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BONDS

What is a bond?

A bond is debt issued by either a federal, state or local government agency or a private company. When you buy a bond, you’re effectively loaning the bond issuer your money. With a bond, the issuer promises to repay your principal with interest.

What’s the difference between a bond and a note?

Nothing really, only the term to maturity. Both are debt instruments usually paying interest every six months but a note generally matures in 2 to 7 years (sometimes 10 years is the upper boundary). Bonds are of longer maturity, from 7 (or 10) to 30 or more years.

Why are bonds considered less risky than stocks?

Bonds overall are more reliable than stocks due to their fixed interest payments and the prior rights of bondholders over stockholders if a company declares bankruptcy. According to "The Truth About Money" (Georgetown University Press, Washington, D.C.), "All investments are designed to produce income or grow in value (sometimes both). Of the two, income is much more reliable than growth. After all, a company’s management cannot make its stock price rise, but it can pay interest to its bondholders and declare stock dividends for shareholders. Therefore, income-producing investments are considered safer (in this case, safety is defined as reliability) than growth-oriented investments because investors can expect to receive their income more reliably than they can expect an investment to grow in value." The greater certainty in bond cash flows over stocks has a price; historically bonds have underperformed stocks with respect to investment yields.

What are the historical rates of return for cash, bonds and stocks and how should they affect how my assets are allocated?

To create a successful long-term investment plan for a lump sum of money, it’s important to strike a balance between the three major financial asset classes.
1. Cash and cash equivalents provide a stable investment value and current investment income. This group includes money market funds, T-bills, and bank CDs.
2. Bonds are interest-bearing obligations issued by corporations, the federal government and its agencies, and state and local governments. The yields offered by these securities are generally higher than those of cash reserves, but their value fluctuates with bond market conditions.
3. Common stocks represent ownership rights in a corporation. They offer potential for capital growth and often pay dividends. Stock market risk can be substantial, however. Your investment returns depend to a great extent on how you allocate your money among these three asset classes. Common stocks have historically delivered the highest returns.
Since 1926, according to Ibbotson Associates, the average annual return on stocks has exceeded 10%. The return on bonds has been 5% and on cash reserves less than 4%. Although stocks and bonds offer the potential for higher returns than cash reserves, they also expose you to more risk, particularly in the short term. Also, remember that these historical returns are averages, which means that to get a 10% average return, annual returns greater than 10% must be offset along the way by annual returns of less than 10%. Finally, historical average returns do not assure future returns.

What’s the difference between a bearer bond and a book-entry bond?

For decades, all bond investors received a bond certificate that detailed the terms on which the bond would be repaid. The certificates had coupons attached that the investor, or "bearer," would pull off and redeem when an interest payment was due. Since the investor actually held the bond, these were called bearer bonds. Starting in the early 1980s, technological advances allowed new bond issues to be registered and stored electronically. These are called book-entry bonds, and have eliminated the need for cumbersome bearer bonds.

What is a callable bond?

A callable bond is a bond that can be retired, or "called in," by the issuer before the bond matures. The power to call a bond gives companies the ability to respond to falling interest rates. Say XYZ Corp. issued bonds with a 12% coupon several years ago, when interest rates were high. If bond rates had since dropped to 7%, XYZ Corp. could call the bonds, issue new bonds at 7% and pay off the investors -- saving millions in interest charges. The investors would come out on the short end, because they would have to re-invest the cash at much lower rates. Callable bonds often pay higher rates than noncallable bonds to compensate investors for this uncertainty. If you decide to buy callable bonds, just remember that the bond might be called back if interest rates drop. Often, there is a grace period before the bond can be called. When buying callable bonds it is important to know when the first call date is.

How do I know if a bond is callable?

A callable bond is one that the issuer can retire, or "call in," after a specified date and before it reaches maturity. This gives the issuer more flexibility to react to dropping interest rates: if the company is paying 11% on its bonds and rates drop to 8%, the company can call the bonds in, re-issue new bonds at 8% saving potentially millions of dollars in interest costs and pay off the investors. Callable bonds often pay higher rates than noncallable bonds to compensate investors for this uncertainty. They also have to state whether the bond is callable or noncallable and the call date in their offering prospectus. If you buy your bonds through a broker, the broker should advise you whether a bond is callable. In bond dealer’s guides, corporate bonds that have NC next to their names are noncallable.

How will I know if my bond is called in?

If you own a callable bond and the issuer decides to call the bond in, you will be notified by mail. Issuers also take out advertisements, usually in publications such as The Wall Street Journal. Should your bond be called, you have no choice but to accept. That’s because the bond will stop paying interest on the date specified by the company.

What are taxable bonds?

