||Only corporations can issue stocks but bonds
can be issued by corporations or government units. "Governments" are bonds
issued by the U.S. Treasury or by agencies of the Federal government. Direct
obligations of the Treasury are considered free of risk that the issuer
will default. Agencies such as the Federal National Mortgage Association
(called FNMA or Fannie Mae) use the proceeds to finance their activities;
the FNMA finances home mortgages.
Another agency, the Government National Mortgage Association (GNMA or Ginnie Mae) issues certificates that are backed by mortgages. In the case of failure, the U.S. government guarantees payment. Some agency obligations are backed by the government and some are not, but agency defaults are considered unlikely.
The Treasury issues instruments due after various lengths of time, known as maturities. The shortest regularly issued maturities, three or six months, take the form of Treasury bills. These are issued every Monday in minimum denominations of $10,000 and in increments of $5,000 above the minimum. Investors bid for them at a discount, by offering, say $97.50 for every $100 of bills. At maturity, the investor will receive $100 for every $97.50 he paid. Yields are expressed on an annual basis, so in the case of a three-month bill purchased for $97.50, the yield would be the discount ($2.50) divided by the price ($97.50) and multiplied by 4 because there are four three-month periods in a year. In this example, the yield would be about 10.25%.
Similar bills due in one year are sold monthly. The Treasury also issues cash management bills on an irregular basis, generally for short periods such as a few days.
Treasury issues maturing in between one and 10 years are called notes. Those maturing in more than 10 years are called bonds. The process of selling these issues to the public takes place in the primary market, with the proceeds going to the issuer.
Secondary markets are made by security dealers in all maturities of Treasury issues. These permit holders to sell their securities before they mature and they permit purchases even at times when the Treasury is not making any offerings in the primary market. The Federal Reserve also uses the market place to buy and sell Treasury issues as part of its monetary policy.
In the secondary market, the prices of bills, notes and bonds fluctuate according to changes in interest rates. But, in one of the more confusing aspects of financial markets, the prices fluctuate inversely to the interest rates. Thus, when interest rates rise, bond prices go down, and when interest rates fall, bond prices go up.
The rationale for this is as follows. Say the Treasury issues some 30-year bonds with an interest rate of 10%, or $10 for every $100. In time, interest rates may rise to 12%. Then, no one in the secondary market will want to pay full price for bonds paying 10% interest when they can buy new ones at 12%. However, they might be willing to pay less than $100 for every $100 of the old bonds. Tables and calculators exist which show the exact price to pay so the yield to maturity on a 10% bond is 12%, taking into account the time left to maturity when the purchase is made. Leaving aside the complicating factor of yield to maturity, a price of $83.33 for every $100 face value of a 10% bond would result in a current return of 12%.
Similarly, when interest rates fall, bond prices will rise because sellers will hold out for a higher price to compensate for the higher-than-market interest paid on their holdings.
Besides the U.S. government and its agencies, bonds may be issued by a variety of other government bodies, which are lumped together under the heading "Municipals" even though they include states, highway authorities and other non-city entities, as well as cities and their agencies. Usually, interest on these issues is exempted from income tax by the Federal government and by the state (and sometimes the city) in which the borrower is located. Because of this privilege, the issuer can pay a lower rate of interest and investors have to consider the after-tax yield, based on their own income-tax situation, when comparing yields on these with those of other bonds. These bonds also are known as Tax Exempts.
Corporate bonds constitute another major group. There are three main types of them:
Mortgage bonds, which are secured by real properties such as buildings.
Debentures, which are backed by a company's earning power rather than by anything specific.
Convertible bonds, which can be exchanged for shares of the issuer's stock. Because of this feature, they carry a lower interest rate than "straight," or non-convertible bonds.
If a company's stock price rises substantially, the value of a convertible bond can be considerably more than its issue price, regardless of the level of interest rate. The interest rate acts as a floor for the bond's price if the stock's price falls.
Some bonds are issued in bearer form, without any
record of the owner's name on it. Registered bonds, like stock
certificates, have the owner's name printed on them. Bearer bonds have
coupons attached to them that can be clipped and presented to banks
for payments of interest on stipulated dates without charge. One common
registered bond is the U.S. Savings Bond, for which a secondary
market does not exist. Treasury bills, because of their short life,
are not issued in certificate form. Buyers get a receipt for their money
and a record of their holding is kept in a computer. This "book entry"
system also is used for newer Treasury notes and bonds.
||Common stock is the usual type of share. It represents
a part of the ownership of the company, has voting rights and is eligible
for a share in the profits, or a dividend.
Preferred stock is a hybrid of common stock and debt. Unlike a bond, it never matures, or comes to a time when the company will pay back the amount originally invested. But unlike a common stock, its dividend is fixed at the time it is issued. The dividend is not a legal obligation of the company, but common-stock dividends can't be paid until all preferred stock dividend obligations are met.
For an investor, preferred stock is similar to bonds.
But from the issuing corporation's point of view, there is a significant
difference: Companies can deduct the interest paid on bonds, but they
can't deduct dividends paid on preferred shares. Because of this drawback,
comparatively little preferred stock has been issued
APPENDIX: A VARIETY OF INTEREST RATES
Treasury Bill Rate. A Treasury bill is a short-term (one year or less) bond issued by the U.S. government. It is a pure discount bond, i.e., it makes no coupon payments, but instead is sold at a price less than its redemption value at maturity. For example, a three-month Treasury bill might be sold for $98. In three months it can be redeemed for $100; it thus has an effective three-month yield of about 2% and an effective annual yield of about 8%. The Treasury bill rate can be viewed as a short-term, risk-free rate.
Treasury Bond Rate. A Treasury bond is a longer-term bond (more than one year, and typically 10 to 30 years) issued by the U.S. government. Rates vary, depending on the maturity of the bond.
Discount Rate. Commercial banks sometimes borrow for short periods from the Federal Reserve. These loans are called discounts, and the rate that the Federal Reserve charges on them is the discount rate.
Commercial Paper Rate. Commercial paper refers to short-term (six months or less) discount bonds issued by high-quality corporate borrowers. Because commercial paper is only slightly riskier than a Treasury bill, the commercial paper rate is usually less than 1% higher than the Treasury bill rate.
Prime Rate. This is the rate (sometimes called the reference rate) that large banks post as a reference point for short-term loans to their biggest corporate borrowers. Because the banking industry is oligopolistic, this rate does not fluctuate from day to day as other rates do.
Corporate Bond Rate. Newspapers and government
publications report the average annual yields on long term (typically 20
year) corporate bonds in different risk categories (e.g., high-grade bonds,
medium grade bonds, etc.). These average yields indicate how much corporations
are paying for long-term debt. However, the yields on corporate bonds can
vary considerably depending on the financial strength of the corporation
and the time to maturity for the bond.