Bond Terms and Features
Just like any other investment category, bonds have developed their own terminology and specific features. Understanding this terminology and bond features will enhance your ability to properly research your bond investment options and ultimately the success of your investment decisions. Below are a list of the most common bond terms and features.
The following section outlines the common terms associated with bonds.
- Principal, Nominal or Face Value, typically is stated in $1,000.00 increments. This is the dollar amount the issuer will calculate and pay interest and it's the amount the issuer agrees to pay the holder at the bond’s maturity date.
- Maturity Date is the date at which the issuer has agreed to pay the bond’s Face Value to the bondholder. Bonds are classified by the time remaining to their maturity dates into three basic categories: Issue Price is the price that the bond was originally issued at in the Primary market. Typically, bonds are issued and priced in terms of $100.00.
- Short-term bonds are those that mature in 3 years or less
- Medium-term bonds mature between 3 and 10 years
- Long-term bonds mature in 10 years or longer
- Coupon, expressed as a percentage, this is the interest rate the bond’s issuer has agreed to pay the bondholder each year. The coupon is applied to the bond’s Face Value to calculate the annual interest payment by the issuer. For example if an investor holds a bond with a Face Value of $10,000 and a Coupon of 5.0%, then the issuer will pay the bondholder $500.00 (5.0% of $10,000 ) per year.
- Coupon Dates are the dates the issuer agrees to make the Coupon interest payments. Most bonds will pay the annual coupon interest in two equal semi-annual payments. The dates are usually established by the bond’s initial issue date. For example, if our 5.0% bond with a $10,000 Face Value has semi-annual Coupon Dates and it was issued on December 1, then the issuer will pay the bondholder $250.00 on June 1 and December 1, every year up to the bond’s Maturity Date.
- Current Yield or Yield to Maturity is expressed as a percentage and it is calculated by adjusting the total interest income earned from the bond from the date of purchase to the date of sale or maturity by all Capital Gains or losses. Essentially, Yield to Maturity is a way to calculate the total amount an investor will earn from a bond.
Example: If an investor pays $950.00 for a $1,000 Par/Maturity Value bond that matures in three years and it has a 5.0% Coupon, then the yield to maturity can be estimated as follows. (To keep the calculation simple, the coupon rate is assumed to be compound interest, which assumes the investor will reinvest the interest income at the same coupon rate.)
- The investor will earn $50.00 per year ($1,000 X 5.0%) for a total interest income of $150.00 over the three-year period.
- If held to maturity, the investor will also earn $50.00 ($1,000 less $950).
- As a result, the investor will have earned $200.00 or 21.0% ($200 divided by $950) over the three years the bond was owned.
- Therefore, from the date of purchase, the yield to maturity in simple terms would be 7.0% per year (21% total return divided by 3 years).
Note: If this bond is held in a taxable account, the investor’s after-tax return would be enhanced because the $50.00 difference between the bond’s Par/Maturity value and the price paid will be taxed preferentially as capital gains.
The following section outlines the basic features of a bond. A single bond issue can have any one or a combination of these features built into its structure.
- A Redemption or Callable feature will grant the issuing corporation the right to purchase the investor’s bond on or after certain dates in the future. The issuer must advise the bondholder of their intention to purchase the bond and the price paid will be according to a set schedule established at the time the bonds were issued. For most bonds the redemption price will initially be higher than the bond’s par value and decline toward the par value over time. Upon receipt of a notice of redemption, the shareholder will be entitled to the redemption price plus accrued and unpaid interest to the date of redemption. Below is an example of a Redemption feature as outlined in the prospectus of the Toronto-Dominion Bank’s 4.317% Medium Term Note (Bond), Due January 18, 2016 and issued in January of 2006. It contains the following definition:
- Redemption Provisions: Prior to January 18, 2011, the Bank may, at its option, with the prior approval of the Superintendent of Financial Institutions (Canada) (the “Superintendent”), redeem the 4.317% Notes in whole at any time or in part from time to time, on not less than 30 days’ and not more than 60 days’ prior notice to the holders of the 4.317% Notes, at a redemption price which is equal to the higher of: (i) par plus accrued and unpaid interest to but excluding the date fixed for redemption and (ii) the Canada Yield Price (as defined below) plus accrued and unpaid interest to but excluding the date fixed for redemption. In cases of partial redemption, the 4.317% Notes to be redeemed will be selected by the Trustee by lot or in such other manner as the Trustee may deem equitable.
