate possible and to limit the firm from certain actions (such as taking on further burdensome debt, thus weakening the existing bondholders’ positions and lowering the probability that they’ll receive the promised interest and principal payments).

The bond indenture often contains a description of restrictive covenants (terms of the bond indenture that limit issuer behavior). Typically, covenants place limitations on the ability of the firm to take on additional debt unless certain tests are satisfied. For example, debt may be limited by covenant to 50 percent of total capitalization (sum of debt and equity). Unfortunately, bond indentures are written in legalese and are typically incomprehensible.

Just as currency comes in different amounts, or denominations, so do bonds. The denomination of a bond is the amount that’s being borrowed. The denominations of corporate bonds are generally $1,000 or $5,000, and the typical bond pays interest semiannually (every six months).

Technically, a bond issue from a large corporation may be for hundreds of millions of dollars, but it’s divided into smaller chunks so that individual investors can afford to purchase the bonds and so that investors can diversify across companies and lower the risk of their holdings.

Unlike stocks, the holder of a bond has no ownership interest in the corporation. A bondholder can only receive what is promised — nothing more. That’s why bonds are often referred to as fixed-income securities. If everything goes as planned, a bondholder knows exactly what she’ll receive and the return she’ll earn if she holds the bond to maturity.

If you bought a bond of a wildly successful company — like Microsoft or Apple — and you held it to maturity, the best you could hope for is to receive the promised interest payments and the full return of the principal amount. Contrast that experience with a stockholder of one of these corporations, who would’ve seen his initial investment grow exponentially in value.

So, why are bonds bought and sold? Well, corporations issue bonds so that they can obtain the money to build or renovate facilities, purchase new equipment, or, in the case of leveraged buyouts, even purchase other companies — in essence, to grow the business. Issuing bonds is a way of raising money (or capital) — an alternative to selling stock in the company.

As for why people buy bonds, an old saying in the financial markets applies: “You can either eat well or sleep well.” Investing in bonds may allow investors to sleep well because, typically, bond returns are much more stable than stock returns. However, over the long term, investing in stocks provides investors with higher returns, allowing them to eat better than bondholders.

“No pain, no gain” applies in the investment banking world as much as in the gym. Investors take on pain (or risk) in exchange for gain (or return). Typically, the more risk (or volatility) that investors accept, the more they may expect in return.

Returns are easy to measure. It’s simply the appreciation in the value of the investment plus any interest or dividends paid. Risk is trickier to measure. Academics typically look at standard deviation, a statistical measure that quantifies how much an asset swings in price. The Return column shows how much the investors earned; the Standard Deviation of Return column shows how much the asset class, on average, changed in price.

Asset Class Return Standard Deviation of Return
Large stocks 11.77% 20.30%
Small stocks 16.51% 32.51%
Long-term corporate bonds 6.36% 8.35%
Long-term government bonds 6.14% 9.78%
Intermediate-term government bonds 5.54% 5.67%
Treasury bills 3.62% 3.10%

Source: Ibbotson SBBI 2012 Classic Yearbook: Market Results for Stocks, Bonds, Bills, and Inflation, 1926–2011 (Ibbotson Associates)