A Bond Vocabulary

Like the word security, which once meant the written record of an investment, the word bond once referred to the piece of paper that described the details of a loan transaction. Today the term is used more generally to describe a vast and varied market in debt securities.

The language of bonds tells potential investors the features of the loan: the time to maturity, how it's going to be repaid, and whether it's likely to be called, or repaid ahead of schedule.

HOW BONDS ARE BACKED UP
Asset-backed bonds, are secured, or backed up, by accounts receivable, or money owed to the issuers. An asset-backed bond can be created when a securities firm bundles some type of debt, like what's owed on mortgages or credit cards, and sells investors the right to receive the payments that consumers are making on those loans.

Debentures are the most common corporate bonds. They're backed by the credit of the issuer, rather than by any specific assets. Though they sound riskier, they're generally not. The debentures of reliable institutions are typically more highly rated than asset-backed bonds.

Prerefunded bonds are corporate or municipal bonds, usually AAA rated, whose repayment is guaranteed by the funds from a second bond issue. Proceeds from the secondary issue are usually invested in safe US Treasury issues.
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Mortgage-backed bonds are backed by a pool of mortgage loans. They're sold to brokers by government agencies and private corporations, and the brokers resell them to investors. Mortgage-backed bonds are self-amortizing. That means each payment you get includes both principal and interest, so that there is no lump-sum repayment at maturity.

Collateralized mortgage obligations (CMOs) are more complex versions of mortgage-backed bonds. Although they are sold as a reasonable alternative to more conventional bonds, evaluating their risks and rewards requires more specialized skills.

BONDS WITH CONDITIONS
Subordinated bonds are repaid after other loan obligations of the issuer have been met. Senior bonds are those with stronger claims. Corporations sometimes sell senior and subordinated bonds in the same issue, offering higher interest and a shorter term on the subordinated ones to make them more attractive.

Floating-rate bonds promise periodic adjustments of the interest rate — to persuade you that you aren't locked into what seems like an unattractively low rate.

Convertible bonds give you the option to convert, or change, corporate bonds into company stock instead of getting a cash repayment. The terms are set at issue. They include the date the conversion can be made, and how much stock each bond can be exchanged for. The conversion option lets the issuer offer a lower initial interest rate, and makes the bond price less sensitive than conventional bonds to changes in the interest rate.

Sinking funds, established at the time a bond is issued, are cash reserves set aside to finance periodic bond calls.

BONDS WITH STRINGS ATTACHED
Callable Bond Redemption Notices

Callable bonds don't always run their full term. The issuer may call the bond, which means pay off the debt, before the maturity date. The process is called redemption. The first date a bond is vulnerable to call is named at the time of issue. Call, or redemption, announcements are published regularly in the financial press.

Issuers may want to call a bond if interest rates drop. If they pay off their outstanding bonds, they can float another bond at the lower rate. (It's the same idea as refinancing a mortgage to get a lower interest rate and make lower monthly payments.) Sometimes only part of an issue is redeemed, rather than all of it. In that case, the bonds to be called are chosen by lottery.

Callable bonds can be less attractive than noncallable ones because an investor whose bond has been called is often faced with reinvesting the principal at a lower, less attractive rate. To protect bondholders expecting long-term steady income, call provisions usually specify that a bond can't be redeemed before a certain number of years, usually five or ten.

POPULAR INNOVATIONS

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You buy zero-coupon bonds at deep discount, or prices far lower than par value. When the bond matures, the accrued interest and the original investment add up to the bond's par value.

Bond issuers like zeros because they have an extended period to use the money they have raised without paying periodic interest. Investors like zeros because the discounted price means you can buy more bonds with the money you have to invest, and you can buy bonds of different maturities, timed to coincide with anticipated expenses, such as college tuition bills for example.

Zeros have two potential drawbacks. They are extremely volatile in the secondary market, so you risk losing money if you need to sell before maturity. And, unless you buy tax-exempt municipal zeros, you have to pay taxes every year on the interest you would have received had it, in fact, been paid.

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