Bonds

 

Basics

When you buy a stock, you become part owner of a company (equity ownership).  When you buy a bond, you become a creditor of the company, not a corporate owner.  When you invest in a bond, you are lending money to a corporation or government and their agencies, which are used to finance a project or put the money to work (working capital).  In turn you are issued an I.O.U., a Promissory Note (a bond) obligating the issuer to:


  • Pay back the principal, the amount they borrow, which is the amount of the bond, also known as Face Value.
  • Give you a date, referred to as Maturity Date, when the bond issuer will pay back the principal amount borrowed from you.  The date signals the end of the life of the bond. Some bond issuers reserve the right to repay the bond earlier than the maturity date, known as Calling.
  • Pay you a fixed interest rate, also called Yield and Interest Payment, at specific intervals.
Bonds, in general, are considered a safer investment than stocks, since you know the amount of "fixed income (interest)" you will be receiving and for how long.  This does not mean that there is no risk with bonds, but the risk varies with the type of bond you purchase.  You have some idea of how much risk you are assuming.  Most bonds require a minimum investment—it can be $1,000 or $5,000.  During difficult and uncertain economic times when the stock market might be depressed, investors tend to move their money into bonds.  Bonds are also a good way to diversify your portfolio.  Most investors have some money invested in bonds.  And although you do not hear about it as often, the bond market is actually larger than the stock market.

All bonds are not created equal.  There are various types of bonds and they range from very safe—those issued by the U.S. Government such as Treasury Notes—to Junk Bonds, also known as high-yield bonds, which are issued, or have been issued, by companies in financial distress.  These bonds pay higher interest, but they might not be able to pay the interest they committed to, or worse, they might not be able to pay the original bond amount.  This only occurs when a company files for bankruptcy.  Even if the company liquidates, a bondholder would likely receive some money, but only a portion of the bond they purchased.

Rating agencies, such as Moody’s, Standard & Poor’s and Fitch, assess bonds, and issue ratings or scores indicating how much of a risk investors take in purchasing a bond.  Bonds with a low rating are at a higher rate of defaulting, and thereby must provide a higher fixed interest rate, to entice you to invest in the bonds.  On the other hand, companies with an excellent rating will offer a smaller interest rate.

The value of the bond, or yield, can change over time. In general, as interest rates rise, bond prices fall; as interest rates fall, bond prices rise.  The further away the bond’s maturity or call date is, the more its price will rise or fall in response to interest rates.  This will be further explained below.

Bonds can be purchased individually or through mutual funds (where you are purchasing a portfolio of many different bonds which spreads your risk).  Bonds are usually only one part of your diversified investment portfolio, which may include stocks, cash and sometimes precious metals.

To find out more about bonds go to
http://www.investinginbonds.com and http://www.tomorrowsmoney.org.
 


 

Types Of Bond Issuers

Bonds are broken into four main types, based on the bond issuer:
  • Corporates (aka: Corporate Bonds):  Corporate bond certificates are very different from common stock certificates.  With a stock, you are an “owner”.  If the company makes money (profits) you might get a higher dividend or higher stock price.  Bondholders do not share in these profits or the company’s growth.  They can only expect repayment of the principal bond amount and the fixed annual interest payment for the length of the bond.  If the company goes bankrupt or fails, bondholders and owners of preferred stock must be paid in full before the common shareholders get any money.  Therefore bonds and preferred stocks are known as "senior securities".
  • State and local governments or their agencies (aka: Municipal Bonds or Munis): These bonds support State and local government needs or special projects.

