The Investment Series: Bond Basics

Bond Basics  (Go to the Investment Series for other Basics)

This is the first article in a series on investment basics. If you are new to investing, it is recommended that the articles be read in order. Prior articles introduce terminology that is used in later articles.

Over time, bonds cannot compete with the potential growth of stocks.
So, what's the attraction of bonds?

Some Types of Bonds

  • Corporate
       - Debentures
       - Secured
       - Convertible

  • Mortgage Backed
    - Government National Mortgage Association (Ginnie Maes)
    -  Federal National Mortgage Association (Fannie Maes)
     - Federal Home Loan Mortgage Corporation (Freddie Macs)

  • Federal Government
    -
    Treasury Bills (1 year or less)
    - Treasury Notes (1 to 10 years)
    - Treasury Bonds (10 years and up)
    - Savings Bonds (Various types: EE, HH, I)

  • Municipal (Munis)
    -
    General Obligation
    - Revenue

What is a Bond?

A bond is an IOU. When you purchase a bond from the issuer, you are lending money to the issuer of the bond. The issuer may be a corporation, a government agency, or a municipality. In return for your loan, the issuer agrees to pay a stated annual interest rate to you. Further, bonds represent a loan for a given period of time after which the issuer promises to repay the loan. The annual interest rate is calculated based upon the face value of the bond and is known as the Coupon Rate. (In older days, bonds had coupons which the bondholder could clip and redeem as they reached their due date.) The face value of the bond is the amount of the loan, typically $1000, and is called the Par Value. The date the Par Value is due back to the bondholder is called the Maturity Date. Bonds with short term maturity dates are often called notes.

Once a bond is issued, it becomes a tradable commodity. Its value on the open market will rise and fall as interest rates change or as faith in the issuer changes. But when it reaches its maturity date, any interim variations in price are of no consequence because the bondholder receives the Par value assuming that the issuer is capable of repaying the loan.

Note that a bond is a debt obligation, and does not represent ownership.

Why Bonds?

Bonds provide a known rate of return

Thus bonds provide a steady, known income.

Bonds return a known value on their maturity date.

This provides security for your money provided you hold the bond to maturity.

Bond yields are generally superior to money market funds, certificates of deposit, and bank accounts.

Yields are related to liquidity and risk. Since bonds vary in price during their life, you could take a loss if you unexpectedly had to sell a bond prior to maturity. (Or you could have a gain.) Also, the issuing company could go bankrupt and be unable to repay the loan.

Government and municipal bonds can have tax advantages.

Standard & Poor's and Moody's provide independent "safety" ratings for corporate bonds. These rating indicate how likely it is that the bondholder will be able to repay the loan.

Lower rating require higher yields to attract investors, but represent higher risk. Ratings provide a standardized and valuable tool for the bond investor.

Why does the value of a bond change if I'm going to get the money back?

Rule 1: When interest rates go up, bond prices go down.

Why should I pay $1000 for your 5% coupon rate bond when I can pay $1000 for a bond being issued with a coupon rate of 6.5%? Clearly, if you want me to buy your bond, you'll have to charge less than $1000 to compensate for the difference in interest rates.

Rule 2 is the converse of rule 1. When interest rates go down, bond prices go up.

Rule 3: The price of a bond is less volatile when its maturity date is close.

As the maturity date of a bond looms closer, the aggregate impact of a difference in interest become less.

Since the price of a bond varies, its yield at any given moment will likely be different than its coupon rate.

Current yield = Coupon rate divided by current market price.

Yield to Maturity = Considers the Current Yield with an adjustment for the difference between the current market price and the par value.

Yield to call = Similar to yield to maturity but considers the call date instead of the maturity date.

Some Important Provisions of Bonds

Callable Bonds: This is similar to being able to pre-pay your mortgage. If the bond is callable, the issuer of the bond has the right to pay-off the loan to the bondholder earlier than the maturity date. Bonds may be freely callable (at any time), non-callable, or deferred call (callable only after a specified number of years). Freely callable bonds are not generally used. When bonds are called a pre-specified premium above the par value is usually added.

Convertible: Holders of these bonds can convert the bonds into shares of common stock if the stock price hits a pre-set trigger price.

Backing: Bonds may be secured. Bonds backed by corporate equipment assets are called equipment certificates. If back by real estate, they are mortgage bonds. If not secured, they are debenture bonds. In the event of bankruptcy, secured bonds are paid first.

All bonds are not alike. The bond prospectus will describe the details of the offering, and S&P or Moody's will provide a "safety" rating for the issuer.

(Note that bond funds are a different animal and will be addressed in a future article.)

An Investment Technique

Richard at a healthy age 60 has accumulated a respectable portfolio and wishes to invest $100,000 of that portfolio in Treasuries. He would like to get the higher rate associated with a five year maturity but is concerned about possibly needing some of the money sooner. One option for Richard is to ladder the bonds as follows:

$20,000 buys one year bonds (Treasury Bills)

$20,000 buys two year bonds (Treasury Notes)

$20,000 buys three year bonds (Treasury Notes)

$20,000 buys four year bonds (Treasury Notes)

$20,000 buys five year bonds (Treasury Notes)

After one year, Richard redeems the first $20,000 and buys a five year bond. The original two year bond is now only one year away from maturity. In fact, each year $20,000 will reach maturity. If Richard uses this $20,000 to buy a 5 year bond each year, in four years all of his bonds will be 5 year bonds. He will be getting five year rates on all of his bonds and will have $20,000 reaching maturity each year.

In Conclusion

Bonds do not have the long term growth potential of stocks but can provide steady income and security of capital if held to maturity. Because of this, bonds are recommended as an increasing percentage of a portfolio as the portfolio owner becomes older. However, bonds are not fixed value investments since their market value can change with interest rates especially when far away from maturity dates.

This concludes our article on bond basics. Check  the next article in our investment series: "Stock Basics".

Safety Rating

S&P's

Moody's
Highest Quality, Lowest Risk AAA Aaa
High Quality AA Aa
High- Medium Quality, Long Tern Vulnerability A A
Medium Quality, Lowest Investment Grade BBB Baa
Below Investment Grade BB Ba
Speculative, Future Default Risk B B
Poor, Clear Default Risk CCC Caa
Very Speculative, Possibly in Default CC Ca
Junk Bonds, Not Paying Interest C C
In Default D  

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