A good way to become familiar with some of the terminology and features of corporate bonds might be to look at a physical example of the real thing. Here we have a bond. Don't get too excited. This bond is from a company that went bankrupt some time ago, so this bond now is not worth a whole lot. But it will help us understand some terms.
First, there is something kind of interesting about this bond in that it has coupons attached to it. As you are studying about bonds, you will hear the term coupon, and when we refer to a coupon, this is what we're talking about. Originally, there were 200 of these individual coupons attached to this bond. The way this worked is that on January 1 and July 1 of each year during the life of the bond, the bondholder would take a pair of scissors and cut this coupon out and then take it down and deposit it in the bank, and the bank would give them $17.50 for each of these coupons. That's how the interest was paid. It really wasn't an automatic process at all. Now, there are a couple interesting things about this. First of all, you may see the term coupon clipper in the financial press.
When I first heard the term coupon clipper, I thought that it referred to someone who was a very frugal person. Someone who would find a copy of the Sunday paper in the train station and clip out the coupons for groceries and then that's what they would live on for the week. Turns out the term coupon clipper refers to something completely different. Now the term coupon clipper is more politely said to refer to a member of the idle rich, whose main activity is clipping coupons and taking them to the bank. Back in the day, these folks were generally referred to as rich widows, but that doesn't seem very pleasant these days.
Another interesting thing about this bond is that it is, as were most coupon bonds, a bearer bond. What that means is that the bond was not registered in anyone's name, that whoever had possession of it was presumed to be the owner. Bearer bonds were quite handy for under-the-table transactions, such as drug deals and money laundering. In the early 1980s, bearer bonds were virtually outlawed. Nearly all bonds issued since then have been registered bonds, which means the bonds are tracked and payment of the coupon is sent automatically. In fact, paper coupons are quite rare these days.
So let's go ahead and take a look at the bond itself. Here's where we have some for which I thought an actual bond might be a good visual aid. We've already talked about the meaning of the terms bearer bond, coupon, and coupon clipper. So let's move on to face value, par value, and principle.
The face value of this bond is $1,000 that we can see printed on the bond, the $1,000. The face value is also referred to as the par value or the principal. All three terms are synonyms. It is important to know what they mean. The way I remember that they mean the same thing is that here we see, on the face of this bond, not on the backside of the bond, but on the face of the bond, we see it’s principle. We also know that par is a golf term. I can easily imagine this guy out playing golf. I can also imagine him being a principal of a high school, even if he did happen to be president of the railroad. Principle, par value, face value. They all mean the same thing. Here's something that is quite critical: they never change. From the day this bond was issued until the company went bankrupt, the principal, the face value, and the par value were $1,000. They could not change. They were printed on the bond. All three of these terms mean the same thing. And they do not change.
The maturity of the bond, which is also the original term of the bond, is printed on the bond itself. For this particular bond (let’s zoom in), and you can probably almost read, July 1, 1997. That's printed on the paper. The bond was issued in 1897, so the term was 100 years. You won’t see many bonds with a term of 100 years today. The maturity and the original term never change.
However, the remaining term of the bond will change. The remaining term of the bond is the time difference between the maturity and the current date. As we move through time closer to the maturity, the remaining term will become shorter. (In this example, we are well past the maturity date. Because the issuer went bankrupt, the bond is of little value. If it were worth anything, I would sell it and go to the Dairy Queen.)
The coupon and coupon rate also are fixed; they are printed on the bond. For this particular bond, the coupon rate is 3 and 1/2 of 1% per annum. The coupon is paid twice per year, so what that means is each 6 months the bondholder receives a payment of $17.50, which is 1.75% of the face value of $1,000. One and three-quarter percent paid twice per year is 3.5% per year.
This does get a little bit tricky. The coupon rate is 3 1/2% and the coupon amount is $35. Those values are expressed in annual terms even though they are paid semiannually. And because those values are written on the bond itself, they can't change.
On the other hand, the price of the bond will change. For a real bond, the price of the bond varies with market conditions and the condition of the issuer. Although this was at one time a real bond, it is now more of a collectors’ item. The value of this bond is probably about $10, which is what I paid for it on eBay.
The current yield and the yield to maturity are calculated based on the price, not the face value, the par value, or the principal. What is the price of a given bond? It’s impossible to tell just by looking at the bond. Look on the Web or call your broker.
Even though the coupon, which doesn’t change, is used to calculate the current yield and the yield to maturity, the current yield and yield to maturity will fluctuate because the price fluctuates.
I hope looking at this bond has helped to solidify some of the terminology involved with bonds, and I especially hope that it will help you to remember which of the items are fixed in amount and which of the items may vary.
I believe you will enjoy working with bonds and find your newly developed knowledge to be quite beneficial.