    • The benefit of municipal bonds is their exemption from federal income taxes. Further, if you live in the state of issue, they are usually exempt from state and local taxes as well.  Because of this tax exemption, municipal bonds have interest rates several percentage points below corporate bonds.  Munis are very advantageous as your income grows and you are in a higher tax bracket.
    • Municipals are issued in $5,000 amounts, compared to corporate bonds which have a $1,000 investment.  However prices are nonetheless quoted as if the principal amount was $1,000.
    • 1900 Municipals are traded over-the-counter Stock Market & Security Exchanges.  You must consult a bond dealer for a price.
    • Some of these bonds also carry Municipal Bond Insurance.  Make sure you know if the bond is insured, and the tax status of the municipal bond you buy. There are several types of municipal bonds, but two major categories
      • General Obligation Bonds:  are considered safer since they are backed by the full faith of the government (and taxing powers), although some states or municipalities are more financially sound than others.  Because of their greater security, they usually have lower interest rates.
      • Revenue Bonds:  are riskier.  These are bonds for specific public works projects, such as a bridge.  The revenue collected, in the case of the bridge (tolls), from the project would be used to pay the bondholders.  Revenue bonds issued for private institutions such as hospitals are even more risky.  Generally these bondholders do not have any claims on any of the community’s other resources.
    • You can get information and statements from the municipality issuing bonds from the Municipal Securities Rulemaking Board’s Electronic Municipal Access (EMMA) site: http://enmma.msrb.org .  You can also obtain information from your bank or stock broker.
  • United States and Foreign Government (aka: Government Bonds)
    • U.S. Government Bonds …U.S Treasury Securities:  (see our section under Savings) since these bonds are backed by the “full faith and credit” of the U.S. government.  Governments issue different types of securities based on maturity.  Treasury Bills (up to and including one year); Treasury Notes (one to seven years); and U.S. Government Bonds (seven to 30 years).  Government securities offer:


      • Maximum security (people don’t believe the U.S. government will go bankrupt).
      • Competitive yields—although riskier corporate bonds will have a higher yield, they will be less secure.
      • Ability to convert the bonds to cash easily (high degree of liquidity) since they are actively traded.
      • Limited taxation, since they are free of state and local taxes (but you do pay federal taxes).
      • See our section under U.S. Treasury Offering, under Investments. You can also go to http://www.treasurydirect.gov.
    • Foreign Governments:  Other countries also issue bonds.   Some people believe in investing overseas when the U.S. economy and/or dollar weakens. However, these bonds are considered riskier investments because of instability in international currencies or governments.
    • Federal Agencies (aka: Agency Bonds):  These are bonds issued by the U.S. government-sponsored agencies.  They are backed by the U.S. government but not guaranteed by it.  Some of the well known issuers are:  Student Loan Marketing Association (Sallie Mae – primary lender for student loans); Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Mortgage Association (Freddie Mac) which helps first time home buyers. Agency bonds are usually exempt, which means you don’t have to pay state and local taxes, but you still have to pay federal Taxes.


 

Bond Terminology

When you get a bond from a government or a company, you get a piece of paper called a bond certificate.  Note: in the new electronic age you might not get a real piece of paper.  On the bond are various numbers which spell out the terms.  It will say who is borrowing the money; for how much; when the bond issuer will repay the money; and how much interest they will pay.  Bonds have their own terminology and you need to understand them if you want to invest in bonds.  Be careful of the word YIELD, based on the context and the word before yield, it can mean various things.  There are four types of yields: Coupon Yield, Current Yield, Yield to Maturity, and Call Yield.


  • Face Value/Par/Principal Amount:  This shows the amount of money you lent the issuer (say $1,000) that they will repay you when the bond matures.  Whoever the investor is at the time of maturity (since bonds can be sold before the maturity date) will receive the face value (principal) for it.  Bonds are usually set in $1,000 denominations.
  • Maturity Date:  The bond expires on the maturity date (when it comes due).  This is the latest date by which the issuer must repay the loan to the bondholder.  This can be from one year or less, to more than 30 years.
  • Term of the Bond:  The amount of time from the day the bond is issued to the day it expires is called the Term of the Bond.  This can be any length of time up to 30 years or more.  Bonds can be further classified into groups with similar time lengths (these are general time specifications;  there is no definitive definition) such as:
    • Ultra Short Term:   Bonds that mature in one year or less
    • Short Term:  Bonds that mature from one to five years
    • Intermediate Term:  Bonds that mature from  five to 10 years
    • Long Term:  Bonds that mature from 10 to 30 years or more
       
  • Coupon Rate/ Coupon Yield/Fixed Interest Payment:   This is the interest rate that the issuer is paying based on the face value of the bond.  A coupon is set at the time the bond is issued and, for most bonds, stays the same until maturity.  In years past, almost all bond certificates came with coupons attached.  Years ago, people use to clip the coupons (every six months= 2 per year) and present them for payment.  This is where the term Coupon Rate came from; it is now known as yield or fixed interest payment.  The coupon Rate is the annual payment expressed as a percentage of the bond’s face-value.

