Banks are the usual issuers of CDs. Individuals, companies and organizations are commonly the depositors that put their money into these financial instruments. The interest payable on a CD is the cost (to the recipient bank) for using the money. The interest receivable on the CD is the return (to the depositor) for providing the money. CDs are issued for periods ranging anywhere from 90 days to five years, and, generally speaking, the longer the term of the CD, the better the interest rate paid to the depositor.

The takeover of Manchester United by the Glazer family beginning in 2005 saddled the historic club with substantial amounts of debt, which is a source of continuing controversy for many long-time supporters of the club. The Glazers paid around £790 million for the team. The family initially took the club private, which created a great deal of debt, but then had an initial public offering (IPO) in 2012. At one point in 2010, the club’s debt exceeded £716.5 million, or over $1 billion, prompting outcry from the club’s supporters. That debt amount was paid down over the next few years. As of February 2015, the club had around £380.5 million of debt, which had increased over the prior quarter. The lack of participation in the Champion’s League in the 2014-2015 season hurt the club’s revenues.

Malcolm Glazer built his wealth through real estate investing, including mobile home parks and shopping centers. The Glazers also own the Tampa Bay Buccaneers of the National Football League (NFL). The Glazer takeover of Manchester United has been fraught with controversy due to the amount of debt used for the transaction.

The Glazers began purchasing their shares in Manchester United in 2003 through a holding company known as Red Football. They built their position over the next few years. In May 2005, the Glazers achieved over a 75% controlling interest in the club, and soon after had the shares delisted from the London Stock Exchange. As part of the takeover, the Glazers saddled the club with a large amount of debt. Around £265 million was secured by the club’s assets, with the total amount of debt around £660 million. This was the first time the club had debt since 1931. The loans were provided by large American hedge funds. The interest rates on the debt amounted to around £62 million a year. A substantial portion of the loans were payment in kind loans, which the club was paying 16.25% interest on at one point. The precarious nature of the club’s balance sheet led to protests by the club’s supporters.

The Glazers refinanced this debt in 2010 by issuing a series of bonds with two main tranches. The first tranche, worth about £250 million, paid interest around 8.75%. The second tranche, worth around $425 million, paid 8.375% in interest. The second tranche was issued as a result of high investor demand in the United States. The funds from the bond offerings were used to pay down outstanding debt.

In 2012, Manchester United had an IPO on the New York Stock Exchange (NYSE). Shares were offered at $14, offering around 16 million shares for sale. Class A shares were offered to the public, while Class B shares were controlled by the Glazers. The classes were structured so that the Glazers maintained voting control of the club, which some viewed as controversial. George Soros, the famed investor, was a major purchaser of Class A shares during the IPO. Money from the IPO was used to pay around £62 million in bonds, decreasing the club’s debt load.

All bonds are redeemed at face value when they reach maturity unless there is a default by the issuer. Many bonds pay interest to the bondholder at specific intervals between the date of purchase and the date of maturity. However, certain bonds do not provide the owner with periodic interest payments. Instead, these bonds are sold at a discount to their face values, and they become more and more valuable until they reach maturity.

Not all bondholders hold onto their bonds until maturity. In the secondary market, bond prices can fluctuate dramatically. Bonds compete with all other interest-bearing investments. The market price of a bond is influenced by investor demand, the timing of interest payments, the quality of the bond issuer, and any differences between the bond’s current yield and other returns in the market.

For instance, consider a $1,000 bond that has a 5% coupon. Its current yield is 5%, or $50 / $1000. If the market interest rate paid on other comparable investments is 6%, no one is going to purchase the bond at $1,000 and earn a lower return for his or her money. The price of the bond then drops on the open market. Given a 6% market interest rate, the bond ends up being priced at $833.33. The coupon is still $50, but the yield for the bond is 6% ($50 / $833.33).

A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion of its nominal value to either cash or a specified number of common shares of equal value. A corporation issues a convertible bond to take advantage of reduced interest rates, since the presence of the conversion option provides upside potential for the bondholders, and these bonds tend to demand lower interest rates compared to standard nominal bonds. Another advantage of issuing convertible bonds rather than equity is the tax deduction of interest, which lowers the cost of capital for a company. Also, as the bonds are converted to equity, a company has no more obligations. However, depending on the number of additional shares issued as a result of conversion, shareholders’ equity value declines as a result of stock dilution.

Convertible Bonds

Convertible bonds are typically issued by firms with substandard credit ratings and high expected growth. For example, in 2014, Tesla Motors issued $2 billion convertible bonds to finance the construction of the Tesla Gigafactory in Nevada. Because Tesla reported low or negative earnings over the previous few years, raising capital for this project using standard nominal bonds was prohibitively expensive as the interest rates demanded by investors were very steep. However, with the conversion option, the interest rates on Tesla’s convertible bonds ranged between 0.25% and 1.25%.

