As an investment, bonds are riskier, but pay a higher interest rate, than money market funds, demand deposits or checkable deposits, but are safer than stocks, and usually less profitable, because they have no potential for growth.
Bonds are long-term debt or funded debt, issued by corporations, and governments and their agencies to finance operations or special projects. Corporations pay back interest and principal from earnings, whereas governments pay from taxes, or revenues from special projects. Unlike preferred stock, a corporation must pay interest on its bonds, and if the corporation goes bankrupt, bondholders are paid before stockholders.
All bonds have a par value, an interest rate, and a maturity date. The interest rate is often called the coupon rate, because many bond certificates have coupons that the bondholder must turn in to receive the interest. In a primary offering, the investor buys the bond for par value from the issuer. Periodically, the issuer pays interest to the investor, which is calculated by multiplying the par value by the interest rate divided by the number of payments in a year. Example: if the interest rate is 6% and the par value is $1,000, then the interest earned annually is $60. If the company pays interest semi-annually, which most do, then the bondholder will receive 2 payments of $30 every year until maturity. When the bond matures, then the current owner gets back the par value of the bond. In other words, the loan is paid off. Because the amount of interest the bond pays is fixed, bonds are a type of fixed-income security.
Bonds can be classified as vanilla bonds (aka conventional bonds) — sometimes referred to verbosely as plain-vanilla bonds — which are bonds having only the basic characteristics, such as a fixed coupon rate and maturity date, and non-vanilla bonds (aka nonconventional bonds), which are bonds that have special characteristics, such as flexible maturity dates and interest rates.
Bond maturities vary widely. Long-term bonds mature in 10 to 30 years or more; intermediate bonds have maturity dates greater than 1 year, but less than 10 years; short-term bonds mature in a year or less. Generally, the longer the maturity date, the greater the interest rate for a given risk class. Such a relationship is sometimes called the term structure of interest rates.
The indenture, or deed of trust, is the legal agreement between the issuer and the bondholder, printed on the bond certificate, that specifies the duties and obligations of the trustee (usually a bank or trust company hired by the issuer), and the rights of the bondholder. The indenture specifies how and when the bond will be paid, the interest rate, the description of any collateral securing the loan, and what the bondholder needs to do if the corporation defaults. The trustee represents the bondholders in dealing with the bond issuer, and will bring suit if interest payments are not made.
Covenants are promises in the indenture, or other debt agreement, that cover certain contingencies, such as debt-equity ratios, dividends, working capital, and, increasingly, leveraged buyouts. Covenants are generally either restrictive or protective. For instance, a change-of-control covenant may require the issuer to pay par value for their bonds to current bondholders when the company is acquired in a leveraged buyout, which frequently degrades the credit quality of the acquired company, and therefore lowers the value of the company's outstanding bonds.
Ownership of Bonds
Bonds can be classified as to how ownership is determined.
Bearer bonds, or coupon bonds, have no name or other identifying information on them; interest and principal are paid to the bearer of the bond; hence the name. Because bearer bonds are highly negotiable, they were used in money laundering, so the Tax Act of 1982 ended any new issuance of bearer bonds, but they still exist because of their long lifespan—up to 30 years. They are called coupon bonds because the bond certificates have interest coupons attached to them, which are redeemed biannually at an authorized bank, which will also redeem the bond when it matures if presented.
Registered bonds are registered to the owner. Interest payments, and the principal when the bond matures, are paid to the registered owner by the company or its trustee. Some bonds — sometimes referred to as partially registered bonds — are registered, but also have interest coupons attached to them.
Book Entry Bonds
Book entry bonds have no certificate, ownership is tracked by computer. The U.S. Treasury, for instance, has used this method of determining ownership since 1986. Eventually, because of its low cost and easy record access, all ownership will probably be tracked this way.
