In the investments world, bonds offer a unique blend of diversification and stability, making them an attractive choice for both novice and seasoned investors. However, the bond market, with its unique terminology and apparent complexity, can seem daunting. But by the end of this post, you’ll have a clear roadmap to navigate the bond market, make informed decisions, and ultimately, fortify your investment portfolio.
What are Bonds?
A bond is essentially a loan taken out by a company from investors. Instead of approaching a bank, the company raises capital from investors who buy its bonds. In return, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. This interest is paid at predetermined intervals, and the principal is returned on the maturity date, marking the end of the loan.
Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Therefore, it is crucial to understand the precise terms before investing. There are six key features to consider when investing in a bond.
Types of Bonds
Bonds can be categorized into:
- Corporate bonds: they refer to the debt securities that companies issue to cover their expenses and raise capital. The yield of these bonds depends on the creditworthiness of the issuing company.
- Sovereign bonds, or sovereign debt: these are debt securities issued by national governments.
- Municipal bonds: they are issued by local governments. The income from municipal bonds is not subject to most taxes, making them an attractive investment for investors in higher tax brackets.
Some bonds can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation, while unsecured bonds are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. These bonds are much riskier than secured bonds.
Bond Maturity
The maturity date is when the principal or par amount of the bond is paid to investors, and the company’s bond obligation ends. It defines the lifetime of the bond. A bond’s maturity is one of the primary considerations an investor weighs against their investment goals and horizon.
When a firm goes bankrupt, it repays investors in a particular order as it liquidates. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.
Understanding Coupon Amount
The coupon amount represents interest paid to bondholders, normally annually or semiannually. The coupon is also called the coupon rate or nominal yield. To calculate the coupon rate, divide the annual payments by the face value of the bond.
While the majority of corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not subject to taxation. Tax-exempt bonds normally have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.
Callable Bonds
Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates.
Risks Associated with Bonds
Like any other investment, bonds come with certain risks. Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa. Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments.
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.
Bond Ratings
Most bonds come with a rating that outlines their quality of credit. That is, how strong the bond is and its ability to pay its principal and interest. Ratings are published and used by investors and professionals to judge their worthiness. The most commonly cited bond rating agencies are Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. They rate a company’s ability to repay its obligations.
Understanding Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations. 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.
There are two ways that bondholders receive payment for their investment. Coupon payments are the periodic interest payments over the lifetime of a bond before the bond can be redeemed for par value at maturity. 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 usually sold at a discount from face value, so the difference between the purchase price and the par value can be computed as interest.
Mastering Bonds
Investing in bonds can be a powerful strategy to diversify and strengthen your portfolio. While the bond market may seem complex at first, understanding the basic terms and dynamics can make the process much simpler and more rewarding. Remember, the key to successful investing lies in making informed decisions and constantly learning and adapting. So, don’t let the apparent complexity of the bond market deter you. Embrace the learning curve, leverage the power of unbroken bonds, and watch your portfolio grow.
