Organizations that issue bonds promise to pay you the face value, or principal, plus interest. You’ll receive the interest, which is also called the coupon, at regular intervals until the bond’s maturity date -- the date on which the bond expires. The principal of a bond is typically due and paid on the maturity date. There are various types of bonds, two of which are serial bonds and debenture bonds.
You become a creditor and are lending money to the issuer when you buy bonds. Companies can borrow money either by going to a financing company or by issuing bonds. Governments usually issue bonds rather than borrowing from banks. Whether a company issues bonds or borrows from a bank largely depends on its size. Larger companies may be more likely to issue bonds, while smaller companies may opt for bank loans. This is because a bond issue can mean substantial transaction costs, which small companies often can’t afford.
With serial bonds, you receive the principal in equal installments over the life of the bond. If you buy a serial bond that matures in five years, for example, the issuer may divide the principal by five. At the end of each year, you receive an installment payment. The bond issuer can divide the principal in many ways, and you could very well get equal installments of two, three or any number. You, of course, agree to the number of installments at the time you purchase the bond. The principal payments don’t impact your interest payment, so you will receive coupon payments at the agreed periods, which may be semesters or years.
When a company borrows by issuing bonds it can make the bond more attractive by pledging part of its assets as collateral. If the company goes bankrupt, you get the assets. Debenture bonds, however, are not secured by assets. Instead, the issuing company pledges the full faith and credit of the company in the repayment of the bond. Basically, you trust that the company will pay because of its credit standing. If you hold debenture bonds issued by a company that goes bankrupt, you will have to wait in line for payment. Those holding bonds secured by assets will receive payments in assets first, and you will get what’s left.
Companies and governments typically issue serial bonds when their cash flows coincide with the bond’s principal repayments. They may also select serial bonds because the interest applies only to the unpaid principal, and this means lower interest payments. Debenture bonds are usually issued by companies with such excellent credit ratings that creditors are confident they will be paid. Because of the confidence in the creditworthiness of the issuer, debenture bonds may very well have a lower interest rate than bonds from less creditworthy issuers that secure their bonds with assets.
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