Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 4Bonds

INTRODUCTION

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

A bondholder is a stakeholder in a business but is not a part owner of the business. Bondholders are entitled only to the interest that was promised and to repayment of principal at the time of maturity and do 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 asset(s) have been earmarked as collateral for the securities. In the case of secured debt, however, the issuer sets aside as collateral specific assets on which the 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 ...