Taxable bonds include all long-term debt instruments other than those issued by cities, states, counties, or other local-government entities (those are called municipal bonds). Taxable bonds are issued by corporations, the U.S. government and its agencies, and foreign governments. U.S. government (Treasury) bonds are exempt from state taxes. Municipal bonds are tax-free with respect to federal taxes and state taxes of the home state of issuance.

How am I charged for buying or selling a bond?

Securities brokers use either of two methods to charge you for buying or selling bonds, notes and bills. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "The first way is to charge you a commission or fee. Called a ’net trade,’ the second way is to include the sales charge in the price. All municipal bonds and most government and corporate bonds are traded ’net.’ Any bonds traded on the exchanges are executed with a commission."

How does accrued interest affect the sale or purchase of a bond?

Accrued interest is interest that has been earned but not yet paid. It usually comes into play when you buy bonds on the secondary market. Bonds typically pay interest every six months, but the interest actually accrues every month. So, if you buy a bond between interest-payment dates, you must pay the seller for the months of interest that have already accrued. You’ll get the full six months interest on the next interest-payment date.

What are at-the-market trades?

Most stocks and bonds are bought and sold on an at-the-market basis. If you call your broker and tell him to buy bonds of XYZ Corp. "at the market," the broker will execute your trade at the current asking price. Trades that aren’t at-the-market involve a buyer or seller specifying a certain price known as a limit order.

What is buying a bond at discount?

Bonds are traded at discounts or premiums in order to bring their stated (coupon) rates in line with market rates. Bonds sell at a discount to their par value when market interest rates are higher than the stated coupon rate (interest payment). If a bond has a coupon rate of 8% and market interest rates rise to 10%, then the bond would sell at a discount. Why? You wouldn’t buy a bond at par value that pays $80 a year when you can buy a comparable one that pays $100 at year. The discount makes up for the lower income received from the 8% bond. Bond prices move inversely to market interest rates since the interest payment is fixed and any adjustments must be made to the market price of the bond.

What is selling a bond at a premium?

Bonds sell at premium to their par value when market interest rates are less than the stated coupon rate (interest payment). If a bond has a coupon rate of 10% and market interest rates fall to 8%, the bond would sell at a premium. Why? You wouldn’t sell a bond you currently own at par if it was paying $100 a year when the best comparable bond you could reinvest the proceeds in pays only $80 a year. The premium paid makes up for the lower reinvestment yield you would receive if you sold the bond.

What factors are used to determine a bond’s rating?

Rating agencies rate bonds based on factors including the issuer’s financial strength and how well it is prepared to cover future interest and principal payments. As a general rule, the higher the rating, the lower the interest the bond pays. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "When you buy a bond, its credit rating should be one of your main considerations. Most bonds are rated by Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P) based on the issuer’s ability to pay interest and principal at maturity. U.S. Treasury and government agencies securities are not rated; most corporate and municipal debt securities are rated. Bonds rated as being investment grade have one of the four highest ratings. Bonds rated below this level are considered low quality and are sometimes referred to as ’junk’ bonds, which means that they carry more risk and more potential for volatility and even default. Some municipal bonds and notes are insured by an insurance company, which generally earns them an Aaa or AAA rating by Moody’s or S&P, respectively. U.S. treasury bonds are backed by the full faith and credit of the U.S. government and are considered risk-free with regard to the possibility of a default.

What is the Lehman Brothers Aggregate Bond Index?

The Lehman Brothers Aggregate Bond Index includes government bonds, corporate bonds, mortgage-backed bonds, and Yankee bonds (Yankee bonds are foreign bonds issued in the U.S. and denominated in dollars) with maturities greater than one year. The Lehman Brothers Aggregate Bond Index may be used as a performance benchmark for bond funds and bond portfolios. The index represents a market portfolio of bonds and represents the market’s average annual rate of return and duration.

What is bond duration?

Duration is a risk measure of the price volatility of a bond to changes in interest rates. The greater the duration, the greater the price volatility. The greater the price volatility, the greater the risk. If an investor anticipates a rise in interest rates, he or she would buy bonds with lower durations (bond prices move opposite to changes in interest rates). Likewise, an anticipation of declining interest rates may result in a strategy of buying bonds with greater durations. Do not confuse duration with a bond’s maturity. For bonds paying coupons, the duration is less than the maturity. The exception is with zero-coupon bonds. The duration of a zero-coupon bond is the same as its maturity. Duration is a complicated calculation, but the percentage price change of a bond using its duration is quite simple: % change in price = -duration x change in interest rates. For example if a bond has a duration of 7.5 and market interest rates rise 2%, the percentage price change in the bond is -15% (-7.5 x 2%). The negative sign before the duration indicates the inverse relation between bond prices and interest rates.

What is a bond’s par value?

The par value of a bond is its face value upon maturity -- the lump sum you will get when it matures. For example, if you purchase a $1,000 zero-coupon bond today, its par value would be $1,000 (the amount of principal you will receive upon maturity) -- even though you may have paid only $500 for it.

