Bonds are referred to as fixed-income investment instruments because they promise the holder a fixed payment. This payment is expressed as a percentage of the amount borrowed by the issuer of the bond and is, technically, an interest payment. It can be classified under different names, however, so it is important to understand the terminology.
While stocks can pay dividends, many bonds pay interest to their holders. The exceptions are zero coupon bonds and some convertible bonds, which may have no traditional interest payments.
Basics of Bonds
A bond is a payment obligation by the issuing entity for a limited period of time. The promised payment is generally expressed as a percentage of the bond's original issue price, which is also known as face value, principal or par value of the bond. This percentage rate is referred to as the coupon rate, and the periodic payments can be referred to as either interest payments or coupon payments.
A bond may, for example, have a face value of $100, an eight-year life and promise 10 percent annual interest. Such a bond would pay $10 every year for the next eight years. At the end of the eighth year, the bondholder would return the expired bond and receive $10 as the final interest payment, along with his original $100, for a total of $110.
Stocks and Dividends
Dividends are cash disbursements made to stockholders. Unlike bonds, stocks do not come with an explicit payment promise. The amount of dividends paid to stockholders varies depending on the profits of the issuing company. Even if profitable, the corporation's board of directors may elect to forgo dividend payments and instead reinvest the cash into the business.
Disappointed shareholders cannot take legal action against the firm or its management, except in case of gross neglect or fraud. Bondholders, however, can sue the corporation for unpaid coupon or principal payments and even force it into bankruptcy.
How Zero Coupon Bonds Work
Not all bonds pay periodic interest. A specific type of bond, called a "zero coupon bond," sells for far less than the par value printed on the bond and makes only one payment to the holder at the time it expires.
A zero coupon bond may expire in five years and promise the investor $100 at the time of expiration. If the original sale price of the bond is only $68, the bondholder's original investment would still grow at an annual rate of 8 percent.
Zero coupon bonds are favored by corporations undertaking big investments, which may sap cash for several years until they bring in positive cash flows.
How Convertible Bonds Work
Another type of bond that may pay no interest or pay far lower interest than the going market rate is the convertible bond. These bonds can be exchanged for or converted into common shares of the issuer. The bond may be sold to the investor originally for $100 and promise a repayment of the same $100 in three years.
At any point, however, it can be converted into five common shares. So if the share price rises above $20, the bondholder will get more than her original $100 by converting the bond into stocks. Should that never occur, she will get her original $100 back at the end of the third year.