WHO ISSUES BONDS?

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. For example, on January 3, 2006, Allied Food Products borrowed $50 million by issuing $50 million of bonds. For convenience, we assume that Allied sold 50,000 individual bonds for $1,000 each. Actually, it could have sold one $50 million bond, 10 bonds each with a $5 million face value, or any other combination that totals to $50 million. In any event, Allied received the $50 million, and in exchange it promised to make annual interest payments and to repay the $50 million on a specified maturity date.

Until the 1970s, most bonds were beautifully engraved pieces of paper, and their key terms, including their face values, were spelled out on the bonds them- selves. Today, though, virtually all bonds are represented by electronic data stored in secure computers, much like the “money” in a bank checking account.1

Investors have many choices when investing in bonds, but bonds are classified into four main types:  Treasury, corporate, municipal, and foreign. Each differs with respect to risk and consequently to its expected return.
Treasury bonds, generally called Treasuries and sometimes referred to as government bonds, are issued by the federal government.2 It is reasonable to assume that the federal government will make good on its promised payments, so Treasuries have no default risk. However, these bonds’ prices decline when interest rates rise, so they are not completely risk free. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasuries, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and on the terms of the specific bond. Default risk is often referred to as “credit risk,” and, as we saw in Chapter 6, the larger the default risk, the higher the interest rate investors demand.

Municipal bonds, or “munis,” are issued by state and local governments. Like corporates, munis are exposed to some default risk. However, munis offer one major advantage over all other bonds: As we discussed in Chapter 3, the interest earned on most munis is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. Consequently, the interest rates on munis are considerably lower than on corporates of equivalent risk.

Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are, of course, exposed to default risk, and so are the bonds of some foreign governments. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if you purchase a corporate bond denominated in Japanese yen, even if the company does not default you still could lose money if the Japanese yen falls relative to the dollar.

  • What is a bond?
  • What are the four main types of bonds?
  • Why are U.S. Treasury bonds not completely riskless?
  • In addition to default risk, what key risk do investors in foreign bonds face?