A number of different kinds of bonds offer variations on this basic formula. Some types of bonds provide alternative interest structures. A zero-coupon bond does not make periodic interest payments. The bondholder realizes interest by buying the bond substantially below its face value. A floating-rate bond has an interest rate that is changed periodically according to an established formula. There also may be provisions that allow either the issuer or the bondholder to alter a bond's maturity date. A callable bond entitles the issuer to pay off the principal prior to the stated maturity date. Similarly, the owner of a putable bond can force the issuer to pay off the principal before the maturity date. A convertible bond gives the bondholder the right to exchange the bond for shares of the issuer's common stock at a specified date.
Friday, August 14, 2009
ISSUING BONDS
Bond issuers can sell bonds directly through an auction process or use investment banking services. The investment banker buys the bonds from the issuer and then sells them to the public.
Corporate bonds are issued by private utilities, transportation companies, industrial enterprises, or banks and finance companies. These corporate bonds can be divided into two additional categories: mortgage bonds, which are secured by the issuer's assets, and debentures, which are backed only by the issuer's credit. Most companies try to establish a financial structure based on a combination of stocks, representing distributed ownership, and bonds, representing debt obligations. A company that raises funds by issuing bonds is said to be leveraged. Because bondholders are paid at a set rate regardless of profits, this approach increases the potential for profit to stockholders but also increases the level of financial risk.
The U.S. government issues bonds through the Department of the Treasury. These bonds, known as government securities, are backed by the unlimited taxing power of the federal government. Federal agencies and government-sponsored enterprises also issue bonds of their own. Generally, all of these federal bonds are considered to be among the safest investments.
Municipal bonds are issued by state and local governments and other public entities, such as colleges and universities, hospitals, power authorities, resource recovery projects, toll roads, and gas and water utilities. Municipal bonds are often attractive to investors because the interest is exempt from federal income taxes and some local taxes. There are two types of municipal bonds: general obligation bonds and revenue bonds. Like a government security, a general obligation municipal bond is secured by the issuer's taxing power. Revenue bonds are used to finance a particular project or enterprise. Income generated by the project provides funds to pay interest to bondholders.
Corporate bonds are issued by private utilities, transportation companies, industrial enterprises, or banks and finance companies. These corporate bonds can be divided into two additional categories: mortgage bonds, which are secured by the issuer's assets, and debentures, which are backed only by the issuer's credit. Most companies try to establish a financial structure based on a combination of stocks, representing distributed ownership, and bonds, representing debt obligations. A company that raises funds by issuing bonds is said to be leveraged. Because bondholders are paid at a set rate regardless of profits, this approach increases the potential for profit to stockholders but also increases the level of financial risk.
The U.S. government issues bonds through the Department of the Treasury. These bonds, known as government securities, are backed by the unlimited taxing power of the federal government. Federal agencies and government-sponsored enterprises also issue bonds of their own. Generally, all of these federal bonds are considered to be among the safest investments.
Municipal bonds are issued by state and local governments and other public entities, such as colleges and universities, hospitals, power authorities, resource recovery projects, toll roads, and gas and water utilities. Municipal bonds are often attractive to investors because the interest is exempt from federal income taxes and some local taxes. There are two types of municipal bonds: general obligation bonds and revenue bonds. Like a government security, a general obligation municipal bond is secured by the issuer's taxing power. Revenue bonds are used to finance a particular project or enterprise. Income generated by the project provides funds to pay interest to bondholders.
INVESTING IN BONDS
From an investor's perspective, stocks offer a higher potential return if profits rise, but bonds are generally a safer investment. Stock dividends are paid out of company profits, while bond interest payments are made even if the company is losing money. If a corporation goes bankrupt, bondholders must be paid before stockholders. Nonetheless, risks are associated with investing in bonds. Because most bonds offer a fixed rate of return, a bond with a low coupon rate will be less valuable if interest rates rise to the point that the investor's money could be more profitably invested elsewhere. If the inflation rate rises in relation to the coupon rate, the value of the investor's return will be reduced.