For example:   A “make believe” company called Hi Five Corporation issues a short term two-year bond which has a face value of $1,000 and pays 5% Interest.  The 5% represents the coupon rate.  You would then earn $50 each year ($1,000 x .05 = $50) for 2 years for a total of $100 for the life of the bond.

  • Coupon Payment:  This is how much money in dollars will be paid at every interest period, every 6 months (2 x a year) (versus yield which is stated as a percentage).

Staying with the same example:  since you are generally paid interest semi-annually (twice a year), and since the annual yield of Hi Five Corp., is $50 (5% of $1,000), the coupon payment would be $25 ($50 ÷ 2 = $25).

  • Current Yield:  This is the annual interest payment calculated as a percentage of the bond’s current market price.  Bond prices can go up or down based on current interest rates.  Bond prices change over the life of the bond, although the bondholder receives full face value at maturity.  If all other factors are equal, an investor would never buy an existing bond from another bondholder when new comparable issued bonds are being offered elsewhere at a higher return.  On the other hand, if interest rates go down, a bondholder would demand more money for a bond with a higher yield.  The term “current yield” really explains how bond prices change.  However, the more important term to long term bond holders is "yield to maturity" (explained below).

    If interest rates go up, you have to offer your bond at a discount to make sure the yield is equal to the current offerings.

In our example:  when the Hi Five Corporation originally issued their bonds, the going rate was 5%.  A year later, bonds are now being issued with a 5.6% interest rate.  In order to provide the same value to the buyer, you would have to offer a $100 discount on the $1,000 bond, bringing the bond price to $900.  Since the coupon rate is fixed at 5% it still only pays $50 annually, but that divided into the market price of $900 versus the original price of $1,000, produces a current yield of $5.6% ($50 ÷ $900 = 5.6%), which would now equal that of the other bonds going to market.


If interest rates go down, you can demand a premium for your money (asking more than you paid for), to make up the difference in rates. 

If, in the Hi Five Corporation example:  interest rates go down to 4.5%, you can now ask for a premium of $100 for your $1,000 bond, bringing the market value to $1,100, which would bring a comparable yield of 4.5% ($50 ÷ $1,100 = 4.5%).

 


CURRENT YIELD

When the bond price is at par (original)
 
$50=5.00% $1,000
When the bond price rises, its
yield declines
$50 = 4.54% (yield declined)
$1,100 (bond price rises)
When the bond price declines,
the yield rises
$50=5.56%(yield rises) $900 (bond price declined)

 

  • Yield to Maturity (YTM)/Redemption Yield:  This is used to determine the rate of return an investor would get if a bond (or any long term investment) is held until maturity, assuming all coupons and principal payments will be made and that the coupon payments are reinvested in the bond’s promised yield.  When a bond first comes out, the bond’s yield is equal to its current yield or coupon rate.  But if you purchase it at a later date, it might be at a premium (where you pay more) or at a discount (where you pay less).  YTM is usually presented in terms of Annual Percentage Rate (APR).  The yield of a bond is measured by the income it generates. Yield is calculated as the amount of interest paid on a bond divided by the price.


In Our Example:   Above we discussed Current Yield (Interest Rate (5%) ÷ Amount of the bond ($1,000 = $50).  But in our Hi Five Corporation, the bond was for two years.   A year had passed so the current yield was actually the yield to maturity.   However, let’s say the bond was a five-year bond, with four years left to maturity, what then?  Use any financial calculator such as (
http://www.moneychimp.com/calculator/bond_yield_calculator.htm ) that will do this for you, or you can ask your broker.

 

  • ADVANCED – Yield To Maturity Calculation (YTM):  But if you really want to know the approximate YTM (does not include re-investment), here is the basic math.

