Bond Basics

A bond is a loan for which the investor is the lender. They are like IOUs. When you purchase a bond, you are lending money to the government, a company, or some other organization. Bonds are sold in fixed increments, normally $1000. The organization that sells a bond is known as the issuer. Like other loans, there is an amount borrowed (face value or par value). There is an applicable interest rate (coupon rate), and a specified time when the bond must be paid off (maturity date). Bond maturities can range from days to decades. The bonds that typical individual investors purchase have maturity dates that are years to decades in length. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months, although quarterly or monthly payments are sometimes specified. Because the cash flow from them is fixed, bonds are also known as fixed-income securities. On the maturity date, the face value of the bond is returned to the bondholder.

(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)
Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.

Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.

Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.

Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.

How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.

Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.

A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.

The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.

In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.

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adapted from Engineering Your Retirement, Golio, Wiley, 2006. http://www.golio.net/EngineeringYourRetirement.html