What are bonds or debentures? – Definition
A corporation or company generally borrow money by means of issuing debentures or bonds. A debenture or bond is a written acknowledgment by a company or corporation of a loan made to it. It is issued to money lenders under the seal of the corporation. It contains a contract for the repayment of the principal sum at a specified date and the payment of interest at a fixed rate until the principal sum is repaid.
Features of Bonds
If you purchase a bond, you will receive a bond certificate. This certificate spells out the terms of an agreement between the issuer and the investor. These terms include the denomination or principal of the bond, its maturity date, the stated rate of interest, the interest payment terms, and any other agreements made between the borrower and lenders.
Denomination of the Bond
Individual bonds usually have a denomination of $1,000, Although In recent
years $5,000 and $10,000 bonds have become more common. In this article, we will assume that all bonds are in $1,000 denominations unless otherwise stated. The denomination, or principal, of a bond, is often referred to as its face value, maturity value, or par value, and it is always on this amount that the required interest payment is calculated.
A total bond issue usually contains several hundred or thousands of individual bonds, For example, a $10 million bond might be made up of 10,000 individual $1,000 bonds. Investors can purchase as many of these individual bonds as they wish. After bonds are issued by a large publicly held company, they trade on the New York Bond Exchange. This enables present and potential investors to sell and purchase bonds after their initial issue, just as they do with shares of stock.
The date that the principal of the bond is to be repaid is called the maturity date, Bonds usually mature in from 5 years to more than 30 years from their date of issue. Bonds whose entire principal is due in one payment are called term bonds, and bonds that are payable on various dates are called aerial bonds.
Stated Interest Rate and Interest Payment Dates
Most bonds have a stated interest rate which is part of the bond agreement. This rate is often referred to as the nominal interest rate and is specified on the bond at the time it is issued. This rate does not change over the life of the bond. The stated rate of interest is fixed by the firm’s management in conjunction with its financial advisers. They attempt to set the rate as close as they can to the market interest rate that exists at the time the bond is issued. The market rate is the interest rate that the money market establishes through hundreds of individual transactions and depends on such factors as prevailing interest rates in the economy and the perceived risk of the individual company.
Most bonds pay interest semiannually, or every six months. However, the stated interest rate is an annual rate based on the face value of the bond. For example, a $1,000, 12% bond that pays interest on January 2 and July 1 will pay interest of $60 ($1,000 x .12 x 6/12) on each of these dates until it matures. In effect, the bond in this example pays 6% interest every 6 months.
Bondholders are unable to vote for corporate management or otherwise participate in corporate affairs in the way that common shareholders do. As a result, bondholders often insist on written covenants as part of the bond agreement. These agreements are often referred to as bond indentures, and although they can take a variety of forms, they usually include restrictions as to dividends, working capital, and the issuance of additional long-term debt. The purpose of these agreements is to ensure that the borrower will maintain a strong enough financial position to meet the interest and principal payments.
Types of debentures or bonds:
The following are the various kinds of debentures that may be issued. by a corporation.
Simple or naked debentures or bonds:
Simple debentures are those which carry no security as to payment of interest or repayment of the principal sum. The holders of these are considered insecure, so these are not popular in the present days. Simple debentures are also cal!ed as naked debentures or bonds.
Mortgage debentures or bonds:
Mortgage debentures are those which are secured by a charge on the assets of the corporation, such as plant, machinery equipment, land, and building. Mortgage debentures are of the following two types:
- First mortgage debentures
First, mortgage debentures are those the holders of which have the first claim on the assets charged.
- Second mortgage debentures
Second mortgage debentures are those the holders of which have a second claim on the assets charged.
Bearer debentures or bonds:
The amount of bearer debentures is payable to hearer. They are negotiable instruments and are transferable by mere delivery.
Registered debentures or bonds:
The name and address of these debenture holders are recorded in the books of the corporation. Transfer of these debentures must be registered In the books of the corporation as in the case of shares. Interest is paid to registered holders.
Redeemable debentures or bonds:
These are debentures which are repayable at the end of a specified period. These are issued subject to the condition that the corporation shall redeem them on a specified date. These debentures are very common now-a-days.
Irredeemable debentures or bonds:
These debentures are never repayable during the existence of the corporation i.e., repayable on liquidation of the corporation.
Convertible debentures or bonds:
These debentures may be converted into ordinary shares or preference shares of the company. This option is given to the debenture holder for the period mentioned in the conditions of the issue.