By Farzad Vajihi – Analyst of stock market and cryptocurrency, Ph.D. in economics
Adding bonds to your investment portfolio can help create a more balanced portfolio by providing diversification and reducing volatility. However, the bond market may appear unfamiliar even to experienced investors. Many investors only dabble in bonds because they find the bond market and its terminology confusing. In reality, bonds are straightforward debt instruments.
How do Bonds work?
Bonds are essentially loans taken out by companies. Rather than borrowing from a bank, the company raises money by selling bonds to investors. In return for the capital, the company pays an interest coupon, the annual interest rate paid on a bond expressed as a percentage of the face value. The company makes interest payments at predetermined intervals, usually annually or semiannually, and returns the principal on the maturity date, thus completing the loan.
Bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Understanding the precise terms before investing is important, as each bond issue is different. In particular, there are six important features to consider when considering a bond.
Type Of Bonds
Corporate Bonds
A corporate Bond is a debt security issued by a company to pay its expenses and raise capital.
The yield of these bonds depends on the creditworthiness of the company issuing them. The riskiest bonds are “junk bonds” but offer the highest returns. Interest from corporate bonds is subject to both federal and local income tax.
Sovereign Bonds
Sovereign, or treasury bonds are debt securities issued by national governments to meet their expenses. Because the issuing governments are unlikely to default, these bonds typically have very high credit ratings and relatively low yields.
In the US, government-issued bonds are called Treasuries; in the UK, they are called gilts. Treasuries are exempt from state and local tax but are subject to federal income tax.
Municipal Bonds
Municipal bonds, or munis, are bonds issued by local governments. It is important to note that this can refer to state and county debt, not just municipal debt, contrary to what the name suggests. Municipal bonds offer an attractive investment opportunity for investors in higher tax brackets, as they are not subject to most taxes.
Maturity date
This is when the principal or par amount of the bond is paid to investors, marking the end of the company’s bond obligation. Therefore, it defines the lifetime of the bond. When investing, an investor must consider the maturity of a bond. This is one of the most important factors in aligning an investment with their goals and time horizon. Maturity is often classified in three ways:
1. In the short term, Bonds in this category mature in one to three years.
2. Medium-term: These bonds have a maturity date of four to 10 years.
3. Long-term: These bonds mature over more than 10 years.
Secured vs. Unsecured
A bond can be secured or unsecured. A secured bond involves pledging specific assets to bondholders in case the company cannot repay the obligation. This pledged asset, also known as collateral, is transferred to the investor if the bond issuer defaults. One type of secured bond is a mortgage-backed security (MBS), which is backed by titles to the homes of the borrowers.
Unsecured bonds, also known as debentures, are not backed by any collateral. This means that the interest and principal are only guaranteed by the issuing company. If the company fails, these bonds return little of your investment, making them much riskier than secured bonds.
Liquidation Preference
When a company goes bankrupt, it repays investors in a specific order as it liquidates. After the company sells off all its assets, it begins to pay out its investors. Senior debt, which is debt that must be paid first, is followed by junior (subordinated) debt. Stockholders receive whatever is left.
Coupon
The coupon amount represents the interest paid to bondholders, usually on an annual or semi-annual basis. The coupon is also referred to as the coupon rate or nominal yield. To calculate the coupon rate, you divide the annual payments by the face value of the bond.
Taxation
Most corporate bonds are taxable investments, but some government and municipal bonds are tax-exempt. This means that income and capital gains from these bonds are not subject to taxation. Tax-exempt bonds typically have lower interest rates compared to equivalent taxable bonds. To compare the return with that of taxable instruments, an investor needs to calculate the tax-equivalent yield.
Callability
Some bonds can be redeemed by the issuer before they reach maturity. If a bond has a call provision, it means that the company has the option to pay it off at earlier dates, usually at a slightly higher price than the face value. Companies may choose to call their bonds if they can borrow at a lower interest rate. Callable bonds are also attractive to investors because they offer better coupon rates.
Risks of Bonds
Bonds offer a reliable way to generate income as they are generally considered safe investments. However, like any investment, they do carry certain risks such as Interest Rate Risk. Interest rates and bonds have an inverse relationship, meaning that when interest rates rise, bond prices tend to fall, and vice versa. Interest rate risk occurs when interest rates change significantly from what the investor expected.
If interest rates decline significantly, the investor may face the possibility of prepayment. On the other hand, if interest rates rise, the investor will be stuck with an instrument yielding below market rates. The longer the time to maturity, the greater the interest rate risk an investor bears, as it becomes harder to predict market developments further into the future.
Credit VS. Default Risk
Credit or default risk refers to the possibility that interest and principal payments due on an obligation will not be made as required. When an investor purchases a bond, they anticipate that the issuer will fulfill the interest and principal payments, similar to any other creditor. When considering corporate bonds, investors should take into account the potential for the company to default on its debt. A company’s safety is often indicated by greater operating income and cash flow in comparison to its debt. Conversely, if the company’s debt outweighs its available cash, investors may choose to steer clear.
Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower-interest-rate environment.
Ratings of bonds
Bonds often come with a credit rating that indicates their credit quality and ability to repay principal and interest. These ratings are used by investors and professionals to assess creditworthiness. The main bond rating agencies are Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. They assess a company’s ability to repay its obligations using different scales. For S&P, the investment grade ranges from AAA to BBB, representing the safest bonds with low risk. (Source: S&P Global Ratings, “Intro to Credit Ratings.”)
Bonds with BB or lower ratings are considered speculative or junk bonds, with a higher likelihood of default and greater price volatility. Firms may not have their bonds rated. In this case, it is the sole responsibility of the investor to assess a firm’s ability to repay. Since rating systems vary between agencies and change over time, it is important to research the rating definition for the bond issue you are interested in.
Bond Yields
Bond yields are all measures of return. Yield to maturity is the most commonly used measure, but it’s important to understand other yield measurements used in specific situations.
Yield to Maturity (YTM)
As noted above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor’s actual return will differ slightly.
Current Yield
The current yield compares the interest income of a bond to the dividend income of a stock. It is calculated by dividing the bond’s annual coupon by its current price. This yield only considers the income portion of the return and is most useful for investors focused on current income.
Nominal Yield
The nominal yield on a bond is the interest percentage paid periodically, calculated by dividing the annual coupon payment by the bond’s par value. It’s important to note that nominal yield does not accurately estimate return unless the current bond price is the same as its par value, so it’s mainly used for calculating other measures of return.
Yield to Call (YTC)
A callable bond may be called before its maturity date, resulting in a slightly higher yield if paid off at a premium. Investors may want to know the yield if the bond is called on a specific date to assess the prepayment risk, to determine whether the prepayment risk is worthwhile.
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation.
Are Bonds Risky Investments?
Bonds have historically been considered more conservative and less volatile than stocks but still carry certain risks. For example, there is a credit risk, which is the risk that the bond issuer will default (The bond market is significantly larger than the stock market in terms of aggregate market value).
Additionally, there is interest rate risk, which means that bond prices can decrease if interest rates rise (Bond prices are inversely related to interest rate movements, so if interest rates go up, bond prices fall, and vice versa).
