Investing in Bonds

9.1 Kinds of Bonds

Knowing the different categories of bonds and their strengths and weaknesses helps you diversify more accurately. Each type responds to a different market cycle. Bonds are categorised by issuers, payment, and even location or currency. The first three kinds of bonds are the most common ones.

Treasury Bonds are a loan to the issuing government or government body. These are often called government bonds. There strength is based on the faith one has in the government. Thus US bonds would be considered safer than bonds issued by Zimbabwe.

Municipal Bonds are a debt to cities, states, or other public entities. Often these are issued to create funds to build roads, schools, hospitals, and other public projects. Some municipal bonds have tax advantages. Some of these bonds may be revenue bonds. The interest and principal on these bonds are paid by the collection of tolls or fees from a specific project.

Corporate Bonds are a debt to corporations issued to raise money for capital improvements, acquisitions, or refinancing old debt. Independent companies rate bonds with ratings such as AAA+ to DDD-. Bonds can also be secured or guaranteed.

• Secured. Secured bonds are backed by assets from the company.
• Guaranteed bonds have a second party such as an insurance company guarantee the bond will be paid.
• Investment grade bonds are from companies with a rating of BBB- or better.
• High yield bonds or junk bonds come from companies with ratings below BBB- or businesses that are considered less stable. The yield on these bonds are usually higher than other bonds to compensate for the increased risk of default. Interesting to note: bondholders get paid before shareholders. So junk bonds may be more secure, but perhaps less liquid, than stock in the same company.

Foreign Currency Bonds are issued in a currency different from the originating country. The issued currency might be more stable than the issuing country’s currency. It can be used to help a company break into foreign markets or be a hedge against foreign exchange risks.

Perpetual Bonds have no redemption date. They have little principal value as their only real value comes from interest payments.

Zero Coupon Bonds or discount bonds pay no regular interest over the bond period. Instead, you pay much less for them than the face value. As you hold them, the interest accrues and you are paid the full face value at maturity.

9.2 Earning Money with Bonds

Sometimes the interest paid on bonds is called a ‘coupon’. This is because paper bonds of the past had coupons attached to the bond. When the bondholder was due interest, he’d take the coupon to the bank to redeem it for the interest.

Zero coupon bonds have no ‘coupons’. That is, they pay no interest for the duration of the bond. Instead, the price of the bond is based on the face value and accrued interest. The closer to maturity, the more value the bond has.

Bond Math

Finding the Yield Rate

Annual Interest Payment – yield rate

Current Price

Factors:

• All interest earned to maturity
• Remaining life of bond
• Face value
• Current market value

Market price is a percentage of the face value

If you choose to hold a bond to maturity, the price and value are simple. You buy a bond. You receive interest, and at maturity, you get your money back (as long as the bondholder does not default.) If you consider buying or selling your bond before maturity, figuring out the market value of a bond is trickier.

To calculate the market value of a bond before maturity, you must first find the yield rate. This comes from dividing the annual interest payment by the current price. Remember, the current price of the bond fluctuates based on:

• Interest rates
• Risks of the issuer
• Demand
• Other factors

For example, if interest rates rise, bond prices will fall. This is an inverse relationship. If a company receives a downgraded rating, its bond prices will fall. Any fear of default reduces the bond price. If interest rates drop, bond prices may rise – even going higher than their face value. The market price is listed as a percentage of the assigned value.

The sale or exchange value of a bond takes into consideration all the above factors. The yield to maturity, or redemption yield, also considers the remaining life of the bond, the bond face value, and the market value of the bond. The U.S. market typically quotes a flat or ‘clean price’ which is the face value price only. Other countries may quote a full or ‘dirty price’ which includes the face amount plus interest accrued to the maturity date.

Buying and Selling: Most bonds are initially bought from the issuer in lots by banks, central banks, hedge funds, or insurance companies.They may then be sold to the general public. Banks may charge a commission on the sale or they may make their profit on the buy/sell spread.

You can buy new bonds or buy them on the secondary market. There is not a bond market in the same way there is a stock exchange. The bond market is decentralised and dealer based. Usually a bank or securities firm buys the bond and either keeps it or resells it. It may be easier for investors to buy a bond fund. This fund holds the bonds, but now you can buy and sell just like a stock.

Rewards and Risks: Investors choose bonds for the steady income they offer. When purchased from a highly rated entity and held to maturity, investors can determine exactly how much they might expect in returns. As a debt holder, bondholders have an advantage over equity or shareholders. If a corporation or business goes bankrupt, bondholders get paid first.

But all investments carry risk and bonds are no different. Here are some of the possible risks.

• Credit Risk: If the issuing entity defaults or goes bankrupt, bondholders may lose their principle. If the company is downgraded, bond price will fall resulting in lower resale price. Price fluctuation does not affect the bondholder if you intend to hold the bond to maturity.
• Revenue Municipal Bonds: Revenue bonds come from things like toll roads, landfills, or other municipal projects that produce income. If the revenue source dries up, the municipality may not be obligated to pay off the bond. You could lose the principal you invested.
• Callable: Corporations or cities may call the bonds or pay them off early. They will pay face value, but you lose the income ‘coupon’. Usually this happens when interest rates are falling, so you may not find as favourable a rate when you reinvest your money.
• Interest Rate Risk: If you sell before maturity, you are subject to market value. Rising interest rates may price your bonds below the face value and you lose part of your original investment.
• Liquidity Risk: Since bonds do not sell on an official market you may not be able to sell your bonds as quickly as you want or exactly when you want to. The resale market for buying and selling bonds is much smaller than new purchases. While there are over two million bonds in existence, only a small percentage – perhaps tens of thousands – change hands on any one day.40

Bonds have traditionally been considered one of the safest investments. The returns are fairly predictable and the volatility is lower than most any other investment vehicle. Some investors are happy to get lower returns along with lower risks. Advisors often recommend bonds for retirees and other people on fixed incomes. These people may not be able to afford the risk of higher volatility found in other investments.