What is the yield curve of a bond?

A graph of the bond yields available at a given moment in time, with yield-to-maturity rising along the vertical line and bond maturities moving outward along the horizontal line. A normal yield curve rises upward to the right, because bonds of a longer maturity generally pay higher yields. The steeper the slope of the yield curve, the less additional maturity you need for a higher yield. An inverted yield curve slopes downward to the right because short-term rates are higher than long-term rates. There may be several reasons for an inverted yield curve such as higher anticipated inflation in the short run versus the long run or possibly a recession in the offing; high short-term rates will work their way through the economy, putting the brakes on longer-term growth. If short and long-term rates are the same, the yield curve is flat. The yield curve is typically constructed using Treasury securities.

What is yield to maturity for a bond?

Yield to maturity is the promised rate of return if the bond is held to maturity. It takes into account the bond’s market price, its par value (principal paid on maturity), its coupon rate (interest payments) and the years remaining until the bond matures. Calculating the yield to maturity is difficult without a financial calculator because the formula is extremely complicated. Brokers and investment advisers should be able to provide the yield to maturity for you.

What are the advantages of laddering bonds or CDs when I buy them?

One way to manage your exposure to inflation and interest-rate risk is to ladder your fixed-rate investments. Say you want to invest in certificates of deposit. You could buy one CD that matures a year from now, another that matures in two years, a third that matures in three years and so on until all of the money is invested. Every year, one of your CDs is going to mature. If interest rates rise, you can re-invest the proceeds of the CD at an even higher rate. If rates fall, you’ll still be getting high interest income from your longer-term CDs. This strategy can work for bond investors as well.

How does immunization protect a bond portfolio?

Immunization is a bond portfolio risk management strategy that protects (immunizes) the portfolio from interest rate changes by matching the duration of the bond portfolio to the duration of the liability (or when the funds from the portfolio are needed). For example, if you are planning to pay college expenses in 5 years for your child and want to invest in bonds during the interim, you should structure the bond portfolio to also have a duration of 5. This protects the bond portfolio from losing value should interest rates rise or over-allocating resources for college funding. Immunization works on the following premise: If interest rates fall, the coupon payments are reinvested at a lower rate than initially but the value of the bond portfolio rises. Conversely, if interest rates rise, the value of the bond portfolio declines but the coupon payments can be reinvested at a higher rate. In essence, immunization offsets interest rate risk against reinvestment rate risk. Unfortunately, the duration of the liability and the duration of a portfolio of coupon bonds do not decline at the same rate and periodic rebalancing of the portfolio is required (at least once a year). Rebalancing can be avoided if the bond portfolio is constructed with zero-coupon bonds.

How does a sinking fund protect bondholders?

A sinking fund is a special reserve account created by a bond issuer. The issuer promises to put money into the account at regular intervals and to use the cash that accumulates to redeem the bonds. A sinking fund gives bondholders an extra layer of protection against default but may also result in the bond being retired prior to its maturity (similar to a call provision).

What types of bonds do unit investment trusts (UITs) purchase?

A unit investment trust, or UIT, is a variation of a closed-end mutual fund but has a definite termination date, which may be rolled over into a subsequent new UIT to maintain continuity. Most invest in a fixed portfolio of bonds that are held until they mature. This sets UITs apart from bond mutual funds, which can buy and sell bonds daily. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "These UITs purchase primarily debt securities issued by entities in the United States. Each trust typically purchases bonds or notes that fall into a particular category of maturities -- that is, short term, intermediate term or long term. Within each category, the trust can be classified as high quality, medium quality or low quality. "U.S. bond trusts also can be classified as being either taxable or tax-exempt. Taxable bond UITs invest in bonds that pay taxable interest income, such as corporate and U.S. government bonds. Tax-exempt bond UITs invest in bonds that pay tax-exempt interest income, such as municipal bonds. Some UITs invest only in municipal bonds issued by one particular state to obtain state income tax benefits. Each bond UIT’s prospectus explains in detail the ratings of the bonds in the portfolio." Other unit investment trusts invest primarily in bonds issued by entities outside of the United States. These UITs operate the same way as trusts that invest in U.S. bonds, but also present currency risk. You purchase shares in the trust, not the individual bonds held in the trust. You also pay trust management fees.

How does a unit investment trust that invests in bonds handle principal payments?

A unit investment trust, or UIT, is a variation of a closed-end mutual fund. The trusts don’t actively buy or sell the securities they hold, which sets them apart from conventional bond mutual funds. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "When a security held in the unit trust is sold or redeemed, the trust generally pays the proceeds to you based on the number of units you hold on a pro-rated basis. Bond UITs, especially, have bonds called or redeemed, thus providing you with payments that are considered a return of principal. Be aware of what portions are principal rather than income when you receive your distribution checks." This is important at tax time.

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