What are Bonds?
Bonds are Fixed-Income Securities. Actually, a bond is basically a loan to a legal entity (Bond Issuer Gov’t or Corporation). The reason they are called Fixed Income Securities is they have:
- A fixed interest rate (unless there is an adjustment component built into the security).
- A fixed payment period.
- A fixed period of time to maturity.
Bonds provide investors with less volatility (extreme price movements) than the stock market. The use of Bonds in an investment portfolio has an important feature: Asset Preservation!
Asset preservation happens when a bond is held to maturity. It maintains its stated value. This feature will add stability and income to your portfolio returns. Salient features of having bonds in your portfolio:
- Bonds have fixed cash flows.
- Bonds diversify your portfolio.
- Bonds are issued by governments and corporations.
- Bonds are characterized by:
- The amount of their par value: Par value is the dollar amount assigned to a security. In a Bond, the par value is the amount repaid to the investor at maturity.
- Price of their face value: As interest rates rise and fall, the price of a bond will be sold above or below its par value.
- Coupon rate: This is the interest rate assigned to the bond.
- Maturity: This is the date that the full amount of the bond (its principal and interest) is due and payable.
- Issuer: A government agency (both foreign and domestic), a corporation or a municipality.
- Bonds are purchased:
- At Par (100%)
- At a Discount (less than 100% i.e. 98%)
- At a Premium (more than 100% i.e. 102%)
Descriptions of various bonds
There are the three main categories of Government securities:
- Bills – Debt securities maturing in one year or less. Sold in increments of $1,000.00 to $5 million.
- Notes – Debt securities that mature in one to 10 years. These notes pay interest every six months.
- Bonds – Debt securities that mature in more than 10 years. These bonds pay interest every six months.
This type of bond makes no coupon (interest) payment. It is issued at a discount that pays its full value at maturity. Example: Pay 80% ($80.00) for the bond and get 100% back ($100.00) upon its maturity.
A corporation can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue.
A short-term corporate bond is less than five years, intermediate bonds are five to 12 years, and long-term bonds are over 12 years.
Asset and Mortgage Backed Securities (ABS & MBS)
An asset-backed security is secured by a collateral asset. These can be cars, credit cards, expensive portraits, coins or other collectible items that have value.
All corporate bonds are rated by an accredited credit rating agency.
Known as “munis”, are next in progression (in terms of risk). Cities don’t go bankrupt that often (but it can happen). A major advantage of munis is their interest payments are free from federal taxation. Munis can also be used as a tax-sheltered investment.
High Yield Bonds (Non-Investment Grade or Junk Bonds)
These are the high risk, high rewards investment instruments. They are used by private equity firms who invest in mergers and acquisitions (take overs), leveraged buyouts, special situations and limited partnerships. Some mergers and acquisitions are friendly, and some are hostile (down-right nasty) in the fight for ownership of a company.
Credit Rating Agencies
Bonds are rated by “Credit Rating Agencies” who look at the credibility of the company issuing the security. Read my book “A Beginners Guide to Wealth Building” for s sample of bond rating charts. It is an at-a-glance view of the credit ratings used to give buyers an idea of the credibility and financial strength of The bond.
Bond Evaluation (valuation)
In purchasing bonds, you need to have some idea of how to evaluate them. The best way to evaluate a bond’s rate of return is through its Yield. The easiest way to think about yield is to ask – what will give me the most “bang” for my bucks! Another way to think of bond yield:
- The more you pay for it, the less yield you get. This is called Premium pricing. You are paying more than 100% (See Bonds are purchased above).
- The less you pay for it, the more yield you get. This is called Discount pricing because you pay less than 100% of the value of the bond. (See Bonds are purchased above).
- The behavior of bonds goes something like this (for fixed bonds):
- When the price goes up, yield goes down.
- When the price goes down, yield goes up.
- When interest rates rise, the price of bonds in the market falls.
- When interest rates fall, the price of bonds in the market goes up.
This theory does not apply to floating rates, inflation-based or adjustable bonds.
Government bonds are considered the safest bonds, followed by municipal bonds, and then corporate bonds.
This is a simplified description. The more features that are put into an issued bond, the more complicated they are to judge. Investment managers have computers to do the hard work analysis for them.
Bonds are not risk free
- Investing in a “Bond Fund” (Example: a fixed income fund) is akin to investing in the equities (stock) market, because these funds are actively traded. In an active market, prices change every few minutes, resulting in bond market volatility. There is some market risk in the buying and selling of bonds. Remember: Buy low, Sell high!
- In the case of corporate bonds, it is always possible for the borrower (a corporation) to default on its debt obligation.
You can purchase most bonds through a brokerage firm or a bank. If you are a U.S. citizen, you can buy government bonds directly from the U.S. Treasury.
Bonds are not long-term star performers. If chosen properly, bonds provide stability in the portfolio (if held to maturity).
Tomorrow we will conclude Securities That Drive The Investment Portfolio with Mutual Funds.
See you tomorrow!
Robert L. Woods (a.k.a. R. LaMont W.)