A number of bonds, in place of a fixed redemption price, will establish the redemption price according to a set formula that relies upon the Canadian Yield Price. The definition of the Canadian Yield Price is contained in the bond’s prospectus. For example, the Toronto-Dominion Bank’s 4.317% Medium Term Note (Bond), Due January 18, 2016 and issued in January of 2006 contains the following definition:
- “Canada Yield Price” shall mean a price equal to the price for the 4.317% Notes to be redeemed calculated on the business day preceding the date on which the Bank has authorized the redemption (which shall be deemed to be the date upon which the Bank has given notice of the redemption) to provide an annual yield from the date fixed for redemption to January 18, 2011 equal to the Government of Canada Yield (as defined below) plus 0.1%. “Government of Canada Yield” on any date shall mean the arithmetic average of the interest rates quoted to the Bank by two registered Canadian investment dealers selected by the Bank, and approved by the Trustee, as being the annual yield to maturity on such date, compounded semi-annually, which a non-callable Government of Canada bond would carry if issued, in Canadian dollars in Canada, at 100% of its principal amount on the date of redemption with a maturity date of January 18, 2011.
The redemption price(s) and the specific redemption dates are outlined in the bond’s prospectus, and can be found at the issuing corporation’s website and/or through the purchase of publications such as “Financial Post’s Annual Bonds - Corporate” and the “Financial Post’s Annual Bonds – Government,” Owen Media Partners.
Typically, redemption features are enforced from a certain date onward at a price that declines, toward the share’s stated par value, with time. The higher initial redemption price, above par value, offers the investor some compensation in the event the issuing corporation decides to redeem the bonds prior to its maturity date.
When purchasing bonds, investors should be aware of the redemption or call price in relation to the bond’s purchase price. An investor does not want to purchase a bond at a price that is above the redemption/call price, only to have the bond redeemed at a later date at a price below their purchase price or book value. This would result in a capital loss.
- A Retraction feature will give the bondholder the right to force the issuing corporation to repurchase the bonds for a specified price, on a specific date. Typically, the retraction price is equal to the bond’s par value and the bondholder is entitled to receive all accrued and unpaid interest up to the retraction date. Retractable bonds may have multiple retraction dates. A retraction feature is not commonly used when bonds are issued.
- A Conversion/Exchange feature will enable the bondholder, and possibly the issuing corporation, the right to convert the bonds into shares of another class, such as common shares. The conversion privilege will specify the share type, the conversion price and the specific conversion date or period. The value of the conversion privilege will depend upon the value of the underlying shares, the conversion ratio and the length of the conversion period.
Note: With regard to taxation, usually the investor’s bond book value is carried over to the new share class/type. In some instances the conversion can trigger a taxable disposition of the original bonds. An investor should consult with their income tax consultant prior to any conversion action.
A Conversion feature embedded in a bond will enable the bondholder or the issuer to convert the bond investment into a set number of common shares of the issuer. This converts the investment from “Debt” capital to an investment in “Equity” capital.
An Exchange feature enables the issuer or bondholder to convert the bond into another series of bond or into a new class of Preferred shares. The Exchange feature simply changes the “Debt” capital into another form of “Debt” capital.
Example: Of a Conversion feature, converting the bond into the issuer’s common shares:
- Convertible: Convertible until December 31, 2012 or one business day prior to the date fixed for Redemption, whichever is earlier, into 27.7778 common shares per $1,000 face/par value of the bond. This is a conversion price per common share of $36.00.