The value of bonds also will vary due to changes in the default risk, or credit rating, of bond issuers. If the issuer of the bond is unable to make timely principal and interest payments, the issuer is said to be in default. Bonds issued by the U.S. government and by most federally related institutions are considered free of default risk. For other issuers, the risk of default is gauged by credit ratings assigned by four nationally recognized rating companies: Moody's Investor's Service, Standard and Poor's Corporation, Duff & Phelps Credit Rating Company, and Fitch Investors Service. Bonds that these rating companies place in the highest categories are known as investment-grade bonds. Bonds that are not assigned an investment grade rating are called junk bonds. These bonds have a higher degree of credit risk but also offer a higher potential yield.
The value of bonds also will vary due to changes in the default risk, or credit rating, of bond issuers. If the issuer of the bond is unable to make timely principal and interest payments, the issuer is said to be in default. Bonds issued by the U.S. government and by most federally related institutions are considered free of default risk. For other issuers, the risk of default is gauged by credit ratings assigned by four nationally recognized rating companies: Moody's Investor's Service, Standard and Poor's Corporation, Duff & Phelps Credit Rating Company, and Fitch Investors Service. Bonds that these rating companies place in the highest categories are known as investment-grade bonds. Bonds that are not assigned an investment grade rating are called junk bonds. These bonds have a higher degree of credit risk but also offer a higher potential yield.
Taxes
Taxation, system of raising money to finance government. All governments require payments of money—taxes—from people. Governments use tax revenues to pay soldiers and police, to build dams and roads, to operate schools and hospitals, to provide food to the poor and medical care to the elderly, and for hundreds of other purposes. Without taxes to fund its activities, government could not exist.
Throughout history, people have debated the amount and kinds of taxes that a government should impose, as well as how it should distribute the burden of those taxes across society. Unpopular taxes have caused public protests, riots, and even revolutions. In political campaigns, candidates’ views on taxation may partly determine their popularity with voters.
Throughout history, people have debated the amount and kinds of taxes that a government should impose, as well as how it should distribute the burden of those taxes across society. Unpopular taxes have caused public protests, riots, and even revolutions. In political campaigns, candidates’ views on taxation may partly determine their popularity with voters.
TYPES OF TAXES
Governments impose many types of taxes. In most developed countries, individuals pay income taxes when they earn money, consumption taxes when they spend it, property taxes when they own a home or land, and in some cases estate taxes when they die. In the United States, federal, state, and local governments all collect taxes.
Taxes on people’s incomes play critical roles in the revenue systems of all developed countries. In the United States, personal income taxation is the single largest source of revenue for the federal government. In 2001 it accounted for about 50 percent of all federal revenues. Payroll taxes, which are used to finance social insurance programs such as Social Security and Medicare, account for almost a third of federal revenues. The United States also taxes the incomes of corporations. In 2001 corporate income taxation accounted for 10 percent of federal revenues.
Taxes on people’s incomes play critical roles in the revenue systems of all developed countries. In the United States, personal income taxation is the single largest source of revenue for the federal government. In 2001 it accounted for about 50 percent of all federal revenues. Payroll taxes, which are used to finance social insurance programs such as Social Security and Medicare, account for almost a third of federal revenues. The United States also taxes the incomes of corporations. In 2001 corporate income taxation accounted for 10 percent of federal revenues.
Individual Income Tax
An individual income tax, also called a personal income tax, is a tax on a person’s income. Income includes wages, salaries, and other earnings from one’s occupation; interest earned by savings accounts and certain types of bonds; rents (earnings from rented properties); royalties earned on sales of patented or copyrighted items, such as inventions and books; and dividends from stock. Income also includes capital gains, which are profits from the sale of stock, real estate, or other investments whose value has increased over time.