Naturally, corporate bonds are issued by corporations, which can be classified as either secured or unsecured. Secured bonds, or asset-backed bonds, are backed by assets of the corporation, such as real estate or equipment. The safety of unsecured bonds, called debentures, depends on the creditworthiness of the issuer. (Confusing as it is, in the UK, a debenture is a secured bond.)
Most corporate bonds correspond to 3 major market sectors:
- Industrials or cyclicals, which constitutes the largest sector;
- publics utilities; and
- banking and finance companies.
Mortgage bonds are secured by real estate.
Equipment Trust Certificate and Serial Bonds
The equipment trust certificate is a bond secured by equipment, frequently issued by railroads and other transportation companies. A down payment is made on the equipment by the corporation, which then issues equipment trust certificates to finance the rest. The certificate holder receives both principal and interest every year until maturity. Often these bonds are issued as serial bonds, which are bonds of the same type, but mature at regular intervals as the collateral depreciates.
Collateral Trust Certificate
Collateral trust certificates are secured by other securities that the corporation owns, which may be the corporation's own securities, or of other companies. These securities are deposited into a trust for the benefit of the bondholders. The safety of these bonds is related to the safety of the underlying securities.
These bonds are insured by another company, or the parent company. Although these bonds are not risk-free, default risk is reduced since both companies would have to default.
In the US, a debenture is a bond that is not secured by any property. Its safety depends on the assets and earning power of the issuer. Thus, debentures are not as safe as other bonds from the same company, but will usually pay a higher interest rate to compensate for the added risk. Debentures issued in the UK, however, are safer because they are secured by collateral.
Income Bonds (Adjustment Bonds)
Not a good investment for regular income, these bonds pay interest if earned, and only to the extent of earnings, up to a maximum. These bonds are usually issued by bankrupt companies reorganizing. These are the only bonds where nonpayment of interest does not lead to an immediate default, so they must generally pay higher interest rates.
Government bonds are issued by governments or their subdivisions to finance current operating expenses or specific projects. Since governments have the right to tax people and businesses within their jurisdiction and because most government bonds also enjoy some tax advantages, government bonds generally pay a lower interest rate than corporate bonds. The 2 major types of government bonds issued within the United States are municipal bonds and US government securities.
Municipal Government Bonds (Munis)
Municipal bonds are issued by municipalities for immediate funds and to finance specific projects. Most municipal bonds are exempt from federal taxes and from state and local taxes, if the bond was issued by a municipality within the taxpayer's state. Because of the tax exemption, and because of their relative safety, municipal bonds generally pay the lowest interest rates.
Some municipal bonds, when they are not backed by the taxing power of the municipality, are insured. In the event of a default, the insurance company pays the par value of the bond. Insured bonds, because of their lower risk, generally have a lower yield than uninsured bonds.
Federal Government Securities
All federal government securities are considered quite safe, and therefore, usually have no credit rating. U.S. government securities are generally exempt from state and local taxes, but not federal taxes. While most government issues trade in the capital markets, notes that mature in a year or less are traded in the money markets. Almost all federal securities, including savings bonds, can be bought at the U.S. Treasury's new website, http://treasurydirect.gov commission-free. Ownership is determined by book-entry only, except for some savings bonds, but even these are moving more to book-entry ownership. There is more flexibility in book-entry ownership. For instance, if you buy the I bonds in certificate form, you must buy them in specific denominations that range from $50 up to $10,000, but with book-entry, you can specify any amount of $25 or more. So if you want to buy a bond for $47.17, you can.
U.S. Government Savings Bonds are the most widely held federal security, but cannot be traded. Paper bonds are issued at half of their face value, book-entry bonds are issued at face value, which can be any amount that is at least $25. However, for both paper and book-entry, $30,000 is the maximum amount that can be purchased. Savings bonds can be redeemed before the maturity date, but not before 1 year, and a penalty of 3 months' interest applies, if redeemed before 5 years. Federal taxes are assessed after redemption, and there are no state or local income tax on interest, but there may be federal, state, and local inheritance, estate, and gift taxes due, if applicable.
