Want to strengthen your portfolio’s risk-return profile? Adding bonds can create a more balanced portfolio by adding diversification and calming volatility. But the bond market may seem unfamiliar even to the most experienced investors.
Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the bond market and the terminology. In reality, bonds are very simple debt instruments.
So how do you get into this part of the market? How do bonds work? Get your start in bond investing by learning these basic bond market terms.
How Do Bonds Work?
A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.
Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.
Types of Bonds
Corporate Bonds
Corporate bonds refer to the debt securities that companies issue to pay their expenses and raise capital. The yield of these bonds depends on the creditworthiness of the company that issues them. The riskiest bonds are known as “junk bonds,” but they also offer the highest returns. Interest from corporate bonds is subject to both federal and local income taxes.
Sovereign Bonds
Sovereign bonds, or sovereign debt, are debt securities issued by national governments to defray their expenses. Because the issuing governments are very unlikely to default, these bonds typically have a very high credit rating and a relatively low yield.
In the United States, bonds issued by the federal government are called Treasuries, while those issued by the United Kingdom are called gilts. Treasuries are exempt from state and local tax, although they are still 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 is not subject to most taxes, making them an attractive investment for investors in higher tax brackets.
Key Terms
Maturity
This is the date when the principal or par amount of the bond is paid to investors and the company’s bond obligation ends. Therefore, 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 10 years.
Long-term: These bonds generally mature over more than 10 years.
Secured/Unsecured
A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation. This asset is also called collateral on the loan. If the bond issuer defaults, the asset is then transferred to the investor. A mortgage-backed security (MBS) is one type of secured bond backed by titles to the homes of the borrowers.
Unsecured bonds, on the other hand, are not backed by any collateral. This means that the interest and principal are only guaranteed by the issuing company. Also called debentures, these bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.
Liquidation Preference
When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.
Coupon
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.
Tax Status
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.
Callability
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 of Bonds
Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments.
Interest Rate Risk
Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall, and vice versa. Interest rate risk comes when rates change significantly from what the investor expected.
If interest rates decline significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments further into the future.
Credit/Default Risk
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—just like any other creditor.
Financial Industry Regulatory Authority. "Bonds: Risks."
When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. 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
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.Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower-interest-rate environment.
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.
Agencies
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. Each rating agency has a different scale. For S&P, investment grade ranges from AAA to BBB. These are the safest bonds with the lowest risk. This means they are 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 will not have their bonds rated, in which case it is solely up to the investor to judge a firm’s repayment ability. Because the rating systems differ for each agency and change from time to time, research the rating definition for the bond issue you are considering.
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.
Yield to Maturity (YTM)
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. Because it is unlikely that coupons will be reinvested at the same rate, an investor’s actual return will differ slightly.
Calculating YTM by hand is a lengthy procedure, so it is best to use Excel’s RATE or YIELDMAT functions (starting with Excel 2007). A simple function is also available on a financial calculator.
Current Yield
The current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bond’s annual coupon by the bond’s current price.
Keep in mind, this yield incorporates only the income portion of the return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par or face value of the bond.
It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.
Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium.
An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate the yield to call using Excel’s YIELD or IRR functions, or with a financial calculator.
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation.
Because future prices are hard to predict, 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.
How Bonds Pay Interest
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.
Convertible bonds are a type of hybrid security that combines the properties of bonds and stocks. These are ordinary, fixed-income bonds, but they can also be converted into stock of the issuing company. This adds an extra opportunity for profit if the issuing company shows large gains in its share price.
Which Is Larger, the Stock Market or the Bond Market?
The bond market is actually much larger than the stock market, in terms of aggregate market value.
What Is the Relationship Between a Bond’s Price and Interest Rates?
Bond prices are inversely related to interest rate moves. So if interest rates go up, bond prices fall, and vice versa.
Are Bonds Risky Investments?
Bonds have historically been more conservative and less volatile than stocks, but there are still risks. For instance, there is a credit risk that the bond issuer will default. There is also interest rate risk, where bond prices can fall if interest rates increase.
The Bottom Line
Although the bond market appears complex, it is really driven by the same risk-return tradeoffs as the stock market. Once an investor masters these few basic terms and measurements to unmask the familiar market dynamics, they can become a competent bond investor. Once you have a hang of the lingo, the rest is easy.
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