Corporate Income Tax
All corporations in the United States and Canada must pay tax on their net income (profits) to the federal government and also to most state or provincial governments. U.S. corporate tax rates generally increase with income. For example, in 2001 corporations with profits of up to $50,000 paid 15 percent in taxes, whereas corporations with profits greater than about $18.3 million were taxed at a flat rate of 35 percent. In Canada the basic rate for corporations was 28 percent in 2000. In 2001 corporate income taxes accounted for about 10 percent of all federal tax revenues in the United States and about 13 percent of all federal tax revenues in Canada.
The corporate income tax is one of the most controversial types of taxes. Although the law treats corporations as if they have an independent ability to pay a tax, many economists note that only real people—such as the shareholders who own corporations—can bear a tax burden. In addition, the corporate income tax leads to double taxation of corporate income. Income is taxed once when it is earned by the corporation, and a second time when it is paid out to shareholders in the form of dividends. Thus, corporate income faces a higher tax burden than income earned by individuals or by other types of businesses.
Some economists have proposed abolishing the corporate income tax and instead taxing the owners of corporations (shareholders) through the personal income tax. Other students of the tax system see the corporate income tax as the price corporations pay in return for special privileges from society. The most important of these privileges is limited liability for shareholders. This means that creditors cannot claim the personal assets of shareholders, because the liability of shareholders for the corporation’s debts is limited to the amount they have invested in the corporation.
The corporate income tax is one of the most controversial types of taxes. Although the law treats corporations as if they have an independent ability to pay a tax, many economists note that only real people—such as the shareholders who own corporations—can bear a tax burden. In addition, the corporate income tax leads to double taxation of corporate income. Income is taxed once when it is earned by the corporation, and a second time when it is paid out to shareholders in the form of dividends. Thus, corporate income faces a higher tax burden than income earned by individuals or by other types of businesses.
Some economists have proposed abolishing the corporate income tax and instead taxing the owners of corporations (shareholders) through the personal income tax. Other students of the tax system see the corporate income tax as the price corporations pay in return for special privileges from society. The most important of these privileges is limited liability for shareholders. This means that creditors cannot claim the personal assets of shareholders, because the liability of shareholders for the corporation’s debts is limited to the amount they have invested in the corporation.
Payroll Tax
Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and salaries. Employers automatically withhold payroll taxes from employees’ wages and forward them to the government. Payroll taxes are the main sources of funding for various social insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and disabled. In 2001 payroll taxes accounted for about 32 percent of all federal tax revenues in the United States; in Canada, the figure was 21 percent. For most people, payroll taxes are the second-largest tax they must pay each year, after individual income taxes.
The U.S. federal government levies the social security payroll tax at a flat 12.4 percent rate on employees’ annual gross wages up to a certain limit. The limit, which was $80,400 in 2001, rises each year at the same rate as the growth in average wages. The government imposes no payroll tax on earnings above the limit. Employers pay half the tax and employees pay the other half. The Medicare payroll tax is 2.9 percent of all earnings, with no cap. Again, employers and employees split the cost of the tax. Self-employed individuals must pay the entire payroll tax.
Although the legislators who set up payroll taxes intended to divide the tax burden equally between employers and employees, this may not occur in practice. Some economists believe that the tax causes employers to offer lower pretax wages to employees than they would otherwise, in effect shifting the tax burden entirely to employees.
The U.S. federal government levies the social security payroll tax at a flat 12.4 percent rate on employees’ annual gross wages up to a certain limit. The limit, which was $80,400 in 2001, rises each year at the same rate as the growth in average wages. The government imposes no payroll tax on earnings above the limit. Employers pay half the tax and employees pay the other half. The Medicare payroll tax is 2.9 percent of all earnings, with no cap. Again, employers and employees split the cost of the tax. Self-employed individuals must pay the entire payroll tax.
Although the legislators who set up payroll taxes intended to divide the tax burden equally between employers and employees, this may not occur in practice. Some economists believe that the tax causes employers to offer lower pretax wages to employees than they would otherwise, in effect shifting the tax burden entirely to employees.
