Bond Basics

Why Issue Corporate Bonds?

Most companies have some sort of bonds where they allow investors to purchase corporate bonds with a fixed rate of return.  This allows the companies to create their own financing without affecting shareholders or going to banking institutions for the money.

Why Not Offer More Shares?

Some companies will issue more shares, but depending on the quality of the income statement, most financial analyst will quickly point out if the offering is under direst.  This will scare potential investors from purchasing any shares.  Also, by issuing additional shares, it will dilute the value of existing shares in the marketplace if their is not enough demand for the stock.

Why Not Banks?

Banks will gladly offer profitable companies more money or lines of credit, but the problem is that it will be at a higher interest rate than if the company simply went to investors directly.  This is because the bank will not only need to make a return, but will pad the rate even more to take in account for the additional risks.  Lastly, investors will purchase corporate bonds with a time horizon of 5 - 10 years.  Banks are unwilling to agree to such lengthy loan periods, because as the length of a loan stretches out, the risks associated with the loan increases.  This often makes it difficult for banks to offer loans at competitive rates to companies.

Benefits of Corporate Bonds

By a company issuing bonds, it is almost like a person placing all of their debts on one low fixed rate credit line for an extended period of time.  This allows the company to operate stress free with a long-term expectation of any cash outlays required to maintain their level of financing.  Most companies enter into financial trouble as a result of variable interest rates or credit drying up.  By issuing corporate bonds, the company allows itself to stay afloat without taking on debt that may become too hard to manage at a later date.

What is a CUSIP Number?

A CUSIP number is a unique, 9 character identifier of all registered stocks, bonds (including government and municipal issues), derivatives, and syndicated loan within the United States and Canada.  It was put in place to make the clearing and settlement of securities more efficient and to reduce the administrative expenses involved with managing this process.

The acronym CUSIP stands for the Committee of Uniform Securities Indentification Procedures.  The CUSIP database is owned by the ABA (American Bankers Association) and is operated by the S&P.
 

How is the CUSIP Derived?

Out of the 9 total characters, the first 6 uniquely identify the issuer and are provided to each issuer in alphabetical order.  These first 6 characters are referred to as the "base" characters.  In some instances, 6 digits will not be enough to identify all of the different issues that an entity has.  Therefore, a 7th digit may be needed here.  This is common with government issued debt.

You may wonder how new issuers are issued a CUSIP alphabetically.  The CUSIP number system has taken into account the fact that there will be new issuers every year.  Therefore, they have placed gaps within the numbering system to allow for future additions.

The next two digits identify the exact issue of the security and the character convention will be different between security types.  These two digits are commonly referred to as the "issue number".  These two characters will be numeric when applied to stocks; however, fixed income securities will have one numeric and one letter.  The letter will reference the maturity month while the number will reference the maturity year.

The final digit is known as the check digit and this number is appended to validate the accuracy of the number being transmitted.  The check digit is derived through a mathematical technique known as the Modulus 10 Double Add Double technique.  Without getting into the guts of this calculation, you should know that this number allows a financial institution to verify that the first 8 digits were transmitted correctly.

Continue to Part 17 - GDP vs. GNP

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What is the Current Yield?

The current yield represents the interest rate of a security and is most commonly associated with bonds.  The current yield is calculated by dividing the annual interest payment by the current bond price.  By comparing the difference of the annual interest and current price of the bond, it gives a measurement of what the investor can expect to make in a years time.  Below is the current yield formula:

Current Yield = Annual Bond Coupon/Current Bond Price

For example, if a bond is priced at $110.45 and the coupon rate is $7.83, the current yield would equal 7.08%. 

How does the Current Yield affect an Investor?

A trader will closely monitor the current yield when looking to exit the position within one year.  In the above formula example if the trader were to purchase the bond, they would receive $7.83 for the investment.  While the investor has received the dividend from the bond, the trader's gain will depend on the price of the bond in a year.  Let's assume the interest rate fell and the price of the bond raised to $114.50 when the investor was ready to close the position.  The actual rate of return for the bond would be 3.6% ($4.05/$110.45). 

Current Yield Basics

• When the bond is selling at a discount, the current yield will be higher than the discount rate
• If the current yield is less than the coupon rate, the bond would be purchased at a premium
• When interest rates rise, bond prices fall
• When interest rates fall, bond prices rise

Continue to Part 3 - How to get Yield to Maturity

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