U.S. Treasury Bills (T-Bills) are direct obligations of the U.S. government, and are highly liquid. Issued weekly to a competitive bidding process, they mature in 4, 13, or 26 weeks. They pay no interest and, unlike bonds and notes, have no specified interest rate. They are always sold at a discount. (Example: $10,000 worth of T-Bills may sell for $9,750.)
U.S. Treasury Notes pay semi-annual interest on the stated par value of the note; the par value is paid when the note matures in 1 to 10 years.
U.S. Treasury Bonds pay semi-annual interest, and mature in 10 to 30 years. 30 year bonds are usually callable after 25 years.
U.S. Treasury STRIPS (Separately Traded Registered Interest and Principal Securities, also called Treasury Receipts) are so called because the interest is stripped from the principal. STRIPS are sold in 2 parts, 1 part being the semiannual interest that is paid for 20 to 30 years, the other being the principal, which is sold at a discount—in essence, making it a zero coupon bond.
U.S. Federal Agency Securities
U.S. Federal Agency Securities are issued by U.S. Government Sponsored Agencies (GSEs) authorized by Congress to issue debt securities for their financial needs. They do not have the direct backing of the U.S. Treasury, but are considered moral obligations of the government. Like other federal securities, the interest from these bonds are exempt from state and local taxes, but not federal tax.
The main agencies issuing debt are the Federal Farm Credit Banks and the Federal Home Loan Banks (FHLB). Federal Home Loan Banks, operating under the Federal Home Loan Bank board, consists of most of the nation's Savings and Loans banks. The FHLB board borrows money by issuing bonds of various maturities, then lends the money to S&L banks, which then lend the money, which includes deposits from banking customers, to home buyers.
There are 2 other GSE's that service the home mortgage market: Fannie Mae and Freddie Mac. The Federal National Mortgage Association (Fannie Mae) was a government-owned corporation, created in 1938, to help low- and middle-income people buy homes. Fannie Mae buys and sells real estate mortgages that are insured by the Federal Housing Administration or guaranteed by the Veterans Administration. It sells unsecured bonds and notes, and mortgage-backed bonds, which are issued at par and pays semiannual interest. Ironically, interest and principal payments from unsecured notes and bonds have priority over mortgaged-backed bonds. Privatized in 1968, equity shares of Fannie Mae were traded on the New York Stock Exchange until 2007.
The Federal Home Loan Mortgage Corporation (FHLMC), otherwise known as Freddie Mac, was a GSE similar to Fannie Mae. However, during the credit crisis of 2007, both Fannie Mae and Freddie Mac became insolvent because of overleveraging and of guaranteeing securities based on subprime loans. As a result, both were placed under the conservatorship of the Federal Finance Housing Agency.
Government National Mortgage Association (GNMA)
The income from Ginnie Maes (also called Ginnie Mae Pass-Throughs), which are pass-through certificates, comes from a pool of mortgage payments. Mortgage holders pay their monthly mortgage to the institution, usually a bank, that originated the loan. The bank then deducts a small percentage, about ½%, and passes the rest to the Ginnie Mae investors. Payments are guaranteed by Ginnie Mae. The mortgages are FHA insured, or guaranteed by the VA or the Farmers Home Administration. The monthly payments consist of principal and interest, have a minimum denomination of $25,000 and are backed by the federal government. Earned interest is taxed.
Real Estate Mortgage Investment Conduits
Real Estate Mortgage Investment Conduits (REMICs) can be corporations, partnerships, or trusts that issue mortgage-backed securities of different classes, with different principal balances, interest rates, average lives, prepayment characteristics, final maturities, different yields and different risks, thus creating a more diverse set of securities with different risk profiles for investors. The Tax Reform Act of 1986 established the legal basis of REMICs, which eliminated double taxation from these securities. Unlike traditional pass-throughs, principal and interest payments are not passed through to investors pro rata, but are divided into classes with different priorities — thereby creating different risk profiles — to the payment streams. The underlying assets of REMIC securities can be either other MBS's or whole mortgage loans.