Consumption Taxes
Consumption Taxes
A consumption tax is a tax levied on sales of goods or services. The most important kinds of consumption taxes are general sales taxes, excise taxes, value-added taxes, and tariffs.
General Sales Taxes
A general sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services. In the United States, most states and many local governments have a general sales tax. The country has no national general sales tax. State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent. In Canada, all provinces except Alberta impose a general sales tax on goods. In some provinces, the provincial sales tax and the federal goods and services tax (GST) are combined into a single tax known as the harmonized sales tax (HST). Local governments in Canada do not have the authority to impose general sales taxes.
Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers (for more information, see the Effects of Taxes section of this article). Most states exempt certain necessities from sales tax, such as basic groceries and prescription drugs. Both individuals and businesses pay sales tax.
A consumption tax is a tax levied on sales of goods or services. The most important kinds of consumption taxes are general sales taxes, excise taxes, value-added taxes, and tariffs.
General Sales Taxes
A general sales tax imposes the same tax rate on a wide variety of goods and, in some cases, services. In the United States, most states and many local governments have a general sales tax. The country has no national general sales tax. State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent. In Canada, all provinces except Alberta impose a general sales tax on goods. In some provinces, the provincial sales tax and the federal goods and services tax (GST) are combined into a single tax known as the harmonized sales tax (HST). Local governments in Canada do not have the authority to impose general sales taxes.
Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers (for more information, see the Effects of Taxes section of this article). Most states exempt certain necessities from sales tax, such as basic groceries and prescription drugs. Both individuals and businesses pay sales tax.
Excise Taxes
Federal, state, and local governments levy excise taxes, which are sales taxes on specific goods or services. Excise taxes are also called selective sales taxes. Goods subject to excise taxes in the United States and Canada include tobacco products, alcoholic beverages, gasoline, and some luxury items. Excise taxes are applied either on a per unit basis, such as per package of cigarettes or per liter or gallon of gasoline, or as a fixed percentage of the sales price.
Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a city might approve a tax on hotel rooms to help pay for a new convention center. Some national governments impose an excise tax on airline tickets to help pay for airport improvements. Revenues from gasoline taxes typically pay for highway construction and improvements. Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and alcoholic beverages, are commonly known as “sin taxes.”
Another type of excise tax is the license tax. Most states require people to buy licenses to engage in certain activities, such as hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic beverages.
Governments sometimes levy excise taxes to pay for specific projects. For example, voters in a city might approve a tax on hotel rooms to help pay for a new convention center. Some national governments impose an excise tax on airline tickets to help pay for airport improvements. Revenues from gasoline taxes typically pay for highway construction and improvements. Excise taxes designed to limit consumption of a commodity, such as taxes on cigarettes and alcoholic beverages, are commonly known as “sin taxes.”
Another type of excise tax is the license tax. Most states require people to buy licenses to engage in certain activities, such as hunting and fishing, operating a motor vehicle, owning a business, and selling alcoholic beverages.
Value-Added Tax
In Canada and Europe the favored form of consumption taxation is a value-added tax (VAT). In this system, the seller pays the government a percentage of the value added to goods or services at each stage of production. The value added at each stage of production is the difference between the seller’s costs for materials and the selling price. In essence, a VAT is just a general sales tax that is collected at multiple stages.
In the production of apple pies, for example, the farmer grows apples and sells them to a baker, who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a consumer. At each stage, the producer adds value to the commodity by processing it with capital (machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer a VAT. However, they can each claim a credit to recover the tax they paid on purchases related to their commercial activities.
In the production of apple pies, for example, the farmer grows apples and sells them to a baker, who turns them into a pie. The baker sells the pie to a restaurant owner, who sells it to a consumer. At each stage, the producer adds value to the commodity by processing it with capital (machines) and labor. The farmer, the baker, and the restaurant owner each charge their customer a VAT. However, they can each claim a credit to recover the tax they paid on purchases related to their commercial activities.
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