Bonds

A bond is a long$-$term loan under which a borrower agrees to make payments of interest and principal, on specific dates, to the holder of the bond $($see $$Critical Concept: Bond$).$ Although bonds are similar in many ways to term loans, a bond issue generally is offered to the public by the borrowing entity and sold to many different investors. Indeed, thousands of individual and institutional investors may par$-$ ticipate when a business sells a bond issue, while a term loan generally has only one lender.

In addition, bonds have a terminology of their own. The issuer of a bond is equivalent to the bor$-$ rower on a term loan, the bondholder is the lender, and the interest rate often is called the coupon rate.

Because bonds are sold to many investors, large amounts of capital can be raised in a bond issue. To illustrate, HCA $($Hospital Corporation of America$)$ raised more than $$1\mathrm{.}5$ billion of debt capital in a single bond issue in $2017.$ Each bond had a principal amount of $$1,000,$ so more than a million individual bonds were sold to thousands of investors to complete the issue. To reach so many investors, bonds generally are sold through brokers rather than directly by the borrowing company.

Bonds are categorized as either government $($Treasury$),$ corporate, or municipal. Treasury bonds are used to raise money for the federal government. Investor$-$owned busi$-$ nesses issue corporate bonds, while states, counties, cities, and not$-$for$-$profit healthcare organizations issue municipal bonds.

Although bonds generally have maturities in the range of $10$ to $30$ years, organiza$-$ tions use both longer and shorter maturities. In fact, in $1995,$ HCA $($then Columbia$/$HCA$)$ issued corporate bonds with a $100-$year maturity. Unlike term loans, bonds usually pay only interest over the life of the bond, and the entire amount borrowed is returned to lenders at maturity. Most bonds have a fixed interest rate, which locks in the current rate for the entire maturity of the bond and hence minimizes interest payment uncertainty. However, some bonds have floating, or variable, rates, so the interest payments move up and down with the general level of interest rates in the economy.

Although municipal, or muni, bonds typically are issued by states, counties, and cities, not$-$for$-$profit healthcare providers are entitled to issue such securities through government$-$ sponsoredhealthcarefinancingauthorities.WhereasthevastmajorityofTreasuryandcorporate bonds are held by institutions$$primarily mutual funds$$nearly half of all outstanding munici$-$ pal bonds are held by individual investors. However, the Republican tax reforms passed by Congress in $2017$ may change the ways in which not$-$for$-$profit hospitals manage their finances.

The primary attraction of most municipal bonds is the fact that bond owners $($lenders$)$ do not have to pay income taxes on the interest earned. Because such bonds are tax$-$exempt, the interest rate set on municipal bonds is less than the rate set on similar corporate bonds. The idea is that municipal bond buyers are willing to accept a lower interest rate because they do not have to pay income taxes on the interest payments received. However, since the $2017$ tax reforms set lower corporate and individual tax rates, the benefit of the interest tax exemption will be less. This may lead to smaller differences between the interest rates set on corporate and municipal bonds.

CRITICAL CONCEPT:

A bond is a type of long$-$term debt used to raise large amounts of capital. Investor$-$owned corporations issue corporate bonds; the US government issues Treasury bonds; and states, counties, cities, and not$-$for$-$profit healthcare providers issue municipal bonds. Bonds typically have maturities in the range of $10$ to $30$ years. Because of the high administrative costs involved in selling bonds $($compared to term loans$),$ bonds are not typically used unless the amount required is greater than $$10$ million, although smaller issues do occasionally occur. To ensure that the entire issue is sold $($the full amount of money is raised$),$ bonds typically are issued in small denominations $($$$1,000$ or $$5,000)$ and sold through brokers to institutions and the public.

Related questions:

$1.$Compare corporate bonds, treasury bonds and municipal bonds. Which of these generally pays the highest rate of interest? Which of these typically has the highest risk of default?

$2.$Suppose that the City of Dallas builds a parking lot in downtown by issuing a bond for $$5$ million. The bond pays a $6$ percent coupon, tax$-$free. The bond's interest payments are paid from the revenue generated by parking fees. In your opinion, what is the risk of default on this bond? Based on your answer $-$ what "grade" should this bond receive $-$ by the rating agency for bond quality? Is this a safe investment for the pension fund of the union of hospital nurses?