Student Loan Marketing Association (Sallie Mae)
Sallie Mae was originally created in 1972 as a government-sponsored entity (GSE), but it started privatizing its operations in 1997, completing the process by 2004 year-end, and offered its stock for public trading. Sallie Mae provides liquidity for private lenders participating in the federal Guaranteed Student Loan Program, supplemental programs, the Health Education Assistance Loan Program or the PLUS loan program for parents of undergraduates.
Sallie Mae issues unsecured debt as discount notes, floating-rate notes, long-term fixed-rate securities, and zero coupon bonds. The interest is exempt from state and local taxes.
The company primarily provides federally guaranteed student loans originated under the Federal Family Education Loan Program (FFELP), offering comprehensive information and resources to assist students, parents and guidance professionals with the financial aid process.
Bond Ratings and Credit risk
How much interest a bond has to pay in order to sell depends not only on prevailing interest rates, but also upon the issuer's credit rating, which is an independent assessment by a credit rating agency of the issuer's credit risk, the risk that the investor may suffer losses because of the issuer's insolvency, or inability to pay the interest and principal. Bonds with higher credit risk must pay higher yields to be attractive to investors.
The 5 major services that rate bonds are S&P, Moody's, Fitch, A.M. Best, and Dominion Bond Rating Service, and are the 5 nationally recognized statistical rating organizations (NRSRO) selected by the Securities and Exchange Commission. Standard & Poor's ratings range from AAA for the highest quality bonds to D, which are bonds in default. Moody's rating system is slightly different, ranging from Aaa for the highest quality down to the lowest rating of C, which characterizes bonds of little or no value. The other rating agencies have similar ratings. All bonds rated BBB or above by Standard & Poor or Baa or above by Moody are considered investment grade; bonds with lower ratings are considered speculative grade, which pays higher interest rates for the higher risk of loss — thus, these bonds are sometimes referred to as high-yield bonds. Bonds with ratings that begin with C or below are referred to as junk bonds, because of their high risk of default. Junk bonds also pay the highest interest rate. Financial institutions and trustees are generally restricted to purchasing investment grade bonds.
Some bonds are not rated because the issuer doesn't want to pay for a rating or because the issuer's credit history is insufficient for a reliable credit rating. Any bond or note backed by the U.S. Treasury is not rated because such securities are considered free of credit risk, since the US can print money, if necessary.
Issuers of municipal bonds can buy insurance for their investors from bond-insuring companies, who will guarantee payment in case of default. Such bonds generally receive the highest ratings from the credit rating services.
Investor Alert! Note that credit ratings are not foolproof. Enron had an investment-grade rating right up until it declared bankruptcy, and WorldCom up to 3 months before filing for bankruptcy!
It's also a good idea to check all of the credit-rating agencies about a particular issuer, because different agencies have different criteria, and different strengths and weaknesses in rating bond issuers.
The return of a bond is largely determined by its interest rate, which, in turn, is determined by the prevailing interest rate and the creditworthiness of the issuer, assessed by credit rating companies, such as Standard & Poor's and Moody's. A higher credit rating allows the issuer to sell its bonds for a higher price, i.e. at a lower interest rate.
Nominal yield, or the coupon rate, is the stated interest rate of the bond, which is a percentage of par value, which, in most cases, is $5,000 for municipal bonds and $1,000 for all other bonds. The coupon is usually paid semiannually. Thus, a bond that pays 6% interest pays $60 dollars per year in 2 semi-annual payments of $30. The return of a bond is the return/investment, or in the example just cited, $60/$1,000 = 6%.
