Do you want to improve the risk-return profile of your portfolio? Bonds add diversification and reduce volatility, making a portfolio more balanced. Even the most seasoned investors may find the bond market confusing, though.
Because of the seeming intricacy of the bond market and its jargon, many investors only make sporadic forays into bonds. Bonds are actually rather basic debt instruments. So, how can one enter this market segment? Start investing in bonds by familiarizing yourself with these fundamental terms.
Basic Bond Characteristics
A bond represents a form of debt utilized by companies. Instead of seeking funds from a bank, the company raises capital by selling bonds to investors. Investors who purchase these bonds essentially lend money to the company. In return for this capital, the company commits to paying an interest coupon, an annual interest rate calculated as a percentage of the bond's face value. The company disburses interest payments at specified intervals, typically annually or semiannually, and repays the principal amount upon the bond's maturity, concluding the borrowing arrangement.
In contrast to stocks, bonds exhibit significant variability based on the terms outlined in their indenture, a legal document specifying the bond's characteristics. Given the uniqueness of each bond issue, it is crucial to comprehend the precise terms before making an investment. Notably, there are six key features to consider when evaluating a bond.
Types of Bonds
Corporate Bonds
Corporate bonds represent debt securities issued by companies to cover their expenses and generate capital. The yield on these bonds is contingent upon the creditworthiness of the issuing company. The riskier bonds, often termed "junk bonds," come with higher potential returns. Interest earned from corporate bonds is subject to federal and local income taxes.
Sovereign Bonds
Sovereign bonds, also known as sovereign debt, are debt securities issued by national governments to meet their financial needs. Due to the extremely low likelihood of default by these governments, these bonds typically receive a very high credit rating and offer relatively lower yields. In the United States, government-issued bonds are referred to as Treasuries, while in the United Kingdom, they are called gilts. Treasuries are exempt from state and local taxes but are still subject to federal income tax.
Municipal Bonds
Municipal bonds, commonly known as munis, are debt instruments issued by local governments. Despite the name, this category encompasses state and county debt, not just municipal debt. Income generated from municipal bonds is generally not subject to most taxes, making them an appealing investment for individuals in higher tax brackets.
Key Terms
Maturity:
Maturity refers to the date when the principal or par amount of a bond is repaid to investors, marking the conclusion of the company's bond obligation. It essentially signifies the lifespan of the bond, and investors often consider it a crucial factor in alignment with their investment goals and time horizon. Maturity is commonly categorized into three groups:
Short-term: Bonds falling into this category typically mature within one to three years.
Medium-term: Bonds with maturity dates ranging from four to 10 years.
Long-term: Bonds maturing over a period exceeding 10 years.
Secured/Unsecured:
Bonds can be either secured or unsecured. Secured bonds involve pledging specific assets as collateral to bondholders in case the company fails to meet its obligation. Mortgage-backed securities (MBS) are examples of secured bonds, backed by titles to borrowers' homes. On the contrary, unsecured bonds, also known as debentures, lack collateral backing. In this case, both interest and principal are guaranteed solely by the issuing company, making them riskier than secured bonds.
Liquidation Preference:
In the event of bankruptcy, firms repay investors in a specific order during the liquidation process. Senior debt takes precedence, followed by junior (subordinated) debt, with stockholders receiving any remaining funds after all assets are sold.
Coupon:
The coupon amount signifies the interest paid to bondholders, typically on an annual or semiannual basis. Also referred to as the coupon rate or nominal yield, it is calculated by dividing the annual payments by the face value of the bond.
Tax Status:
While most corporate bonds are taxable, certain government and municipal bonds are tax-exempt, meaning that income and capital gains are not subject to taxation. Tax-exempt bonds generally offer lower interest rates compared to equivalent taxable bonds, requiring investors to calculate the tax-equivalent yield for comparison.
Callability:
Some bonds may be redeemed by the issuer before reaching maturity. Bonds with a call provision allow the company to repay them earlier, usually at a slight premium to the par value. This option is often exercised when prevailing interest rates enable the company to borrow at more favorable terms, making callable bonds appealing to both issuers and investors due to potentially better coupon rates.
Risks of Bonds
Bonds serve as a reliable source of income due to their generally secure nature as investments. However, like any investment, they are not without risks. Below are some of the most prevalent risks associated with bond investments:
Interest Rate Risk:
Bonds and interest rates share an inverse relationship; as rates rise, bond values tend to fall and vice versa.
Interest rate risk arises when rates deviate significantly from investors' expectations.
A substantial decline in interest rates poses the risk of prepayment, while rising rates may leave investors with a bond yielding below market rates.
The time to maturity plays a crucial role, with longer maturities carrying higher interest rate risk due to increased difficulty in predicting market developments further into the future.
Credit/Default Risk:
This risk pertains to the possibility that the issuer fails to meet interest and principal payment obligations.
Investors typically expect that issuers will fulfill their commitment to timely interest and principal payments, just as any other creditor.
Assessing corporate bonds involves considering the likelihood of the company defaulting on its debt.
Safety in this context is often associated with companies boasting higher operating income and cash flow in comparison to their debt. Conversely, a higher debt-to-cash ratio may signal increased risk for investors.
Prepayment Risk:
Prepayment risk refers to the chance that a bond issue will be repaid earlier than anticipated, often through a call provision.
Investors may face challenges when a company chooses to repay the obligation early, typically when interest rates have substantially declined.
Instead of holding onto a high-interest investment, investors are left to reinvest funds in a lower interest rate environment.
How Interest is Paid on Bonds
Bondholders receive returns on their investment through two primary methods. Coupon payments represent periodic interest disbursements throughout the bond's lifespan until it matures, at which point the bond can be redeemed for its face value.
However, some bonds follow a different structure, known as zero coupon bonds. These bonds lack periodic coupon payments and instead provide returns solely through the redemption of the face value at maturity. Typically sold at a discounted price, the variance between the purchase cost and face value serves as the implicit interest.
Another variation is seen in convertible bonds, a hybrid security blending characteristics of both bonds and stocks. While functioning as standard fixed-income bonds, convertible bonds offer the additional feature of conversion into the issuing company's stock. This dual nature provides investors with an extra avenue for profit, especially when the company experiences significant gains in its stock price.
Conclusion
The bond market is essentially driven by the same risk/return considerations that drive the stock market, despite its seeming complexity. An investor might become a proficient bond investor after they grasp these few fundamental phrases and metrics that reveal the well-known market dynamics. The rest is simple once you get the hang of the jargon.
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Disclaimer
Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.
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