Nature of Bonds Payable

Corporate bonds normally differ in face amount, interest rates, interest payment dates, and maturity dates. Bonds also differ in other ways such as whether corporate assets are pledged in support of the bonds.

1. Bond Characteristics and Terminology

The underlying contract between the company issuing bonds and the bondholders is called a bond indenture. A bond issue is normally divided into a number of individual bonds. The face amount of each bond is call the principal. This is the amount that must be repaid on the dates the bonds mature. The principal is usually $1,000, or a multiple of $1,000. The interest on bonds may be payable annually, semiannually, or quarterly. Most bonds pay interest semiannually.

When all bonds of an issue mature at the same time, they are called term bonds. If the bonds mature over several dates, they are called serial bonds. For example, one-tenth of an issue of $1,000,000 bonds, or $100,000, may mature 16 years from the issue date, another $100,000 in the 17th year, and so on.

Bonds that may be exchanged for other securities, such as common stock, are called convertible bonds. Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. Bonds issued on the basis of the general credit of the corporation are called debenture bonds.

2. Proceeds from Issuing Bonds

When a corporation issues bonds, the proceeds received for the bonds depend on:

  1. The face amount of the bonds, which is the amount due at the maturity date.
  2. The interest rate on the bonds.
  3. The market rate of interest for similar bonds.

The face amount and the interest rate on the bonds are identified in the bond indenture. The interest rate to be paid on the face amount of the bond is called the contract rate or coupon rate.

The market rate of interest, sometimes called the effective rate of interest, is the rate determined from sales and purchases of  similar bonds. The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions.

By comparing the market and contract rates of interest, it can be determined whether the bonds will sell for more than, less than, or at their face amount, as shown below.

If the market rate equals the contract rate, bonds will sell at the face amount.

If the market rate is greater than the contract rate, the bonds will sell for less than their face value. The face amount of the bonds less the selling price is called a discount. A bond sells at a discount because buyers are not willing to pay the full face amount for bonds whose contract rate is lower than the market rate.

If the market rate is less than the contract rate, the bonds will sell for more than their face value. The selling price of the bonds less the face amount is called a pre­mium. A bond sells at a premium because buyers are willing to pay more than the face amount for bonds whose contract rate is higher than the market rate.

The price of a bond is quoted as a percentage of the bond’s face value. For example, a $1,000 bond quoted at 98 could be purchased or sold for $980 ($1,000 x 0.98). Likewise, bonds quoted at 109 could be purchased or sold for $1,090 ($1,000 x 1.09).

Source: Warren Carl S., Reeve James M., Duchac Jonathan (2013), Corporate Financial Accounting, South-Western College Pub; 12th edition.

One thought on “Nature of Bonds Payable

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