Debt securities are distinguished by their promise to pay a fixed or specified stream of
income to their holders. The coupon bond is a typical debt security.
Treasury notes and bonds have original maturities greater than one year. They are issued
at or near par value, with their prices quoted net of accrued interest.
Callable bonds should offer higher promised yields to maturity to compensate investors
for the fact that they will not realize full capital gains should the interest rate fall and the
bonds be called away from them at the stipulated call price. Bonds often are issued with a
period of call protection. In addition, discount bonds selling significantly below their call
price offer implicit call protection.
Put bonds give the bondholder rather than the issuer the choice to terminate or extend the life of the bond.
Convertible bonds may be exchanged, at the bondholder's discretion, for a specified number of shares of stock. Convertible bondholders "pay" for this option by accepting a lower
coupon rate on the security.
Floating-rate bonds pay a fixed premium over a referenced short-term interest rate. Risk is
limited because the rate paid is tied to current market conditions.
The yield to maturity is the single interest rate that equates the present value of a security's cash flows to its price. Bond prices and yields are inversely related. For premium bonds, the coupon rate is greater than the current yield, which is greater than the yield to maturity. The order of these inequalities is reversed for discount bonds.
The yield to maturity often is interpreted as an estimate of the average rate of return to an
investor who purchases a bond and holds it until maturity. This interpretation is subject to
error, however. Related measures are yield to call, realized compound yield, and expected
(versus promised) yield to maturity.
Treasury bills are U.S. government-issued zero-coupon bonds with original maturities of
up to one year. Treasury STRIPS are longer term default-free zero-coupon bonds. Prices
of zero-coupon bonds rise exponentially over time, providing a rate of appreciation equal
to the interest rate. The IRS treats this price appreciation as imputed taxable interest
income to the investor.
When bonds are subject to potential default, the stated yield to maturity is the maximum
possible yield to maturity that can be realized by the bondholder. In the event of default,
however, that promised yield will not be realized. To compensate bond investors for
default risk, bonds must offer default premiums, that is, promised yields in excess of those
offered by default-free government securities. If the firm remains healthy, its bonds will
provide higher returns than government bonds. Otherwise, the returns may be lower.
Bond safety often is measured using financial ratio analysis. Bond indentures offer safeguards to protect the claims of bondholders. Common indentures specify sinking fund
requirements, collateralization, dividend restrictions, and subordination of future debt.
The term structure of interest rates is the relationship between time to maturity and term to maturity. The yield curve is a graphical depiction of the structure.
