Über die Autorin bzw. den Autor

Annette Thau is a former municipal bond analyst for the Chase Manhattan Bankand a visiting scholar at the Columbia UniversityGraduate School of Business. She haswritten many articles for the AAII Journal andlectured to groups nationwide. In November2009, she was a featured speaker at the nationalmeeting of the American Association ofIndividual Investors.

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THE BOND BOOK

The McGraw-Hill Companies, Inc.

Contents

Chapter One

This chapter

* Defines a bond

* Explains how bonds are issued and traded

* Defines some key terms used in buying and selling bonds

FIRST, WHAT IS A BOND?

Basically, a bond is a loan or an IOU. When you buy a bond, you lend your money to a large borrower such as a corporation or a governmental body. These borrowers routinely raise needed capital by selling (or, using Wall Street vocabulary, by "issuing") bonds for periods as brief as a few days to as long as 30 or 40 years. The distinguishing characteristic of a bond is that the borrower (the issuer) enters into a legal agreement to compensate the lender (you, the bondholder) through periodic interest payments in the form of coupons; and to repay the original sum (the principal) in full on a stipulated date, which is known as the bond's "maturity date."

HOW BONDS ARE ISSUED AND TRADED

The process of issuing bonds is complex. Because the sums involved are so large, issuers do not sell bonds directly to the public. Instead, bonds are brought to market by an investment bank (the underwriter). The investment bank acts as an intermediary between the issuer and the investing public. Lawyers are hired by both parties (that is, the issuer and the underwriter) to draw up the formal terms of the sale and to see to it that the sale conforms to the regulations of the Securities and Exchange Commission (the SEC).

To illustrate the process, let us say that the State of New Jersey needs to borrow $500 million in order to finance a major project. New Jersey announces its intention through trade journals and asks for bids. Underwriters (major broker-dealer firms such as Merrill Lynch, Goldman Sachs, Morgan Stanley, etc.) or smaller, less well-known firms (there are dozens of them) compete with each other by submitting bids to New Jersey. A firm may bid for the business by itself in its own name. More often, firms form a group called a syndicate, which submits a joint bid. The State awards the sale to the firm or syndicate which submits the bid which results in the lowest interest cost to the state. The underwriters then get busy selling the bonds.

The underwriter (or the syndicate) handles all aspects of the bond sale, in effect buying the bonds from the issuer (New Jersey) and selling them to the investing public. The investing public is made up of large institutions such as banks, pension funds, and insurance companies as well as individual investors and bond funds. The large institutional investors are by far the biggest players in the bond market.

Once the bonds have been sold, the underwriter retains no connection to the bonds. Payment of interest and redemption (repayment) of principal are—and will remain—the responsibility of the issuer (New Jersey). After the sale, the actual physical payment of interest, record-keeping chores, and so forth are handled for the issuer by still another party, a fiduciary agent, which is generally a bank that acts as the trustee for the bonds.

KEY TERMS FOR BONDS

The exact terms of the loan agreement between the issuer (the State of New Jersey) and anyone who buys the bonds (you or an institution) are described fully in a legal document known as the indenture, which is legally binding on the issuer for the entire period that the bond remains outstanding.

First, the indenture stipulates the dates when coupons are paid, as well as the date for repayment of the principal in full; that is, the bond's maturity date.

The indenture then discusses a great many other matters of importance to the bondholder. It describes how the issuer intends to cover debt payments; that is, where the money to pay debt service will come from. In our example concerning the State of New Jersey, the indenture would specify that the State intends to raise the monies through taxes; and in order to further document its ability to service the loan, there would be a discussion of the State's economy. The indenture also describes a set of conditions that would enable either the issuer or the bondholder to redeem bonds at full value before their stipulated maturity date. These topics are discussed in greater detail in the sections dealing with "call" features and credit quality.

All of the major terms of the indenture, including the payment dates for coupons, the bond's maturity date, call provisions, sources of revenue backing the bonds, and so on, are summarized in a document called a prospectus. It is a good idea to read the prospectus. Until recently, a prospectus was available only for new issues. Bond dealers were allowed to destroy a prospectus six months after a bond was issued. The prospectus of all new municipal bonds, as well as many older issues, is now archived and available online (see Chapter 5).

When the prospectus is printed before the sale, it is known as a "preliminary prospectus," or a "red herring"—that term derives from the printing of certain legal terms on the cover of the prospectus in red ink. After the sale, it is sometimes called an official statement, or OS.

The most elementary distinction between bonds is based on who issued the bonds. Bonds issued directly by the U.S. government are classified as Treasury bonds; those issued by corporations are known as corporate bonds; and those issued by local and state governmental units, which are generally exempt from federal taxes, are called municipals or "munis" for short. The actual process of selling the bonds differs somewhat from sale to sale but generally conforms to the same process.

Many bonds are issued in very large amounts, typically between $100 million and $500 million for corporates and munis; and many billions for Treasuries. To sell the bonds to the public, the investment bank divides them into smaller batches. By custom, the smallest bond unit is one bond, which can be redeemed at maturity for $1,000. The terms par and principal value both refer to the $1,000 value of the bond at maturity. In practice, however, bonds are traded in larger batches, usually in minimum amounts of $5,000 (par value).

Anyone interested in the New Jersey bonds may buy them during the few days when the underwriter initially sells the bonds to the investing public (this is known as buying "at issue") or subsequently from an investor who has decided to sell. Bonds purchased at the time of issue are said to have been purchased in the "primary market." Bonds may be held to maturity, or resold anytime between the original issue date and the maturity date. Typically, a bondholder who wishes to sell his bonds will use the services of a broker, who pockets a fee for this service.

There is a market in older issues, called the "secondary market." Some bonds (for example, 30-year Treasuries) enjoy a very active market. For many bonds, however, the market becomes moribund and inactive once the bonds have "gone away" (that is an expression used by traders) to investors. It is almost always possible to sell an older bond; but if the bond is not actively traded, then commission costs for selling may be very high. Pricing, buying, and selling bonds, as well as bond returns, are discussed in greater detail in Chapters 2 and 4....