Bonds trading in the secondary market will usually have prices that are less or more than par value, thus yielding an interest rate that differs from the nominal yield, called the current yield, or current return. So the price of bonds moves in the opposite direction of interest rates.
|Current Yield||=||Annual Interest Payment|
Current Market Price of Bond
|Current Yield Example|
|$60 Annual Interest Payment|
$800 for Bond
|=||8% Current Yield|
Because current bond prices fluctuate, an investor can pay more or less than the par value for a bond. If the investor holds the bond until maturity, he will lose money if he paid a premium for the bond, and he will earn money if he paid for it at a discount. The yield-to-maturity, or true yield, of a bond that is held to maturity will have to account for the gain or loss that occurs when the par value is repaid. The formula for yield to maturity is complicated and difficult to solve, but it generally will yield an interest rate comparable to newly issued bonds with the same credit rating. The following formula provides an approximation:
|=|| AIP + (PV - CBP)/Years|
- AIP = Annual Interest Payment
- PV = Par Value
- CBP = Current Bond Price
- Years = Number of Years until Maturity
|$60 + ($1,000 - $800)/3|
($1,000 + $800)/2
When a bond is bought at a discount, yield to maturity will be greater than the current yield; bought at a premium, the yield to maturity will be less.
Zero coupon bonds pay no interest, but are sold at a discount to par value, which is paid when the bond matures.
When looking at bond quotes, you will notice that most of them hover around 100. Each bond point = $10; therefore, to get the actual bond price, you must multiply the quote by 10. Thus, a bond quote of 94.25 = an actual price of $942.50.
Federal government and agency bonds are also quoted in points of $10 each. Here's a quote for a 91 day Treasury Bill: 97.970194. T-Bills are sold at a discount, so to buy this, you would have to pay $979.70, and you would get $1,000 back when the Bill matures in 91 days. If you wanted to buy 1,000 T-Bills at this price, you would have to multiply this quote by 10,000 for a total cost of $979,701.94, then you would receive $1,000,000 back in 91 days.
Current Bond Rates, Bond Screener
Repayment of Principal
The principal of a term bond is paid when the term ends. Term bonds have only 1 maturity.
Some bond issues have serial maturities—the bonds are the same except for different maturity dates, and bonds with longer maturities have a higher interest rate. Bonds with serial maturities are not callable. Equipment Trust Certificates are generally issued this way so that the principal remaining to be paid will have lesser value than the depreciating assets backing them up. Some municipal bonds are also issued with serial maturities.
A balloon maturity combines features of term and serial maturities. A portion of the principal, along with interest, is paid each year until the final year, when the remaining principal, or balloon, payment is made.
Some bonds are never callable: equipment trust certificates, FNMAs, and FHLBs. Most bonds, however, provide a callable provision that allows the issuer to refinance if interest rates decline.
When interest rates rise, bond prices go down. If a company wanted to retire its debt, it could do so by buying its bonds in the open market for less money than it would have to pay when the bond matures. If a company has the free cash, it would be advantageous for it to do this. If the bond issue doesn't have a large trading volume, the company may publish a tender offer in a major newspaper, such as the Wall Street Journal, at a slightly higher price than the current market price to motivate the bondholders to sell back the bonds to the company. The tender offer may be for all of an issue, or only part of it. If the company only wants to buy some of them back, then it will buy from those who sell first, until the company has fulfilled its goal.
When interest rates decline, the price of bonds go up. It would not be profitable for the company to buy back its bonds on the open market, because it will have to pay more than par value, the value that the company would have to pay when the bond matures. However, if the bond is callable, then the company can sell new bonds at the prevailing lower interest rate, and use that money to call back the higher interest bonds, in effect, refinancing their debt for a lower cost, which in bond parlance is known as refunding. Whether a bond is callable is stated in the indenture, and includes a schedule of when the bond can be called and at what price, specified as a percentage of par value. Generally, the sooner the bond is called, the more the company pays over par value. This call premium is to compensate the investor for losing his investment earlier than anticipated.
