4. BONDS & FIXED INCOME¶

4.1. Bond¶

4.1.1. What Is a Bond?¶

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.

4.1.2. The Issuers of Bonds¶

Governments (at all levels) and corporations commonly use bonds in order to borrow money. Governments need to fund roads, schools, dams or other infrastructure. The sudden expense of war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. Bonds provide a solution by allowing many individual investors to assume the role of the lender. Indeed, public debt markets let thousands of investors each lend a portion of the capital needed. Moreover, markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals—long after the original issuing organization raised capital.

KEY TAKEAWAYS

Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.
Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.
Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

4.1.3. How Bonds Work¶

Bonds are commonly referred to as fixed income securities and are one of three asset classes individual investors are usually familiar with, along with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly traded; others are traded only over-the-counter (OTC) or privately between the borrower and lender.

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

The initial price of most bonds is typically set at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower once the bond matures.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

4.1.4. Characteristics of Bonds¶

Most bonds share some common basic characteristics including:

Face value is the money amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium $1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.
The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50 every year.
Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.
The maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
The issue price is the price at which the bond issuer originally sells the bonds.
Two features of a bond—credit quality and time to maturity—are the principal determinants of a bond’s coupon rate.

If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest. Bonds that have a very long maturity date also usually pay a higher interest rate. This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.

Credit ratings for a company and its bonds are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings. The very highest quality bonds are called “investment grade” and include debt issued by the U.S. government and very stable companies, like many utilities. Bonds that are not considered investment grade, but are not in default, are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk.

Bonds and bond portfolios will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called “duration”. The use of the term duration in this context can be confusing to new bond investors because it does not refer to the length of time the bond has before maturity. Instead, duration describes how much a bond’s price will rise or fall with a change in interest rates.

The rate of change of a bond’s or bond portfolio’s sensitivity to interest rates (duration) is called “convexity”. These factors are difficult to calculate, and the analysis required is usually done by professionals.

4.1.5. Categories of Bonds¶

There are four primary categories of bonds sold in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms.

Corporate bonds are issued by companies. Companies issue bonds rather than seek bank loans for debt financing in many cases because bond markets offer more favorable terms and lower interest rates.
Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors.
Government bonds such as those issued by the U.S. Treasury. Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1 – 10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as “treasuries.” Government bonds issued by national governments may be referred to as sovereign debt.
Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

4.1.6. Varieties of Bonds¶

The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, being recalled by the issuer, or have other attributes.

Zero-coupon bonds do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. U.S. Treasury bills are a zero-coupon bond. For example, the U.S. Treasury sold 26-week bills with $100 face value for $98.78 on October 18th, 2018. That equates to a total annual yield of 2.479% once the bondholder is repaid the entire $100 at the maturity date.

Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. For example, imagine a company that needs to borrow $1 million to fund a new project. They could borrow by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy bonds with an 8% coupon that allowed them to convert the bond into stock if the stock’s price rose above a certain value, they might prefer to issue those.

The convertible bond may the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

Callable bonds also have an embedded option but it is different than what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures. Assume that a company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years. If interest rates decline (or the company’s credit rating improves) in year 5 when the company could borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are not as valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

A Puttable bond allows the bondholders to put or sell the bond back to the company before it has matured. This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders.

The possible combinations of embedded puts, calls, and convertibility rights in a bond are endless and each one is unique. There isn’t a strict standard for each of these rights and some bonds will contain more than one kind of “option” which can make comparisons difficult. Generally, individual investors rely on bond professionals to select individual bonds or bond funds that meet their investing goals.

4.1.7. Pricing Bonds¶

The market prices bonds based on their particular characteristics. A bond’s price changes on a daily basis, just like that of any other publicly-traded security, where supply and demand in any given moment determine that observed price. But there is a logic to how bonds are valued. Up to this point, we’ve talked about bonds as if every investor holds them to maturity. It’s true that if you do this you’re guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.

The price of a bond changes in response to changes in interest rates in the economy. This is due to the fact that for a fixed-rate bond, the issuer has promised to pay a coupon based on the face value of the bond – so for a $1,000 par, 10% annual coupon bond, the issuer will pay the bondholder $100 each year.

