The basics of bonds – MoneyWeek Investment Tutorials
Introduction to Bond
Bear markets should remind investors of bond’s safety and stability. It just makes sense to have at least part of your portfolio invested in bonds.
Companies and governments need money to function. A company needs funds to expand into and governments need money for everything from infrastructure to social programs. Large organizations need far more money than the bank can provide. One way to do this is to raise money by issuing bonds to a public market. Investors each lend a portion of the capital needed by buying bonds. A bond is a loan for which you are the lender.
The issuer of a bond must pay the investor for use of their money. This is called interest payment which are made at a predetermined rate and schedule. The interest rate is referred to as the coupon. The date on which the issuer has to repay the amount borrowed is called the maturity date. Bonds are called fixed-income securities.
You buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Because most bonds pay interest semi-annually, you’ll receive two payments of $40 every year. When the bond matures you’ll get your $1,000 back.
Debt and Equity
Bonds are debt instruments and stocks are equity. When purchasing equity (stock) an investor buys ownership in a corporation. Ownership comes with voting rights and the right to share in future profits. By purchasing debt (bonds) an investor becomes a creditor. The primary advantage of being a creditor is that you have a higher claim on assets than shareholders. In the case of bankruptcy, a bondholder gets paid before a shareholder. There is generally less risk in owning bonds than in owning stocks
Why buy Bonds? Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Retired individual living off a fixed income simply cannot afford to lose their principal capital or the income that bond pays. Bonds are appropriate when you need your capital on short term horizons. When you cannot afford to take the chance of losing the money going towards your education or as down payment for a home. Bonds are the best investment when money is needed for a specific purpose in the near future.
Personal financial advisors advocate maintaining a diversified portfolio and changing the mix of asset classes throughout your life. In your 20s and 30s, a majority of wealth should be in equities. In your 40s and 50s shifting out of stocks into bonds which will pay a steady stream of income into your retirement.
Face Value / Par Value
The face value is the amount of money a bondholder will get back when a bond matures. A newly issued bond sells at the par value. Corporate bonds have a par value of $1,000, but can be much greater for government bonds. A bond’s price fluctuates in response to a number of variables. When a bond trades at a price above the face value it is be selling at a premium. When a bond sells below face value, it is selling at a discount. Coupon or Interest Rate The coupon is the amount bondholders will receive as interest payments. Bonds pay interest every six months, but it’s also possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and par value is $1,000, it’ll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond.
Another possibility is an adjustable interest payment or a floating-rate bond where the interest rate is tied to market rates through an index, such as the rate on Treasury bills. Maturity The maturity date is the date when the investor will be repaid. Maturities can range as long as 30 years Shorter maturities are more predictable and less risky than bonds that matures in 20 years. The longer the maturity, the higher the interest rate. A longer term bond price will fluctuate more than a shorter term bond. Issuer The issuer of a bond is a crucial factor to consider. The U.S. government is more secure than corporations. Its default risk is small – so small that U.S. government securities are known as risk free assets. Government will always be able to raise revenue through taxation. A company must continue to make profits in order to pay bondholders. This added risk means corporate bonds must offer a higher yield to entice investors.
The bond rating system helps investors determine a company’s credit risk. Huge corporations are safer investments, have a high rating, while smaller, risky companies have a lower rating.
AAA to Aaa bonds have the highest quality risk and are rated investment grade.
AA to Aa bonds are high quality risk and rated investment grade also.
A to A bonds are considered strong risk and rated investment grade.
Baa to BBB are considered medium grade and are investment grade.
Ba, B to BB, B are considered as junk status and are speculative grade.
Caa/Ca/C to CCC/CC/C are junk status and highly speculative.
C to D are junk status and graded as default.
Whenever a company credit rating falls its grade can change from investment quality to junk status. Junk bonds are the debt of companies in some financial difficulty. They are risky and have to offer much higher yields than any other debt. Thus not all bonds are safer than stocks.
Yields and Prices
Bond prices change daily just like other publicly-traded securities. When investors hold bonds to maturity they are guaranteed to receive their principal back along with interest payments. However bonds do not have to be held to maturity. Bond can be bought and sold at any time in the open market.
Returns and Yields
Yields are returns you earn on a bond. Yield is calculated using a formula: yield = coupon amount divided by price. When buying a bond at par, yield is equal to the earned interest rate. If the price changes so will the yield. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10%. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). If the bond’s price goes up to $1,200, the yield shrinks to 8.33% ($100/$1,200). Yield To Maturity Yield to maturity (YTM) is a complicated yield calculation that gives the total earnings you receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the stipulated yield of the bond) plus any gain ( purchased at discount) or loss ( purchased at premium). YTM is more accurate for comparing bonds with different maturities and coupons. The relationship Between Price And Yield The relationship of yield to price states that when price goes up, yield goes down and vice versa. Technically, bond’s price and its yield are inversely related. Bond buyers want high yields. Buyers wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. If you already own a bond, you’ve locked in your interest rate, so you wish the price of the bond goes up. This way you can profit by selling your bond into the future.
The prevailing interest rates levels influences bond prices. When interest rates rise, the prices of bonds fall raising the yield of older issued bonds and bringing them into alignment with newly issued bonds. Conversely when interest rates fall, bond prices rise lowering the yield of the older issued bonds and bringing them in line with currently issued bonds with lower coupon rates.
Types Of Bonds
Government Bonds Fixed-income securities are classified according to the length of their maturities. The three categories: Bills – debt securities maturing within one year. Notes – debt securities maturing within 10 years. Bonds – debt securities maturities over 10 years. Marketable securities from the U.S. government – collectively called Treasuries – follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills or T-bills. All debt issued by the U.S. are considered extremely safe for developed countries. The debt of some developing countries have more substantial risk. And like companies, countries can also default on payments. Municipal bonds Municipal bonds or “munis”, are bonds issued by municipalities. A major advantage for munis is the earnings are free from federal tax. Plus municipal governments may choose to treat bond earnings completely tax exempt for residents. Corporate Bonds
Corporation may issue bonds same as they issue stock. Big corporations have more flexibility on how much debt they may issue or however much the markets will accept. Short-term corporate bond are less than five years; intermediate are five to 12 years and long term bonds are those with maturities over 12 years. Corporate bonds pay out higher yields because there are more inherent risk to a company defaulting than from a government. The advantage is that they can be more rewarding because of the added risk for investors. A company’s credit quality is very important in determining they yield investors will receive. Variations corporate bonds include convertible bonds which the holder can convert into stock, and callable bonds which allow the company to redeem prior to the maturity date. Zero Coupon Bonds
This is a bond that makes no interest payments. It is issued at a discount to face value. For example a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $700; you’d be paying $700 today for a bond that will be worth $1,000 in 10 years.
Bond transactions can be made through a full service or discount brokerage and a bond broker. You may also buy into mutual funds that specializes in bonds.
You may purchase government bonds through a government agency. In the U.S. you can buy bonds directly from the government through TreasuryDirect at http://www.treasurydirect.gov. The Bureau of the Public Debt created TreasuryDirect for individuals to buy bonds directly from the Treasury without a broker.
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