The Relevance of Bonds in Your Investment Portfolio
Adding bonds to your financial investment mix can develop a balanced account. They aid in expanding your profile and minimizing value swings. Despite this benefit, even experienced investors may find the bond market intimidating. The bond market can be confusing. Its jargon often keeps people from understanding bonds better. Bonds are simple financial debt tools at their core. It’s very important to remember this.
A bond is simply a loan taken out by a company. The company gets the money from investors who buy its bonds instead of going to a bank. The company pays an interest coupon for the capital. This is the annual interest rate, shown as a percentage of the face value. The company pays interest at set times, usually once a year or twice a year. It returns the principal amount on the maturity date, which ends the loan.
Important: Bonds are a form of IOU between the lender and the borrower.
Bonds differ from stocks because their terms can change a lot. This is due to the indenture, a legal document that defines the bond’s features. Every bond issue is unique. So, it’s key to know the exact terms before you invest.
1. Understanding Bond Types and Characteristics
The Three Main Types of Bonds
Corporate Bonds
Companies issue corporate bonds to raise money and cover costs. The interest yield depends on the company’s credit rating. Junk bonds are the most perilous but offer potentially greater returns. Income earned from corporate bonds is taxable at both the federal and state levels.
Sovereign Bonds
Sovereign bonds, also known as sovereign debt, are issued by national governments. They help cover government expenses. The issuing governments are unlikely to default. So, these bonds usually have a high credit rating and a low yield.
Bonds issued by the federal government in the United States are called Treasuries. Those issued by the United Kingdom are called gilts. Treasuries are exempt from state and local tax, although they’re subject to federal income tax.
Municipal Bonds
Municipal bonds, or munis, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Municipal bond income usually isn’t taxed. This makes it attractive for investors in higher tax brackets.
Key Bond Features You Must Know
Maturity
This is when the bond’s principal, or par amount, is paid to investors. It’s also when the company’s bond obligation ends. It defines the lifetime of the bond. A bond’s maturity is one of the primary considerations that an investor weighs against their investment goals and horizon. Maturity is often classified in three ways:
- Short-term: Bonds that fall into this category tend to mature in one to three years.
- Medium-term: Maturity dates for these types of bonds are normally four to ten years.
- Long-term: These bonds generally mature after ten years.
Secured/Unsecured
A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company can’t repay the obligation. This asset is also called collateral on the loan. The asset is then transferred to the investor if the bond issuer defaults. A mortgage-backed security (MBS) is one type of secured bond backed by titles to the homes of the borrowers.
Any collateral doesn’t back unsecured bonds. The interest and principal are only guaranteed by the issuing company. Also known as debentures, these bonds offer little back if the company fails. They’re much riskier than secured bonds.
Coupon
The coupon amount represents interest paid to bondholders, normally annually or semi-annually. The coupon is also called the coupon rate or nominal yield. Divide the annual payments by the face value of the bond to calculate the coupon rate.
Tax Status
Most corporate bonds are taxable. But, some government and municipal bonds are tax-exempt. This means their income and capital gains aren’t taxed. Tax-exempt bonds normally have lower interest than equal taxable bonds. An investor should calculate the tax-equivalent yield. This helps compare returns with taxable investments.
Callability
An issuer can pay off some bonds before maturity. A company can pay off a bond early if it has a call provision. This often happens at a small premium to par. A company may choose to call its bonds if interest rates allow it to borrow at a better rate. Callable bonds also appeal to investors because they offer better coupon rates.
2. The Risks Every Bond Investor Should Understand
Bonds are a great way to earn income because they are relatively safe investments. But they do come with certain risks, just like any other investment.
Interest Rate Risk
Interest rates share an inverse relationship with bonds. When rates rise, bonds tend to fall, and vice versa. Interest rate risk comes when rates change significantly from what the investor expects.
An investor faces the possibility of prepayment if interest rates decline significantly. They’ll be stuck with an instrument yielding below-market rates if interest rates rise. The longer the time to maturity, the higher the interest rate risk for an investor. This is because it is tougher to predict market changes far in the future.
Credit/Default Risk
Credit or default risk means borrowers may miss interest or principal payments. When an investor buys a bond, they expect the issuer to pay the interest and principal. This is similar to what happens with any other creditor.
An investor should consider the chance that the company might default on its debt when evaluating corporate bonds. Safety usually means the company has greater operating income and cash flow compared to its debt. If the inverse is true and the debt outweighs available cash, the investor may want to stay away.
Prepayment Risk
We call the chance that a bond will be paid off sooner than expected prepayment risk. This usually happens due to a call provision. This is bad news for investors. The company only wants to repay early when interest rates drop a lot. Investors must reinvest their money at lower interest rates. They can’t keep holding on to high-interest investments.
