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Bond Characteristics: What are Bonds?

Bond characteristics outline the conditions of an investment, including its payment and interest terms. They will differ depending on the type of bond, issuer and investor’s preferences.

Public and Private Issues

Companies can borrow money either through the public debt market or through private placements. In terms of bond characteristics and how they apply to issuers, a “public” bond issue is approved by a securities agency, which ensures disclosure through a “prospectus” or “information circular.” It is important to note that disclosure does not mean investment suitability. A highly speculative bond issue is allowed, as long as the speculative nature is adequately disclosed. A “private placement” is something directly negotiated between the issuer and a lender or group of lenders and is restricted in trading under securities law. This means that only “sophisticated investors” may purchase or trade in these securities. This usually means some minimum investment restriction.

Types of Fixed Income Securities

Most things called bonds aren’t really bonds at all. Bonds and bond characteristics encompass the wide sweep of fixed income securities. What distinguishes between bonds in a legal sense is the collateral pledged and the legal rights to this collateral.

Most bonds have no specific security attached to them and really should be called “unsecured debentures.” This means that in a default situation, the bondholders rank equally with the other unsecured creditors of the company. Since governments do not pledge specific security, most government bonds are actually debentures. An unsecured debenture usually has a “negative pledge” which prevents the issuer from having assets secured ahead of that issue. Any bond issues that have senior issues ahead are “subordinate.”

A “secured debenture” has some particular asset attached to it, like a factory, building or shopping center. If this involves real estate collateral, these bonds are known as “mortgage bonds”. A mortgage bond is different than a mortgage, which is a legal document registered against a particular real estate asset. A mortgage bond is a bond with a trust indenture that “secures” its collateral by way of a mortgage. A “first mortgage bond” has the first mortgage and senior claim on an asset or group of assets.

Bond Covenants

Another aspect of bond characteristics is a covenant: a pledge or undertaking by an issuer to do certain things or avoid others. Usually, a covenant will be a “financial covenant” which specifies that, for example, the issuer will maintain an interest coverage ratio over a certain level or a leverage ratio (debt/equity) under a specific level. These ratios are meant to constrain the issuer to financial prudence.

Covenants can also be “non-financial” in nature, such as providing financial information to bondholders, protecting against the selling of assets, or changes of control, or making sure the assets of the company have adequate insurance. Issuers do not like to have covenants because they restrict their actions. Issuers with outstanding “covenant” bond issues have “closed off” these issues and currently issue debt under their unsecured debenture and mid-term note programs. This is one of the reasons for the development of asset-backed securities.

Bond Payment Terms

The legal documentation for a bond and its bond characteristics is required to specify the terms for both interest and principal payments. Interest can be paid monthly, semi-annually or annually. This makes a difference to the compounding of the interest and will affect the trading of a bond. In North America, most bonds pay interest semi-annually. “Eurobonds,” which trade in Europe, pay interest annually. Asset-Backed Securities (ABS) pay interest monthly, reflecting the payment terms of the underlying mortgages and loans. The currency of payments is important. Some bonds have the coupon paid in one currency and the principal in another. Bonds that pay part of their principal before maturity are said to “amortize” their principal. That’s the case, for instance, with many mortgage bonds.

The Importance of Bond Characteristics

Bond characteristics are important because they outline the conditions of the investment and the payment and interest terms. While defining a bond is usually more straightforward, the characteristics of a particular bond can differ based on the type of bond, the issuer, and the investor’s preferences.