Example: Of an Exchange feature, converting the bond into another bond:
- Exchange: Exchangeable on a minimum of 30 days notice on April 30 and October 31 of each year into an equal amount of new bonds. Exchangeable by the bondholder, only after notice from the issuer, for an equal aggregate principal amount of new bonds. The material attributes of the new bonds will be the same as those of the issue exchanged, except that the new bonds will rank senior and equally with the other deposit liabilities of the issuer and will include events of default related to default in the payment of interest due thereon.
Example: Of an Exchange feature, converting the bond into another bond:
- Exchange: Exchangeable into 40.00 first preference shares, Series 1, of the issuer, per $1,000 face/par value of the bond. This represents an exchange price per first preference share, Series 1, of $25.00. The first preference, Series 1, shares will pay semi-annual non-cumulative dividends equal to $0.50 per share.
- A Change of Control feature began to appear in bond issues after 2006 and originates from the era when it was popular for Private Equity firms to buy all of the outstanding common shares of a public company, effectively making the company a privately owned entity. The private equity firm would finance the purchase of common shares by borrowing massive amounts of money through large issuance of debt. In these takeovers, the “Equity” capital holder (common shareholders) often profited handsomely, while existing bondholder saw the value of their bonds drop because the newly issued debt threatened the issuers ability to pay bondholders interest and repay the bondholder’s capital. As a result, bond investors began to desire a feature that would protect their investment in the event of a change in ownership.
- A typical Change of Control feature would appear as follows:Change of Control: In the event of a Change of Control Repurchase Event (The acquisition of voting control over 50% or more of the combined voting power and below investment grade credit rating event), the issuer shall be required to offer to purchase all of the outstanding debentures at a price equal to 101% of the face/par value of the bond, plus accrued and unpaid interest to, but not including, the date of repurchase.
- A Floating Rate feature means that the bond will pay an annual interest rate based upon a preset formula. The bondholder’s interest payments will fluctuate according to the underlying formula. For example, the bonds interest rate may be tied to Banker’s Acceptance Rate, the London InterBank Offer Rate (LIBOR), or another established short-term rate.
Bankers' Acceptances are short-term promissory notes issued by corporations with the unconditional guarantee of a major Canadian chartered bank. When issued directly by a financial institution such as a chartered bank, they are known as Bearer Deposit Notes (BDNs). They have the same high quality as the guaranteeing bank and usually offer a slightly higher return than Government of Canada T-Bills. They are available for terms from one month to one year.
LIBOR is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is established on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full-year. The LIBOR is the world's most widely used benchmark for short-term interest rates.
A Floating-rate bond usually has its interest rate set in relation to an established short-term rate. For example, the bond’s interest payment could be stated as “Interest rate is banker’s acceptance plus 0.40%.”
- A Fixed/Floating Rate feature describes a bond that initially pays a fixed annual interest rate that will change to a floating interest rate at a future specified date. Initially the coupon rate is set at a fixed rate for a set period of time (usually five years). At a specific date, the bond will convert from paying a fixed annual rate to paying a variable rate of interest that will be calculated for each payment period. The floating rate is usually based upon the Banker’s Acceptance Interest Rate, which changes daily\\\For example, the interest rate details may state, “Beginning on January 25, 2010 the bond’s interest rate will be banker’s acceptance plus 1.00%. Interest will be paid quarterly.”
- A Purchase Obligation or Sinking Fund feature is another common feature of some bond issues. This feature requires the issuing corporation to purchase and cancel a certain amount of the bond issue each year in the secondary market or directly from bondholders. The issuer may be required to purchase a fix dollar amount each year or a certain percentage of the face/par value of the bonds issued and held by investors.
A Sinking Fund feature is funded by a pool of money set aside by the issuer to help repay a bond issue. This will decrease the risk that the issuer will be short of cash to repay the bond principal at maturity. By purchasing a portion of the bond issue each year, the company will face a smaller bill at maturity.
Note: For answers to specific questions about bonds and the bond market, visit our section FAQ: Bonds and Debentures.