Say that prevailing interest rates are also 10% at the time that this bond is issued, as determined by the rate on a short-term government bond. An investor would be indifferent investing in the corporate bond or the government bond since both would return $100. However, imagine a little while later, that the economy has taken a turn for the worse and interest rates dropped to 5%. Now, the investor can only receive $50 from the government bond, but would still receive $100 from the corporate bond.

This difference makes the corporate bond much more attractive. So, investors in the market will bid up to the price of the bond until it trades at a premium that equalizes the prevailing interest rate environment—in this case, the bond will trade at a price of $2,000 so that the $100 coupon represents 5%. Likewise, if interest rates soared to 15%, then an investor could make $150 from the government bond and would not pay $1,000 to earn just $100. This bond would be sold until it reached a price that equalized the yields, in this case to a price of $666.67.

4.1.8. Inverse to Interest Rates¶

This is why the famous statement that a bond’s price varies inversely with interest rates works. When interest rates go up, bond prices fall in order to have the effect of equalizing the interest rate on the bond with prevailing rates, and vice versa.

Another way of illustrating this concept is to consider what the yield on our bond would be given a price change, instead of given an interest rate change. For example, if the price were to go down from $1,000 to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

4.1.9. Yield-to-Maturity (YTM)¶

The yield-to-maturity (YTM) of a bond is another way of considering a bond’s price. YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled. YTM is a complex calculation but is quite useful as a concept evaluating the attractiveness of one bond relative to other bonds of different coupon and maturity in the market. The formula for YTM involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:

\[YTM = \sqrt[n]{ \frac{Face Value}{Present Value} } - 1\]

We can also measure the anticipated changes in bond prices given a change in interest rates with a measure knows as the duration of a bond. Duration is expressed in units of the number of years since it originally referred to zero-coupon bonds, whose duration is its maturity.

For practical purposes, however, duration represents the price change in a bond given a 1% change in interest rates. We call this second, more practical definition the modified duration of a bond.

The duration can be calculated to determine the price sensitivity to interest rate changes of a single bond, or for a portfolio of many bonds. In general, bonds with long maturities, and also bonds with low coupons have the greatest sensitivity to interest rate changes. A bond’s duration is not a linear risk measure, meaning that as prices and rates change, the duration itself changes, and convexity measures this relationship.

4.1.10. Real World Bond Example¶

A bond represents a promise by a borrower to pay a lender their principal and usually interest on a loan. Bonds are issued by governments, municipalities, and corporations. The interest rate (coupon rate), principal amount and maturities will vary from one bond to the next in order to meet the goals of the bond issuer (borrower) and the bond buyer (lender). Most bonds issued by companies include options that can increase or decrease their value and can make comparisons difficult for non-professionals. Bonds can be bought or sold before they mature, and many are publicly listed and can be traded with a broker.

While governments issue many bonds, corporate bonds can be purchased from brokerages. If you’re interested in this investment, you’ll need to pick a broker. You can take a look at Investopedia’s list of the best online stock brokers to get an idea of which brokers best fit your needs.

Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the market price of the bond will fluctuate as that coupon becomes more or less attractive compared to the prevailing interest rates.

Imagine a bond that was issued with a coupon rate of 5% and a $1,000 par value. The bondholder will be paid $50 in interest income annually (most bond coupons are split in half and paid semiannually.) As long as nothing else changes in the interest rate environment, the price of the bond should remain at its par value.

However, if interest rates begin to decline and similar bonds are now issued with a 4% coupon, the original bond has become more valuable. Investors who want a higher coupon rate will have to pay extra for the bond in order to entice the original owner to sell. The increased price will bring the bond’s total yield down to 4% for new investors because they will have to pay an amount above par value to purchase the bond.

On the other hand, if interest rates rise and the coupon rate for bonds like this one rise to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and begin selling at a discount compared to the par value until its effective return is 6%.

The bond market tends to move inversely with interest rates because bonds will trade at a discount when interest rates are rising and at a premium when interest rates are falling.

4.2. Bond Yield¶

4.2.1. What is Bond Yield?¶

Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. Setting the bond yield equal to its coupon rate is the simplest definition. The current yield is a function of the bond’s price and its coupon or interest payment, which will be more accurate than the coupon yield if the price of the bond is different than its face value. More complex calculations of a bond’s yield will account for the time value of money and compounding interest payments. These calculations include yield to maturity (YTM), bond equivalent yield (BEY) and effective annual yield (EAY).

