Bonds are the primary instrument companies and governments use to borrow large sums over multi-year periods. Unlike bank loans, bonds are marketable securities — they can be traded between investors. Libby Chapter 10 covers bond mechanics from the issuer's perspective: how bonds are structured, what happens when a company issues a bond at exactly its face value, and the times-interest-earned ratio that tells you whether the company can actually service that debt.
A bond is a formal debt contract between a borrower (the issuer) and a lender (the bondholder). The issuer promises two things: (1) to pay periodic interest — called coupon payments — throughout the bond's life, and (2) to repay the entire principal at maturity. Unlike a bank loan, the bondholder can sell their claim to someone else in the bond market at any time.
| Term | Definition | Example | Where It Appears |
|---|---|---|---|
| Face value (par value) | The principal amount the issuer will repay at maturity; the denomination of the bond contract | $1,000 per bond | Balance sheet: Bonds Payable at face value |
| Coupon rate | Annual interest rate stated on the bond certificate, applied to face value to calculate the cash payment | 6% annual | Drives the cash interest payment — never changes |
| Coupon payment | Cash paid to bondholders = face value × coupon rate (often split semi-annually) | $1,000 × 6% = $60/yr, or $30 every 6 months | Cash flow statement: financing or operating |
| Maturity date | The date the issuer must repay the face value; bond life is typically 5–30 years | December 31, Year 5 | Balance sheet: current vs. long-term classification |
| Market (effective) rate | The interest rate investors demand in the current market for this risk level; may differ from coupon rate | Currently 8% for similar bonds | Determines whether bonds sell at par, discount, or premium |
The coupon rate is set when the bond is originally written and never changes. The market rate fluctuates daily based on central bank policy, inflation expectations, and the issuer's creditworthiness. When these two rates are equal, the bond sells at exactly face value (at par). When they diverge — which is most of the time — the bond sells above or below face value. This lesson covers the at-par case; Lesson 2 covers the premium and discount cases.
When the coupon rate exactly equals the market rate on the issue date, investors pay exactly face value. The math is clean: an investor paying $1,000 for a 6% coupon bond when the market demands 6% is getting exactly the return they require. No premium, no discount.
Bond Carrying Value — Discount and Premium Converge to Face Value at Maturity
Both bonds: $100M face value · 5-year maturity · Carrying value recorded at amortized cost
$112
$108
$104
$100
$96
$92
$88
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year
Premium Bond
Face Value
Discount Bond
Issue
$108M
$100M
$92M
1
$106.4M(−$1.6)
$100M
$93.5M(+$1.5)
2
$104.7M(−$1.7)
$100M
$95.1M(+$1.6)
3
$103M(−$1.7)
$100M
$96.8M(+$1.7)
4
$101.5M(−$1.5)
$100M
$98.4M(+$1.6)
5
$100M(−$1.5)
$100M
$100M(+$1.6)
Premium Bond — Coupon > Market Rate
Issued above face value ($108M). Premium amortized down each year. Annual interest expense on income statement is less than the coupon paid — the premium reduces effective cost.
Discount Bond — Coupon < Market Rate
Issued below face value ($92M). Discount amortized up each year. Annual interest expense on income statement is more than the coupon paid — the discount increases effective cost.
Figure 6.1 — Both bonds are issued at different prices but always repay $100M face value at maturity. The premium amortizes downward; the discount amortizes upward. Interest expense on the income statement reflects the effective yield rate, not the coupon rate.
Jan 1 Yr1: Issue. DR Cash $1,000,000 / CR Bonds Payable $1,000,000. Every Jun 30 and Dec 31: DR Interest Expense $30,000 / CR Cash $30,000 (semi-annual). Total interest over 5 years: $30,000 × 10 payments = $300,000. Dec 31 Yr5: DR Bonds Payable $1,000,000 / CR Cash $1,000,000. Bonds Payable balance = $0 after maturity.
Before a company issues bonds, creditors ask one fundamental question: can this company afford the interest? The times-interest-earned (TIE) ratio — also called interest coverage — answers it directly. It measures how many times operating profit covers the annual interest obligation:
| Component | Formula | Where to Find It | What It Means |
|---|---|---|---|
| Numerator: EBIT | Operating income (earnings before interest and taxes) | Income statement, before interest expense line | What the company earns from operations before paying its lenders or the government |
| Denominator: Interest expense | Annual interest cost on all debt | Income statement: Interest expense line | The fixed annual cost of all borrowed money |
| TIE ratio | EBIT ÷ Interest expense | Calculated from income statement | How many times over the company can pay its interest |
After a bond is issued, it can be bought and sold between investors in the secondary market. The price fluctuates based on how the market rate has changed since issuance — even though the coupon payment never changes. This is the fundamental interest rate risk of bonds:
Key Takeaways
A company issues $500,000 of 8% bonds at par on January 1. Interest is paid semi-annually. What is the June 30 journal entry?