 


Annual Accumulated Discount
÷ Number of years to maturity
+ Annual interest payment
x 100 = Yield to Maturity (YTM)
Average of face value + Current price

 

We will use the example our High Five – Yield to Maturity with a Discounted ($100 Bond):

  • Corporate Bond: Hi Five Corporation
  • Term of Bond: 5 years
  • Years to Maturity : 4 years
  • Purchase Price: $900 (a $100 discount)
  • Face Value: $1,000
  • Annual Interest Payment: 5% or $50

First we know the interest is 5% per year, one year has passed on our 5 year bond which means we still have four years to go.  We will receive $50 per year (5%), and another $100 when the bond matures, since we purchase the $1,000 Face Value Bond for $900 (remember it is $1,000 bond we purchased for $900 = $100).

I.  Calculate the Annual Accumulated Discount
a. Discount Amount ÷ number of years to maturity
$100 (Discount Amount) ÷ 4 (# of years to maturity) = $25
Annual Accumulated Discount $25 ($100 discount ÷ by 4 years left) = $25 per year )
+ Plus $50 (Annual interest payment = $50) = $75 $25 + $50 = $75


II.   Average of Face Value ($1,000 face value ) plus Current Price
($900 current price) ÷ by 2(average) = $950

 

$ 75 ($25 + $50)

x 100 = 7.89% Yield to Maturity (YTM)

 

$950 ($1,900 ÷ 2)


 

Issue Types

Bonds can be issued in two different ways:
  • Registered Bonds:  The owner’s name is registered with the corporation and interest rates are mailed directly to the owner (bondholder).  These are generally issued by corporations.
  • Bearer Bonds:   The bond is presumed to belong to whoever is in possession of the bond.  These are generally issued by governments, municipalities and agencies.

 

Backing Types

Most bonds are unsecured and are based on the reputation and your faith that the issuer will repay its debt.
  • Secured Bonds:   A secured bond is backed by collateral (like equipment or property) which may be sold if the bond issuer does not fulfill its obligation.
  • Unsecured or Debenture Bonds This is backed by the "full faith and credit" of the issuer, but not collateral.  In the case of the U.S. government, that means a great deal.  In the case of some companies, not as much.

 

 

Bond Ratings

Bond-rating services are Moody’s, Standard & Poor’s, and Fitch.  The grade a bond receives is based on the rating service’s belief, which is based on financial calculations and the issuer’s ability to meet the interest and principal requirements and evaluation of the potential of default by the issuer.  These services rate most of the publicly-held corporate and municipal bonds.  In addition, some rate treasury and government agency issues.  However, they do not rate privately-placed bonds.  Privately-placed bonds are where investors, usually institutions, purchase bonds directly from the issuer without any public distribution.

The highest rating on bonds is AAA for the best, most financially-secure corporations.  Ratings fall after that with grades as low as either C or D (only Fitch has D ratings).  Debts rated AAA, AA, A and BBB are considered investment grade (considered suitable for purchases by investments).  The higher the bond is rated, the lower the return, and the safer the investment.



The opposite of the safest AAA grade bond is the Junk Bond, also known as high-yield bonds.  These are rated below BBB or BBB3 by Moody’s.  These bonds are issued by organizations that are not rated as investment grade because of a risk of default (not being able to meet their obligations).  These securities are high risk investments, yet because of the risk they have a high-yield debt security, which pays a higher interest rate.  That is why they are also referred to as high-yield bonds.  If you invest in speculative, very risky bonds, you might not only fail to receive the promised interest, but you might lose all or part of the principal if the company goes bankrupt or liquidates.  With these bonds, although you get a great interest rate, you are taking a greater risk that the company may default on the bonds or you will get less than you paid for them.

After a rating is issued, it is reviewed periodically and can change to reflect the current economic health of the company.  A rating change can drastically affect both the value of the bond and the yield it might be able to offer in the future.  The three rating services have different rating systems and sometimes will differ in their opinion of a bond issuer.