4.2.2. Overview of Bond Yield¶

When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers agree to pay investors interest on bonds through the life of the bond and to repay the face value of bonds upon maturity. The simplest way to calculate a bond yield is to divide its coupon payment by the face value of the bond. This is called the coupon rate.

\[Coupon Rate = \frac{Annual Coupon Payment}{Bond Face Value}\]

If a bond has a face value of $1,000 and made interest or coupon payments of $100 per year, then its coupon rate is 10% ($100 / $1,000 = 10%). However, sometimes a bond is purchased for more than its face value (premium) or less than its face value (discount), which will change the yield an investor earns on the bond.

4.2.3. Bond Yield Vs. Price¶

As bond prices increase, bond yields fall. For example, assume an investor purchases a bond that matures in five years with a 10% annual coupon rate and a face value of $1,000. Each year, the bond pays 10%, or $100, in interest. Its coupon rate is the interest divided by its par value.

If interest rates rise above 10%, the bond’s price will fall if the investor decides to sell it. For example, imagine interest rates for similar investments rise to 12.5%. The original bond still only makes a coupon payment of $100, which would be unattractive to investors who can buy bonds that pay $125 now that interest rates are higher.

If the original bond owner wants to sell her bond, the price can be lowered so that the coupon payments and maturity value equal yield of 12%. In this case, that means the investor would drop the price of the bond to $927.90. In order to fully understand why that is the value of the bond, you need to understand a little more about how the time value of money is used in bond pricing, which is discussed later in this article.

If interest rates were to fall in value, the bond’s price would rise because its coupon payment is more attractive. For example, if interest rates fell to 7.5% for similar investments, the bond seller could sell the bond for $1,101.15. The further rates fall, the higher the bond’s price will rise, and the same is true in reverse when interest rates rise.

In either scenario, the coupon rate no longer has any meaning for a new investor. However, if the annual coupon payment is divided by the bond’s price, the investor can calculate the current yield and get a rough estimate of the bond’s true yield.

\[Current Yield = \frac{Annual Coupon Payment}{Bond Price}\]

The current yield and the coupon rate are incomplete calculations for a bond’s yield because they do not account for the time value of money, maturity value or payment frequency. More complex calculations are needed to see the full picture of a bond’s yield.

4.2.4. Yield to Maturity¶

A bond’s yield to maturity (YTM) is equal to the interest rate that makes the present value of all a bond’s future cash flows equal to its current price. These cash flows include all the coupon payments and its maturity value. Solving for YTM is a trial and error process that can be done on a financial calculator, but the formula is as follows:

\[Price = \sum_{t-1}^T \frac{CashFlows_t}{(1 + YTM )^t} \qquad \textrm{where:} \qquad YTM = \textrm{Yield to maturity}\]

In the previous example, a bond with $1,000 face value, five years to maturity and $100 annual coupon payments was worth $927.90 in order to match a YTM of 12%. In that case, the five coupon payments and the $1,000 maturity value were the bond’s cash flows. Finding the present value of each of those six cash flows with a discount or interest rate of 12% will determine what the bond’s current price should be.

4.2.5. Bond Equivalent Yield – BEY¶

Bond yields are normally quoted as a bond equivalent yield (BEY), which makes an adjustment for the fact that most bonds pay their annual coupon in two semi-annual payments. In the previous examples, the bonds’ cash flows were annual, so the YTM is equal to the BEY. However, if the coupon payments were made every six months, the semi-annual YTM would be 5.979%.

The BEY is a simple annualized version of the semi-annual YTM and is calculated by multiplying the YTM by two. In this example, the BEY of a bond that pays semi-annual coupon payments of $50 would be 11.958% (5.979% X 2 = 11.958%). The BEY does not account for the time value of money for the adjustment from a semi-annual YTM to an annual rate.

4.2.6. Effective Annual Yield – EAY¶

Investors can find a more precise annual yield once they know the BEY for a bond if they account for the time value of money in the calculation. In the case of a semi-annual coupon payment, the effective annual yield (EAY) would be calculated as follows:

\[EAY = \left( \frac{ 1 + YTM }{ 2 } \right) ^2 - 1 \qquad \textrm{where:} \qquad EAY = \textrm{Effective annual yield}\]

If an investor knows that the semi-annual YTM was 5.979%, then he or she could use the previous formula to find the EAY of 12.32%. Because the extra compounding period is included, the EAY will be higher than the BEY.

