Financial Investing 13 - Bonds and Debentures

Debentures are loans, secured by a corporation, municipality or government. Bonds and debentures are instruments that provide for a maturity at which time the principal will be repaid. In addition to the payback of principal, the borrower will pay interest at stated intervals, usually semi-annually.

There are four common types of bonds and debentures:

1. Government bonds and debentures
2. Corporate bonds and debentures
3. Domestic bond funds
4. International bond funds.

In this article, we will discuss the overall concepts of bonds and debentures

a) Security

*Bonds are considered as secured debt. If the borrower defaults, the assets can be seized to satisfy the bondholder.
* Debentures, on the other hand, are unsecured, but are supported by the general credit of the corporation, municipality or government issuing the bonds. When issued by governments, there is the ability to raise taxes to honor their repayment obligation.

b) Contract features

Bonds and debentures are prominent players in the debt market. They come in 3 maturity durations.

i. Short Term: three years or less.
ii. Medium Term: three to five years.
iii. Long Term: more than ten years
and the most common features in the contract are
i. Identify the Term to maturity.
ii. Show interest payment structure.
iii. Provide a coupon rate.
iv. Indicate the valuation and pricing.

In bonds and debentures, the issuer is the borrower and the lender is the bond owner. when bonds are sold on the secondary market, the ownership changes. Each bond that is sold requires the presentation of a prospectus. Prospectus is a document that lists the name of the issuer, bond features, assets securing the loan and other details. In addition, a prospectus also gives the company background, purpose of the bonds and other information of value to the buyer.

There are types of bonds, but the two most common are Bearer Bonds and Registered Bonds.

i. Bearer bonds are owned by the holder and are issued with coupons for interest payments.The holder may sell the bond at any time.

ii. Registered bonds are registered with the issuer who keeps a record of the owner. They may only be sold by the registrant and interest payments are made by check to the registered owner.
Other Corporate Bond types include

i. Redeemable bonds.
ii. Callable bonds.
iii. Retractable bonds.
For bonds of these types, the principal amount borrowed may be paid back anytime prior to maturity and thirty days notice is generally required before exercising the option.

c) Bond and Taxation

If a bond is sold before maturity, it can be sold using any of the following three methods

i. At Par: yield will be identical to the coupon rate.
ii. At Discount: yield will be less than the coupon rate.
iii. At a Premium: yield will be more than the coupon rate.

Bonds are taxed on a bond year basis and attract taxation in two ways

i. 1. Capital Gains. The adjusted cost base of a bond is the purchase price plus any sales commission less any accrued interest paid. Any profit is considered a capital gain and any loss is considered a capital loss.

ii. Coupon rate or interest earned

d) Government bonds

Government bonds are debentures. The investment risk is nil due to the federal government's ability to increase taxes which will generate additional income to make bond payments. These bonds and debentures are subject only to interest rate risks. Government bonds can be used to satisfy the following investment objectives:

i. Provide income.
ii. Ensure safety of principal.
iii. Very Liquid.

They are taxed on a bond year basis and are eligible for any deferred tax saving plan.

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