The Basics of Bonds

Printer Friendly Printer Friendly February 3, 2017

At Stock Rover, we specialize in tools and data primarily for equity research, but we also aim to provide well-rounded investment education to novice and intermediate level investors. So here is a brief primer on bonds, a very popular alternative investment instrument to equities.

You can buy and sell individual bonds through most brokerage houses. Although you can’t research bonds in Stock Rover, you can track those that you own in your portfolio. If you have linked your portfolio in Stock Rover to your brokerage, bonds should appear automatically in your portfolio as an asset. Or if you are manually updating your portfolios in Stock Rover, just edit “Other Assets” in the Update Portfolio window.

Bonds: What Are They?

A bond is a debt security. Basically, it’s an IOU. When you buy a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer.

In return for that money (the principal), the issuer provides you with a bond in which it promises to pay a specified rate of interest (known as the coupon) during the life of the bond and to repay the face value of the bond when it matures, or comes due. This means you get a steady predictable stream of income while you have lent out your principal.

Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds.

Bonds can be also called bills, notes, debt securities, or debt obligations. They are traded in units of $1,000.

What’s the Risk?

The risk of buying bonds is that the issuer could default and you might not get the principal back. As with stocks, riskier bonds can offer more reward (a higher coupon), but are also more likely to default.

Bond ratings help you identify bonds with the lowest likelihood of default. The riskiest bonds, with a rating of BB or lower, are called junk bonds. On the other end of the spectrum, U.S. Treasury bonds have the highest rating and are generally considered the safest type of investment, sometimes referred to as a “risk-free” investment, because they are guaranteed by the U.S. government. The potential return of any non-risk-free investment can be compared to this risk-free rate in order to estimate the risk premium, as we did here in this blog post.

Note also that some bonds are callable. A callable bond can be called back, or redeemed by the issuer before the bond is due. Getting a bond called is undesirable, because it means a bunch of money is dumped on you that you need to reinvest, generally at less attractive rates (which is why the bond would get called in the first place—the market rate would have become more favorable to issuers). Because being callable is an undesirable feature for the buyer, callable bonds tend to have higher coupons.

Bonds are usually callable at or slightly above par. Par is face value of the bond (i.e., the amount of the principal that you lent). If a bond is callable at par, that means all of principal is returned. Or the bond could be callable at something like $102, which means the issuer pays an additional 2% penalty to call the bond, so you would receive $102 for every $100 of principal you lent (or $1,020 for every $1,000).

Bond Valuation

Bonds are primarily valued on the following five things:

  1. The quality of the issuer and the bond (bonds are rated by ratings agencies)
  2. The core interest rate the bond pays (coupon)
  3. The tax treatment of the coupon (fully taxable, federal tax exempt, or federal and state tax exempt)
  4. The duration of the bond
  5. The callable characteristics

An Example

You could buy a $100,000 Massachusetts G.O. (general obligation) bond. G.O.s are guaranteed by Massachusetts state tax revenues. Let’s say our Mass G.O. bond has a 20-year life and pays an interest rate of 4%. Note that the bond interest is federal tax free and is also state tax free if you live in Massachusetts. The interest (AKA the coupon) is paid twice a year. So you get $2,000 every 6 months. At the end of 20 years, the principal is returned to you and the bond expires. If the bond is callable, it could be called back anytime on or after the first call date of the bond, which is stated by the bond issuer. A typical call date for a 20 year bond might be 6 years after the issue date, though this varies widely.

For trading purposes (i.e., if you want to sell your bond to another buyer), the par value is often quoted on a scale of 100. So if par is 100 and by the time the bond goes on sale, interest rate conditions may have changed—say rates have increased. Now instead of the 4.0%, investors want a 4.2% return in order to buy that same Mass G.O. bond. The bond would need to priced at a discount to par in order to sell. So in this case, it would sell at 95.24, a discount to par, and they buyer would spend $95,240 to purchase that $100,000 bond. The amount paid at maturity is still the amount shown on the certificate, which in this case would be $100,000.

Other Types of Bonds

Here are two common bonds that are structurally different from a typical bond:

  1. Zero coupon bonds. This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let’s say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you’d be paying $600 today for a bond that will be worth $1,000 in 10 years.
  2. Variable rate bonds. They pay as base interest rate, plus an amount from the change in an index. The best example is TIPS or Treasury Inflation-Protected Securities. TIPS provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

Advantages of Bonds

  • Stability. Bonds are normally less volatile than stocks. A portfolio with both stocks and bonds can reduce your portfolio’s losses during stock market declines versus an all stock portfolio.
  • Income. Bonds pay interest regularly, so they can help generate a steady, predictable stream of income from your savings.
  • Security. Next to cash, U.S. Treasury bonds are the safest, most liquid investments on the planet. Other types of bonds are typically safer than stocks. Even for corporate bonds, in the event of financial distress bondholder are placed ahead of stockholders for claims on remaining capital.
  • Tax savings. Certain bonds (e.g. municipals) provide tax-free income. These bonds usually pay lower yields than comparable taxable bonds, but may provide higher after-tax income to investors in high tax brackets.

Disadvantages of Bonds

  • Inflation. The term “inflation” refers to a general increase in prices of goods and services and a fall in the purchase power of money. A few bonds are inflation-protected (e.g., TIPS), but most are not. Since bond interest payments are fixed, there is nothing you can do about the situation, except watch inflation erode the value of your bonds. For example, if your bonds pay 4 percent per year but inflation increases from 2% to 5%, you have gone from a net 2% real gain to a net 1% real loss.
  • Interest rate risk. Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
  • Liquidity. Bonds are not as liquid as stocks. You can trade your bonds before they reach maturity, but the market tends to be highly illiquid. As a result, you may have to sell them at a rate lower than your purchase price.
  • Lower returns. Since the purchase of a bond is a low-risk investment, investors are willing to accept lower returns than they would get from stocks. Some may argue that even low-interest bonds can outperform bad stocks, which is true. On average, however, the return on a highly rated bond is still often much lower than the return on an average stock.

We hope you enjoyed this short course on bonds. Look out next week for our primer on Mutual Funds.





Comments

Brokers mark up bonds, which is how they get paid and how they make their commission. The fees depend on the broker and on the bond. It wouldn’t be a stretch to say brokers can make a lot of money when clients trade bonds. An investor would need to ask the broker what the markup fees are for bond trading to in order to understand these costs.

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