4.2.7. Complications Finding a Bond’s Yield¶

There are a few factors that can make finding a bond’s yield more complicated. For instance, in the previous examples, it was assumed that the bond had exactly five years left to maturity when it was sold, which would rarely be the case.

When calculating a bond’s yield, the fractional periods can be dealt with simply; the accrued interest is more difficult. For example, imagine a bond has four years and eight months left to maturity. The exponent in the yield calculations can be turned into a decimal to adjust for the partial year. However, this means that four months in the current coupon period have elapsed and there are two more to go, which requires an adjustment for accrued interest. A new bond buyer will be paid the full coupon, so the bond’s price will be inflated slightly to compensate the seller for the four months in the current coupon period that have elapsed.

Bonds can be quoted with a “clean price” that excludes the accrued interest or the “dirty price” that includes the amount owed to reconcile the accrued interest. When bonds are quoted in a system like a Bloomberg or Reuters terminal, the clean price is used.

4.2.8. Bond Yield Summary¶

A bond’s yield is the return to an investor from the bond’s coupon and maturity cash flows. It can be calculated as a simple coupon yield, which ignores the time value of money and any changes in the bond’s price or using a more complex method like yield to maturity. The yield to maturity is usually quoted as a bond equivalent yield (BEY), which makes bonds with coupon payment periods less than a year easy to compare.

Bonds can be purchased through a variety of different sources. A common way to go about purchasing some bond types is to use an investment account through a broker.

4.3. Four basic things to know about bonds¶

Want to strengthen your portfolio’s risk/return profile? Adding bonds can create a more balanced portfolio by adding diversification and calming volatility. Yet even to experienced stock investors, the bond market may seem unfamiliar. Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the market and the terminology. In reality, bonds are actually very simple debt instruments – you can get your start in bond investing by learning these basic bond-market terms.

1. Basic Bond Characteristics

A bond is simply a type of loan taken out by companies. Investors lend a company money when they buy its bonds. In exchange, the company pays an interest “coupon” (the annual interest rate paid on a bond, expressed as a percentage of face value) 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 the bond’s 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.

Maturity

The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the company’s bond obligation will end.

Secured/Unsecured

A bond can be secured or unsecured. Unsecured bonds are called debentures; their interest payments and return of principal are guaranteed only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.

Liquidation Preference

When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all its assets, it begins to pay out to investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left over.

Coupon

The coupon amount is the amount of interest paid to bondholders, normally annually or semiannually.

Tax Status

While the majority of corporate bonds are taxable investments, there are some government and municipal bonds that are tax-exempt, meaning that income and capital gains realized on the bonds are not subject to the usual state and federal taxation.

Because investors do not have to pay taxes on returns, tax-exempt bonds will 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.

2. Risks of Bonds

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.

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.
Interest Rate Risk: Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of prepayment. If interest rates increase, 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 farther out into the future.

3. Bond Ratings

Agencies

The most commonly cited bond rating agencies are Standard & Poor’s, Moody’s and Fitch. These agencies rate a company’s ability to repay its obligations. Ratings range from ‘AAA’ to ‘Aaa’ for “high grade” issues very likely to be repaid to ‘D’ for issues that are in currently in default. Bonds rated “BBB” to “Baa” or above are called “investment grade”; this means that they are unlikely to default and tend to remain stable investments. Bonds rated “BB” to “Ba” or below are called “junk bonds,” which means that default is more likely, and they are thus more speculative and subject to price volatility.

Occasionally, 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 ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering.

4. 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 said 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) for this computation. A simple function is also available on a financial calculator.
Current Yield: 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 amount by the bond’s current price. Keep in mind that this yield incorporates only the income portion of 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 value (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 this yield 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.

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, then he or she can become a competent bond investor. Once you’ve gotten a hang of the lingo, the rest is easy.

4.4. What Is the Quickest, Easiest, and Cheapest Way to Buy a Bond?¶

Bonds usually can be purchased from a bond broker through full service or discount brokerage channels, similar to the way stocks are purchased from a stockbroker. While the presence of online brokerage services has brought investing costs down, dealing with a bond broker can still be prohibitive to some retail investors.

4.4.1. How Bond Brokers Work¶

Many specialized bond brokerages require high minimum initial deposits; $5,000 is typical. There may also be account maintenance fees. And of course, commissions on trades. Depending on the quantity and type of bond purchased, broker commissions can range from 0.5% to 2%.