When a bond is called, it ceases to pay interest after the call date. However, a bond cannot be called until a certain amount of time has elapsed, specified in the indenture, and when it is called, usually a premium is paid — the call premium, which decreases yearly — to compensate the investor for the shorten maturity. After all, a bond will be called when interest rates have declined and bond prices have risen, a time when the bondholder of a high yielding bond is getting good interest and can sell at a high price. But this is the risk in buying high yielding, callable bonds in times of low interest rates. If the bond is called, not only do interest payments stop, but the call premium may be less than what the bond would get on the open market. Thus, before paying a premium for a bond, it would be wise to check the call specifics.
How Bonds are Called
Bonds all have unique CUSIP alphanumeric identifiers. When only some of the bonds are called, bond identifiers are selected randomly, and the bondholders are notified. When issuers can choose when to call a bond, that is an optional call. When the issuer provides a sinking fund to retire debt, how much and when is specified in the indenture, and thus, it is a mandatory call. Many bonds, especially municipal bonds, fund specific projects, and the interest and principal are paid from money earned by the project, such as the tolls collected by a bridge. If the bridge is destroyed, no more money can be collected, so an extraordinary call, or catastrophe call is made. Insurance covering the project pays the bondholders off.
Rather than refunding to pay back principal, some bond issuers establish a sinking fund — an escrow account — in which the issuer deposits periodic payments to retire some bonds regularly. If interest rates are rising, the fund will purchase the bonds in the open market; if rates are decreasing, then the bonds will be called.
Pre-refunding usually occurs when there is a call protection period and prevailing interest rates are low. Pre-refunding allows a lower rate to be locked in by issuing the new bonds before the call date of the original bonds. Pre-refunding can also be used to lock in lower rates on noncallable bonds, using an escrow account. These bonds are said to be escrowed to maturity. Usually, the entire issue is refunded at once and is common for bonds approaching maturity. A company may refund if it does not have the money to pay for the entire issue or may decide to use its cash for other needs.
When a bond issue is pre-refunded, a new issue is sold at a lower coupon rate before the original bond issue can be called, which locks in a favorable interest rate. The proceeds from the new issue are placed in an escrow account and invested in US government securities, and the interest received from those investments are used to pay interest on the original or pre-refunded bonds, called at the 1st call date using the escrowed funds. Pre-refunded bonds are generally rated AAA or Aaa. The advance refunding terminates the issuer's original obligation, call defeasance, so the pre-refunded bonds are no longer considered outstanding debt of the issuer.
Special bonds have additional characteristics that differentiate them from other bonds.
Convertible bonds, usually debentures, can be converted into common stock of the corporate issuer at the discretion of the investor. Either the number of shares or the share price is specified in the indenture. The number of shares of stock that each bond can be converted to is known as the conversion ratio. Thus, a bond that can be converted into 10 shares of stock has a conversion ratio of 10 to 1. If the share price is specified in the indenture instead of the number of shares, then the conversion ratio can be found by dividing the par value of the bond—$1,000—by the share price. Thus, if a share price of $20 is specified, then the conversion ratio is $1,000/$20 = 50 shares.
Some bonds specify different conversion ratios, or different conversion prices, for different time periods. For instance, the indenture may say that in the first 10 years, the bond may be converted to 20 shares; afterwards, 40 shares. There is also an anti-dilutive provision where the conversion ratio or conversion price is changed to reflect any stock splits or stock dividends.
The convertibility factor, like many special bond features, lowers the interest rate that the corporation would otherwise have to pay without this feature, and it appeals to investors who want current income, but would like to take advantage of any growth in the corporation. Because convertible bonds are callable, the conversion can be forced by the company if bond prices drop. This eliminates debt and interest payments for the company.
