Want to improve your portfolio’s return-risk profile? Bonds can help create a balanced portfolio by increasing diversification and reducing volatility. Even experienced investors may find the bond market confusing.
The apparent complexity and terminology of the bond market confuses many investors, who only make a passing attempt to understand bonds. Bonds are actually very simple debt instruments. How do you enter this market segment? Learn the basics of bond market terminology to get started in investing.
Bond Characteristics
bonds are simply loans taken out by companies. Investors who purchase the bonds of the company provide the capital instead of a bank. The company will pay an interest coupon in exchange for money. This is the annual rate of interest paid on the bond expressed as a percent of its face value. The company pays interest at regular intervals, usually annually or semi-annually. At maturity, the company returns the capital.
Bonds, unlike stocks, can differ significantly depending on their Indenture. This is a legal document that outlines the characteristics of the bonds. It is crucial to know the exact terms of each bond before investing. There are six key features that you should look out for when evaluating a bond.
A bond is a type of IOU that the lender makes with the borrower.
Corporate Bonds
Corporate bonds are debt securities issued by companies to cover their costs and raise capital. The yield on these bonds is determined by the creditworthiness and the size of the company issuing them. These bonds offer the best returns but are also riskier. The federal and local income tax applies to interest from corporate bonds. 1
Sovereign Bonds
Sovereign debt or sovereign bonds are debt securities that national governments issue to pay for their expenses. These bonds have high yields and credit ratings because the governments giving them are unlikely to default. In the United States, bonds issued by federal governments are known as Treasury, while those shown in the United Kingdom are known as gilts. Treasuries do not have to pay state or local taxes, but they still must pay federal income tax.
Municipal Bonds
Municipal Bonds or munis are bonds issued by local government. This term can also refer to county and state debt. Most municipal bond income is exempt from tax, which makes it a good investment for those in higher tax brackets.
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Secured/Unsecured
A bond can either be secured or unsecured. A secure bond is a bond that pledges assets to bondholders in the event the company fails to repay its obligation. The support can also be called collateral for the loan. If the bond issuer defaults on the loan, then the purchase will be transferred to the investor. A mortgage-backed security is a type of secured bond that is supported by the title of the borrower’s home.
Unsecured bonds are those that do not have collateral backing them. The issuing company guarantees the principal and interest. These bonds, also known as debentures, return very little of your initial investment in the event that the company fails. They are, therefore, much more risky than secured bonds.
Liquidation Preference
In the event of bankruptcy, a company will pay out its investors in an orderly manner as it liquidates. Investors are paid after a company has sold off its assets. The senior debt must be paid before the junior debt (subordinated). Stockholders receive whatever is left.
Discounts on the Purchase of a Coupon
The coupon represents the interest that is paid to bondholders. This occurs normally every year or half-year. It is also known as the nominal rate or coupon. Divide the annual payments by face value to calculate the coupon rate.
Tax Status
Some government and Municipal bonds do not tax income or Capital Gains. Tax-exempt bond interest rates are usually lower than those of taxable bonds. To compare returns between taxable and tax-exempt instruments, an investor must calculate their tax-equivalent return.
Callability
An issuer can pay off some bonds before they reach maturity. A bond with a call clause can be paid at an earlier date, at the company’s option, and usually at a small premium over per. If interest rates are low, a company can choose to call their bonds. Investors also like callable bonds because they have better coupon rates.
Risks of Bonds
Bonds can be a good way to generate income, as they are generally considered to be safe investments. Like any investment, bonds do have certain risks. These are the most common risks associated with these investments.
Interest Rate Risk
Bonds and interest rates have an inverse relationship. When rates rise, bonds fall, and vice versa. Investors are exposed to interest rate risk when rates differ significantly from their expectations. Investors who face prepayment risk if interest rates drop especially are at risk. Investors who are stuck with instruments that yield below market rates will find themselves in a difficult situation if interest rates increase. The longer the maturity date, the higher the risk of interest rates for an investor, as it is more difficult to predict future market conditions.
Credit/Default Risk
Credit or default risks are the risks that the interest and principal payments on an obligation will not be made in the required manner. Investors expect the bond issuer to make the required interest and principal payments, just like any other creditor.
Investors should consider the risk of default when they evaluate corporate bonds. When a company is more secure, it has a higher operating income and cash flow compared to the debt. Investors may not want to invest if the debt exceeds the cash available.
Prepayment Risk
Prepayment is a risk that an issue of bonds will be repaid earlier than expected. This risk is usually a result of a Call Provision. Investors may not be happy with this because the company will only repay an obligation if interest rates are low. Investors are forced to reinvest their funds into a low-interest rate environment instead of holding a high-interest investment.
Agencies
Most commonly cited are Standard & Poor’s Moody’s Investors Service and Fitch Ratings. The rating agencies assess a company’s capacity to pay its debts. Each agency uses a different rating scale. S&P’s investment grade ranges between AAA and BBB. These bonds are the most secure and have the lowest risks. They are less likely to default, and they tend to be stable investments. 10
The bonds rated below BB are classified as speculative or junk bonds. They are subject to greater price volatility, and default is more likely.
Investors can only judge the repayment capability of a company if their bonds are not rated. The rating systems for each agency are different and can change over time. Research the rating definition of the bond issue that you’re considering.