Stock Dilution

When convertible bonds are converted to equity by bondholders, a significant stock dilution could occur, which may result in substantial reduction in shareholders’ value per share. Thus, if a company wants to issue stock through a secondary offering in the future, it may not be able to raise as much capital due to stock dilution from convertible bonds.

The main difference between yields and interest rates is that each term refers to different financial instruments. Yield commonly refers to the dividend, interest or return the investor receives from a security like a stock or bond, and is usually reported as an annual figure.

Interest rate generally refers to the interest charged by a lender such as a bank on a loan, and is typically expressed as an annual percentage rate (APR).

A Yield Example

For example, if PepsiCo (NYSE: PEP) pays a quarterly dividend of 50 cents and the stock price is $50, then the annual dividend yield would be 4% [(50 cents x 4 quarters) / ($50)]. Therefore, the current yield is 4%.

If the stock price increases to $100 and the dividend remains the same, then the yield becomes 2%. (Bond yield is a bit more complex; if you want to learn about it, take a look at our tutorial: Bond Basics: Yield, Price And Other Confusion.)

An Interest Rate Example

As an example of interest rates, suppose you go into your bank to borrow $1,000 for a new bicycle, and the bank quotes you a 5% interest rate on your loan. If you borrow this amount for one year, the interest you would pay on top of paying back the $1,000 would be $50 (simple interest: $1000 x 0.05).

If the interest rate is compounded, the interest rate you will pay would be a little bit more. Lenders charge interest to compensate for the opportunity cost of not being able to invest it somewhere else. (To learn more about compound interest, see Accelerating Returns With Continuous Compounding.)

Companies issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue.

The costs involved in borrowing money directly from a bank are prohibitive to a number of companies. In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed when it gives a large loan to a company. In other words, restrictive covenants protect the bank’s interests; they’re written by securities lawyers and are based on what analysts have determined to be risks to that company’s performance.

Here are a few examples of the restrictive covenants faced by companies:

• They can’t issue any more debt until the bank loan is completely paid off
• They can’t participate in any share offerings until the bank loan is paid off
• They can’t acquire any companies until the bank loan is paid off

Relatively speaking, these are straightforward, unrestrictive covenants that may be placed on corporate borrowing. However, debt covenants are often much more convoluted and carefully tailored to fit the borrower’s business risks. Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the chief executive officer (CEO) quit, or should earnings per share drop in a given time period. Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk.

Simply put, banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.

For more further reading, see Debt Reckoning and Corporate Bonds: An Introduction To Credit Risk. For more about bonds, see Bond Basics Tutorial and Advanced Bond Concepts.

Although it is rare, companies and governments do issue bonds that exceed an average person’s life expectancy. For example, multi-billion dollar companies such as the Walt Disney Company (DIS) and Coca-Cola (KO) have issued 100-year bonds in the past.

Many of these bonds and debentures contain an option that lets the debt issuer partially or fully repay the debt long before the scheduled maturity. For example, the 100-year bond that Disney issued in 1993 was suppose to mature in 2093, but the company can start repaying the bonds any time after 30 years (2023).

Countries such as Argentina, Austria and Mexico have recently issued 100-year bonds, and there has been talk of them being considered in the United States in the future as well.

Why Long-Term Bonds Are Attractive for Some Investors 

Companies issue bonds with long maturities because the goal of any business is to profit from the market’s demand. When it comes to 100-year bonds, there is a group of investors that have shown a strong demand for these bonds. Specifically, certain institutional investors use 100-year bonds to lengthen the duration of their bond portfolios to fulfill certain duration-based goals.

Some analysts see the demand for this type of long-term bond as an indicator of consumer sentiment for a specific company. After all, who would buy a 100-year bond from a company they didn’t believe would last? For example, if there was especially high demand for Disney’s 100-year bond, this could mean that many people believe that the company will still be around to pay out the bond a century later.

Believe it not, 1,000-year bonds also exist. A few issuers (such as the Canadian Pacific Corporation) have issued such bonds in the past. There have also been instances of bonds issued with no maturity date, meaning that they continue paying coupon payments forever.

In the past, the British government has issued bonds called consols, which make coupon payments indefinitely. These types of financial instruments are commonly referred to as perpetuities.

(To learn more about bonds and duration, see the Bond Basics Tutorial and Advanced Bond Concepts.)

Bonds are marketable and relatively liquid securities, and there are several different accounting methods for discounting their values to give investors a sense of their present worth. The most common of these is called yield to maturity, or YTM, which represents the expected rate of return on a bond if held to maturity. Spot rates are not specific to bonds; they are most often quotes for currencies or commodities but can be useful for calculating bond price for immediate settlement. The spot rate is quite similar to YTM with one major exception: it varies from period to period as future interest rate fluctuations are anticipated.