 

 

CREDIT RATINGS

 

CREDIT RISK

Moody's

Standard & Poor’s

Fitch

INVESTMENT GRADE

Aaa AAA AAA
Highest Quality Aa AA AA
High Quality (very strong) A A A
Upper Medium Grade (strong) Bba BBB BBB
Medium Grade      
 

NOT INVESTMENT GRADE

     
Lower Medium Grade (somewhat speculative) Ba BB BB
Low Grade (speculative) B B B
Poor Quality (may default) Caa CCC CCC
Most Speculative Ca CC CC
No interest being paid or bankruptcy petition filed C C  
Lower Medium Grade (somewhat speculative) Ba BB BB
In default B B B
Simplified Ratings C CCC CCC


 

Interest Rates: The Key To Understanding Bonds

Interest rates can be regarded as the cost a company must pay to borrow money and therefore it is affected by supply and demand.  When there is a lot of expansion in the economy there is a great deal of demand for money and often not enough supply of money to go around, so interest rates tend to rise.  In the reverse, during economic downturns fewer people need money and interest rates generally fall.  Bond yields reflect not only the current economic demand for money but estimated future demand as well.  Since a bond’s yield is fixed for a period of time (based on the bond’s life), this must be taken into consideration when the bonds are initially offered.  Also the bond yield will affect the long term price of the bonds based on the economy.


 

Trading Of Bonds & Bond Pricing

Although like stocks, bonds can be traded.  You do not have to hold on to the bond until maturity, and investors can buy or sell bonds at any time during the bond’s term.  Before the maturity date, the value of the bond may be equal to, more or less, the full or face value of the bond.  If investors can get more for lending money than the rate the bond offers, the price of that bond will go down.  However, if the rate of the bond is higher than what the current interest rates are being offered for the bond, the bond will increase in value.  Once a bond is issued, the term rate is called yield, since there are adjustments to the price of the bond.  However, a bondholder receives full face value at maturity.

For example:  Let’s say you have a bond for $10,000 for 10 years at 5%.  Five years have gone by, and you have five years left.  You need to sell your bond, but times have changed.  The economy has heated up and people can now get 8% interest at a bank.  The difference between the two rates is 3% or ($300 per year).  This would amount to $1,500 over the remaining five years of the bond ($300 x 5 = $1,500).  Therefore you would have to sell the $10,000 bond for $8,500 to keep your bond competitive with today’s current market rates.


 

Calling - Callable Bonds

On the face of a bond some issuers state that they have the right to retire or call the bond before its maturity.  This generally takes place in deflationary periods.  If, for example, the U.S. was in a high inflation period, a company might issue a 30 year bond at 8%.  If the market 10 years down the road cooled off and comparable new bonds were being issued at a 4% interest rate, then the company would call the 8% bonds, and reissue 4% bonds.  Most bonds also have a provision that they cannot be called for a certain period of time, which can be five or 10 years.  If a bond has a call provision, it generally has a slightly higher annual yield to compensate the buyer if the bond should be called.  The call provision will spell out the first call date and whether the bond will be called at par or slightly above par value.

Many companies set up, and regularly put aside, money in a "Sinking Fund".  These funds are then used to redeem or buy back securities or preferred stock.  Bonds are generally called at par value, so a bondholder who might have paid a premium for the bond could lose money.

 

Convertible Bonds

These are bonds that can be swapped for the same company’s common stock at a fixed ratio, providing a specified amount of bonds for a specified number of shares of stock.  The terms are outlined when the bond is issued.  Some investors like the ability to convert since, IF the price of the stock rises enough you can profit by swapping your bonds for stock.  However, Convertible Bonds are normally offered at a slightly lower rate than a regular bond, since you have the option to "convert" the bond to stock.  If the stock price fails to rise or goes down, you will lose money on convertibles.  Because convertible bonds can be converted to stocks, they tend to be more closely in sync with the stock market versus the bond market.  These are very complicated securities.

 

Zero Coupon Bonds

Zero coupons bonds do not pay interest during the life of the bond, but instead offer the purchaser a substantial discount compared to the face value of the bond.  Thus, the investor’s income comes only from the increase in value of the bond.  There are complicated tax consequences of these bonds, so consult a tax specialist to see if these are appropriate for you.  These may be secured or unsecured.

 

 

 

 

Online Resources For Information On Bonds

GENERAL SITES
RATING SITES

INTERNATIONAL INFORMATION

If you are researching International funds and want information on the country go to: