Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 4

Bonds

Bonds and debentures, which we have already introduced, are referred to as fixed-income securities. The reason is that once the rate of interest is set at the onset of the period for which it is due to be paid, it is not a function of the profitability of the firm. It is for this reason that all bonds—including floating-rate bonds, which entail the resetting of interest at the commencement of each interest-payment period—are referred to as fixed-income instruments. Interest payments are therefore contractual obligations, and failure to pay what was promised at the start of an interest-computation period will amount to default.

A bondholder is a stakeholder in a business but is not a part owner of the business. She is entitled to only the interest that was promised and to the repayment of principal at the time of maturity of the security and does not partake in the profits of the firm. As we discussed earlier, bonds may be unsecured or secured. Unsecured debt is referred to as a debenture in the United States, and the term connotes that no specific assets have been earmarked as collateral for the securities. In the case of secured debt, however, the issuer sets aside specific assets as collateral on which investors have a claim in the event of default. Debt securities may be negotiable or nonnegotiable. A negotiable security is one that can be traded in the secondary market, whereas a nonnegotiable security cannot be endorsed by the holder in favor of another investor. ...