Features of Bonds14/05/2020
Repayment of Principal:
Bonds are issued in denomination of Rs. 1,000 but there are also bonds of values of Rs. 500 and Rs. 100 and of values as high as Rs. 5,000 and Rs. 10,000. Financial institutions are known to buy corporate bonds bearing higher values. The value of the bond is called the ‘face value, par value or maturity value’.
The face value of the bond represents the promise to repay the amount to the bondholder at the end of the specified period. This, in other words, may be called the most important feature of bond, return of the principal to the lender on a fixed date specified earlier.
Specified Time Period:
The second feature is the maturity date of the bond. The time specified in the bond is called the maturity date or date of repayment of principal amount. The maturity date of bonds varies according to the requirement of each organization. Some organizations issue bonds of a long-term nature. The number of years of these bonds varies from 20 years to 100 years maturity.
Other issues of bonds are for medium term and their maturity is between 5-10 years. Shorter-term bonds are identified as those whose maturity is below 4 years. The bond indenture specifically gives the maturity date of the bond. This is the promise to pay the principal amount on a specified date after the expiry of the number of years for which it is issued.
Bonds have an additional feature of ‘call’. This is a privilege to the issuing company to re-purchase bonds at a slightly higher price above the par value. For example, a bond of face value of Rs. 1,000 and maturity of 20 years yields an interest of Rs. 70 annually. After the first 5 years of issue, the market rate of interest on bonds falls considerably.
The ruling rate being 5% the company may choose to use the call feature and buy back the bond for Rs. 1,050. This is a little higher than the face value of Rs. 1,000. By calling the bonds, the company saves money. It may call back the bonds yielding interest of Rs. 70 and issue fresh bonds which will yield Rs. 50 per year.
The firm has been able to save Rs. 20 per year per bond for the next 15 years till the maturity of the bond. By paying Rs. 50 higher than the face value on the bond for early redemption of the bond, the company saves a much higher amount.
The bond holder is on the losing side because he gets the return of the principal amount earlier than he expected. Since, the current market rate of interest is prevailing at a lower rate he cannot buy any other bond which will fetch him an income of Rs. 70 per bond per year. This feature gives a right to the issuing company.
The bondholder should be aware of the call feature before he makes an investment in bonds. He can protect himself by investing in bonds of shorter durations. Although there is risk of fluctuations in interest rates for short durations, a ten year period is considered to be good life of a bond from the point of view of the bondholder.
Pledge of Security:
The issuing company sometimes promises to pay to the bondholder by offering some security like property. The pledge of security is a promise to the bondholders in writing and signed under seal and presented to the trustee by the company. A simple promise to pay without the proper formalities is not considered as a pledge of security.
The rate of interest to be paid to bondholder and the time of payment is recorded in the bond as well as in the indenture, ‘interest rate’ is also called the ‘coupon rate’. Interest on bond may be made by cheque or coupon. When interest is paid to the bondholder by cheque the principal amount on the bond is usually registered to interest value.
The coupons are numbered and every coupon represents, the interest payment period. When the coupon becomes due, the bondholder presents the coupon to the authorized banker and receives interest. The coupons are usually bearer bonds and are negotiable when they become due and payable.
Coupons should be kept safely because it is difficult to recover them if they are lost, since the name of the owner is not required in order to en-cash them. Interest either by coupon or by cheque is paid on the face value of the bond. The rate cannot be changed once it has been fixed. The interest is paid in Rupee Value in India. Gold bonds were issued in India in the early 1950s but now only Rupee Bonds are issued.
Interest on bonds should be paid regularly by the issuing authority. Government bonds are very reliable as they are paid in time. Sometimes, interest is not paid by companies when it is due. The bond issue in this case is considered to be in default and both the interest and principal become due and payable to the bondholder. The trustees of the bondholder at this point of time protect the interest of the bondholders.
In order to be sure that interest and principal sum on the bond will be repaid, it is necessary that the bonds are evaluated and analysed before investing in them.
An investor must look into the net operating profit of the firm as well as its net income after taxes. This will to a great extent determine the quality of the bond. It must be emphasized that bonds will be considered secure when the interest charges are low and the net operating income is high.
Sometimes, the bond issuing companies offer security through assets and in writing, assuring the bondholders of the payment of interest. Sometimes, the company promises to maintain a minimum working capital position or a particular cash position. Interest is guaranteed in assumed bond, guaranteed bond or joint bond.
Interest on bonds is also protected by the ‘acceleration clause’. When interest is due but not paid, this clause gives the right to the bondholder to represent himself through the trustee. This clause gives the bondholder the right of a creditor and he can make a claim on his assets but cannot be sure of receiving the principal amount.
The bondholder will be reassured if on an analysis of the company’s position. It is found that the company’s operating income is sufficient to cover all expenses pertaining to the company’s account inclusive of all interest charges made on its issue of debt.
Covenants are productive clauses in the bond indenture. They are agreements between the company and the bondholders through the trustees. Through these agreements the company binds itself to the bondholders.
The company agrees to control its operations and in this way offers some protection to bondholders. Sometimes, a company makes an agreement to limit the amount of dividend to be paid to its equity shareholders. Other covenants protect the bondholder by ensuring a minimum, cash balance to be maintained by the firm.
Certain covenants or agreements are specifically used on a particular class of bonds. For example, mortgage bonds may include a covenant to limit the company’s expenses or debt position up to a fixed percentage of the value of new purchases of property, for example, 75% of the property.
Covenants are agreements or promises which tone up the quality of the bonds and assure repayment of principal and interest. There are different kinds of bonds based on these special features: Repayment of principal, Maturity date, Call, Pledge of security, Interest and Covenants.