The advantages of convertible bonds to an investor is that it offers appreciation potential if the company does well, and its stock rises; but, if the company suffers, and the stock price declines, the investor can still keep the bond as a bond, and collect interest and principal, or sell it, based on the interest that it pays. If the company ever goes bankrupt, the bondholder will have superior claims over any stockholder.
The disadvantages include a lower interest rate, and the possibility that the bond will be called prior to conversion, or even before when it can be converted, since some bonds restrict conversions to certain time frames.
Advanced Refunded Bonds
Advanced refunded bonds, or pre-refunded bonds, are usually municipal bonds. New bonds, called refunding bonds, are issued to buy Treasuries at a higher interest than the municipal bonds, which are then used to retire the debt of the original bond issue as they mature. Thus, the pre-refunded bonds are no longer backed by the pledge of the municipal issuer. However, because the bonds are now backed by Treasuries, they are considered risk-free.
Catastrophe bonds (frequently shortened to cats), first marketed in the 1990's in response to Hurricane Andrew and the earthquake in Northridge, California, are issued by insurance companies to cover catastrophes such as windstorms in Europe and earthquakes in Japan, but the majority cover hurricanes in the United States. It is a means by which insurance companies can transfer their risk. Reinsurance is not readily available for such disasters, and, in the event of a disaster, insurance companies get their money faster from catastrophe bonds than they do from reinsurance. Another advantage of bonds over reinsurance is that the issuer can get coverage over several years.
The risks of catastrophe bonds are hard to assess because their ratings are often based on a model portfolio rather than actual risks, which, in any case, is very difficult to forecast.
Catastrophe bonds are attractive to investors because, since it is possible to lose the entire principal from a disaster, they pay very high yields, and they don't correlate with stocks or even with other bonds, thereby providing diversification.
Some municipal and corporate bonds have a put option, stated in the indenture, that allows the investor to require the issuer to buy back the bond at par value before the maturity date, which makes the bonds more attractive to investors in times when interest rates may rise, forcing the price of bonds down, or when the credit rating of the company or municipality deteriorates, causing the price of the bonds in the secondary market to decline.
Shariah is the law of Islam and it bans usury and interest payments—consequently, it also bans bonds. So that Muslim countries can benefit from international investment, and so international investors can invest in projects in Muslim countries, variations of the typical bond have been financially engineered to work somewhat like bonds, but still be compliant with Shariah—thus, they are called Islamic bonds (aka sukuk).
One such structured product is the lease-back, or ijarah, structure. If a company wanted to raise money to build a plant, for instance, using this method, it would set up a special entity specifically for this project that would buy the plant. Investors would lend money to the special entity, in return for lease payments, in lieu of interest, for the term of the deal. At the end of the term, the principal is returned to investors, and the project becomes the property of the company.
Another way to avoid paying interest, at least in name, is to form a joint venture called a musharakah. The joint venture partners buy Islamic bonds and receive a percentage of profits over the term of the loan.
Malaysia has used the deferred payment sale principle of bai' bithaman ajil. A bank buys an asset on behalf of a customer, then sells it back later for a profit. However, bai' bithaman ajil, is not acceptable to the Middle East, which has a different interpretation of Shariah, so Malaysia has been promoting financial structures that are globally compliant and can be included in the global Shariah stock indexes. Standardization also helps to reduce the cost of developing and marketing Islamic bonds.
To gauge the safety of Islamic bonds, the Islamic International Rating Agency has developed the credit-rating Shariah Quality Ratings. However, there is political risk with these bonds, since the laws of many of these countries that issue sukuk are not clear in cases of default by the issuer, as recently evinced by the Dubai crisis. The rules governing the priority of repayment of the sukuk holders in cases of default is not consistent, and, in many cases, a plaintiff must first get permission from the government to bring a court case against a government-owned issuer.
Investment Alert: Before you buy any Islamic bonds, you might want to read this NYT article: Dubai Crisis Tests Laws of Islamic Financing.