To appreciate the difference between YTM and spot rates, understand bond investing basics. Bond prices are purchased at “par value,” or the dollar amount printed on the bond, such as $1,000. Each bond generates interest payments, also known as the “coupon.” A bond’s yield is the discount rate that represents the its cash flow to its present dollar value. However, bonds are time-sensitive instruments since the time until maturity is constantly shrinking, which means fewer future coupons as they age.

Without getting bogged down by technical details, it is important to know that a bond’s yield moves inversely with its price. The YTM calculates the interest rate the investor would earn from investing every coupon payment from the bond at an average interest rate until maturity. Thus, bonds trading at below par value, or discount bonds, have a YTM higher than the actual coupon rate, and bonds trading above par value, or premium bonds, have a YTM lower than the coupon rate.

The spot rate is calculated by finding the discount rate that makes the present value of a zero-coupon bond equal to its price. These are based on future interest rate assumptions, so spot rates can use different interest rates for different years until maturity, whereas YTM uses an average rate throughout. In essence, this means spot rates use a more dynamic and more potentially accurate discount factor in a bond’s present valuation.

To make appropriate decisions in bond investing, it is important to understand the concept of the yield calculations that bonds receive. As an important aspect of investing basics, bond yields are the rate of return you receive after purchasing a bond and are the accounting measurements that allow you to compare one bond with another. Two yield calculations are generally evaluated when it comes to selecting callable bonds for a portfolio: yield to maturity and yield to call.

Yield to Maturity

A bond’s yield to maturity calculation provides you with the total return you would receive if the bond was held through its maturity date. Yield to maturity assumes that all interest payments are received from the date of purchase until the bond reaches maturity, and that each payment is reinvested at the same rate as the original bond. However, you can utilize the spot rate to determine market value of a purchase, as this metric takes into account fluctuating interest rates. Yield to maturity is based on the coupon rate, face value, purchase price and year until maturity, calculated as:

Yield to maturity = {Coupon rate + (Face value – Purchase price/years until maturity)} / {Face value + Purchase price/2}

Yield to Call

For most bond investors, it is important to also estimate the yield to call, or the total return that would be received if the bond purchased was held until its call date instead of full maturity. Because it is impossible to know when an issuer may call a bond, you can only estimate this calculation based on the bond’s coupon rate, the time until the first (or second) call date, and the market price.

An education savings bond program allows qualified taxpayers to exempt all or a portion of interest earned upon redemption of eligible savings bonds from their annual gross income. To qualify for this program, savings bonds must be Series EE or Series I bonds issued after 1989. The bonds become tax exempt when the owner uses both the principal and interest to pay for higher education at qualified institutions for himself, a spouse or a dependent.

The following rules apply in order for you to take advantage of the program:

1. The bond owner must be 24 years of age at the time of purchasing the bond. If a parent buys the bond for his or her child and puts it in the child’s name who is under 24 years of age, the bond does not qualify.

2. When the savings bonds are redeemed, all funds must be used toward higher education payments for the owner, his or her spouse or a dependent. The Internal Revenue Service, or IRS, only recognizes payments made to qualified institutions where the U.S. Department of Education has established student-aid programs. Funds can only be used towards tuition, including lab and course fees, and degree-required courses. Ineligible expenses include room and board, books, sports and recreational activities.

3. Funds from the redeemed bonds can also be used to make tax-free contributions to a Coverdell Education Savings Account.

4. Eligible education expenses must be incurred during the same tax year as the bond’s redemption.

5. Any nontaxable education payments, education aid or tax-free scholarships must be subtracted from eligible expenses.

6. If the total proceeds from the bonds are less than the amount of eligible expenses, all of the interest accrued on the bond remains tax-free. However, if the bond proceeds exceed the eligible expense amount, the amount of tax-exempt interest is subject to a prorated reduction.

7. The amount of interest eligible to be tax exempt is based on the owner’s modified adjusted gross income, or MAGI. If the owner’s MAGI reaches a certain threshold, he may not be eligible for the education savings bond program. For joint tax filers in 2013, that threshold was between $109,250 and $139,250. For single filers, the MAGI must fall between $72,850 and $87,850 to still take advantage of tax exemptions through the program. Married owners are required to file joint taxes to receive the exemption.

8. All payments made with bond proceeds must be reported to the IRS. This includes all receipts, bills or proofs of payment. It is also necessary to keep a detailed, itemized record of all bonds that are redeemed. The IRS has designed specific forms to be filled out when the education savings bond program is claimed on the owner’s taxes.