Understanding Bond Ratings
Most bonds have a rating that shows their credit quality. This rating shows how trustworthy the bond is. It reflects its ability to repay both principal and interest. Ratings are published and used by investors and professionals to judge their worthiness.
The main bond rating agencies are S&P, Moody’s, and Fitch Ratings. They rate a company’s ability to repay its obligations. Each rating agency has a different scale. Investment grade ranges from AAA to BBB for S&P. These are the safest bonds with the lowest risk. They’re unlikely to default and tend to remain stable investments.
Bonds rated BB or below are speculative bonds, also known as junk bonds. Default is more likely, and they are more speculative and subject to price volatility.
Firms may not get their bonds rated. In that case, investors must decide if the firms can repay. Rating systems vary by agency and change over time. So, check the rating definition for the bond issue you’re looking at.
How to Gauge Bond Returns: Recognizing Yields
Bond returns are all steps of return. Maturity is a key measure, but knowing other return aspects is also important.
Yield to Maturity (YTM)
Yield to maturity (YTM) is the yield dimension most often cited. It measures the return on a bond when an investor holds it until maturity. It also assumes that all discount coupons are reinvested at the YTM rate. Coupons probably won’t be reinvested at the same rate. So, a capitalist’s real return will vary slightly.
Important: Calculating YTM by hand takes time. It’s easier to use Excel’s RATE or YIELDMAT functions, available since Excel 2007. A simple function is also available on a financial calculator.
Current Yield
The current yield lets you compare the interest from a bond with the dividends from a stock. You calculate this by dividing the bond’s annual coupon by the bond’s current price.
This yield only includes the income part of the return. It does not consider any capital gains or losses. It’s thus most useful for investors who are only concerned with current income.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It’s calculated by dividing the annual coupon payment by the par or face value of the bond.
The nominal yield only gives an accurate return estimate if the bond price equals its par value. The nominal yield is, therefore, used only for calculating other measures of return.
Yield to Call (YTC)
The issuer may call a callable bond before it matures. This means there is a chance it won’t reach its full term. Investors will realize a slightly higher yield if the callable bonds are paid off at a premium.
An investor in this bond might want to know the yield if the bond issuer calls it on a specific date. This can help determine whether the prepayment risk is worthwhile. It’s easiest to calculate the yield to call using Excel’s YIELD or IRR functions or with a financial calculator.
Realized Yield
If an investor plans to hold a bond for a specific time, they should calculate its realized yield instead of waiting until maturity. The investor will sell the bond in this case, and we must estimate this projected future bond price for the calculation.
Future prices are hard to predict, so this yield measurement is only an estimation of return. This yield calculation is best performed using Excel’s YIELD or IRR functions or by using a financial calculator.
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4. How Bonds Pay You: Interest Payment Structures
Bondholders receive payment for their investment in two ways. Coupon payments are regular interest payments made during a bond’s life. They continue until the bondholder redeems it for its par value at maturity.
Traditional Coupon Bonds
Most bonds make regular interest payments, called coupons. These payments happen at set times, usually once a year or twice a year. These payments represent the return on your investment while you hold the bond. At maturity, you receive your principal back along with the final interest payment.
Zero-Coupon Bonds
Some bonds are structured differently. Zero-coupon bonds are bonds with no coupon. The only payment is the face-value redemption at maturity. Zeros are often sold below face value. So, you can calculate the difference between the purchase price and par value as interest.
Convertible Bonds
Convertible bonds blend features of both bonds and stocks. These are regular, fixed-income bonds. However, they can also turn into stock of the issuing company. This provides a chance for extra profit if the issuing company sees big gains in its share price.
Understanding Liquidation Preference
A firm repays investors in a particular order as it liquidates when it goes bankrupt. It begins to pay out its investors after it sells off all its assets. Senior debt must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.
Frequently Asked Questions About Bonds:
Which Is Larger, the Stock Market or the Bond Market?
The bond market is much larger than the securities market in terms of total market value.
What Is the Partnership between a Bond’s Cost and Interest Rates?
Bond rates are inversely associated with interest rate steps. Bond rates fall if interest rates increase and the other way around.
Are Bonds Risky Investments?
Bonds are usually safer and less volatile than stocks. Still, they come with risks. There’s a credit risk that the bond issuer will default. There’s also interest rate risk, where bond prices can fall if interest rates increase.
The Bottom Line: Mastering Bond Investing
The bond market seems tricky, but it works like the stock market. Both are driven by risk-return tradeoffs. They can be skilled bond investors when they master a few basic terms and measurements. This knowledge reveals the familiar market dynamics. The rest is easy after you have a hang of the lingo.
Knowing these four key aspects of bonds—types, risks, yields, and payment structures—can help you make smart investment choices. The bond market allows investors to diversify beyond stocks. This creates more balanced and resilient portfolios.