When using a broker (even your regular one) to purchase bonds, you may be told that the trade is free of commission. What often happens, however, is that the price is marked up so that the cost you are charged essentially includes a compensatory fee. If the broker isn’t earning anything off of the transaction, he or she probably would not offer the service.

For example, say you placed an order for 10 corporate bonds that were trading at $1,025 per bond. You’d be told, though, that they cost $1,035.25 per bond, so the total price of your investment comes not to $10,250 but to $10,352.50. The difference represents an effective 1% commission for the broker.

To determine the markup before purchase, look up the latest quote for the bond; you can also use the Trade Reporting and Compliance Engine (TRACE), which shows all over-the-counter (OTC) transactions for the secondary bond market. Use your discretion to decide whether or not the commission fee is excessive or one you are willing to accept.

4.4.2. Buying Government Bonds¶

Purchasing government bonds such as Treasuries (U.S.) or Canada Savings Bonds (Canada) works slightly differently than buying corporate or municipal bonds. Many financial institutions provide services to their clients that allow them to purchase government bonds through their regular investment accounts. If this service is not available to you through your bank or brokerage, you also have the option to purchase these securities directly from the government.

In the U.S., for example, Treasury bonds and bills (T-bonds and T-bills) can be purchased through TreasuryDirect. Sponsored by the U.S. Department of the Treasury Bureau of the Fiscal Service, TreasuryDirect lets individual investors buy, sell and hold Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), and Series I and EE Savings Bonds in paperless form via electronic accounts. No fees or commissions are charged, but only U.S. citizens are eligible to participate.

4.4.3. Bond Funds¶

Another way to gain exposure in bonds would be to invest in a bond fund, a mutual fund or exchange-traded fund (ETF) that exclusively holds bonds in its portfolio.

When buying and selling these funds (or, for that matter, bonds themselves on the open market), keep in mind that these are “secondary market” transactions, meaning that you are buying from another investor and not directly from the issuer. One drawback of mutual funds and ETFs is that investors do not know the maturity of all the bonds in the fund portfolio since they are changing quite often, and therefore these investment vehicles are not appropriate for an investor who wishes to hold a bond until maturity.

Another drawback is that you will have to pay additional fees to the portfolio managers, though bond funds tend to have lower expense ratios than their equity counterparts. Passively managed bond ETFs, which track a bond index, tend to have the fewest expenses of all.

4.5. How To Invest In Corporate Bonds¶

When investors buy a bond, they are lending money to the entity that issues the bond. The bond is a promise to repay the face value of the bond (the amount loaned) with an additional specified interest rate within a specified period of time. The bond, therefore, may be called an “I.O.U.”

4.5.1. Bond Types¶

The various types of bonds include U.S.government securities, municipals, mortgage and asset-backed, foreign bonds, and corporate bonds.

Corporate bonds are issued by companies and are either publicly traded or private. Bond rating services – such as Standard & Poor’s, Moody’s, and Fitch – calculate the risk inherent in each bond issue, or the chances of a default or failure to pay, and assign a series of letters to each issue signifying its risk factor.

4.5.2. Bond Ratings and Risk¶

Bonds rated triple-A (AAA) are the most reliable and the least risky; bonds rated triple B (BB) and below are the most risky. Bond ratings are calculated using many factors including financial stability, current debt, and growth potential.

In a well-diversified investment portfolio, highly-rated corporate bonds of short-term, mid-term, and long-term maturity (when the principal loan amount is scheduled for repayment) can help investors accumulate money for retirement, save for a college education for children, or to establish a cash reserve for emergencies, vacations or for other expenses.

4.5.3. Buying (and Selling) Bonds¶

Some corporate bonds are traded on the over-the-counter (OTC) market and offer good liquidity – the ability to quickly and easily sell the bond for ready cash. This is important, especially if you plan on getting active with your bond portfolio. Investors may buy bonds from this market or buy the initial offering of the bond from the issuing company in the primary market. OTC bonds typically sell in $5,000 face values.

Primary market purchases may be made from brokerage firms, banks, bond traders, and brokers, all of which take a commission (a fee based on a percentage of the sale price) for facilitating the sale. Bond prices are quoted as a percentage of the face value of the bond, based on $100. For example, if a bond is selling at 95, it means that the bond may be purchased for 95% of its face value; a $10,000 bond, therefore, would cost the investor $9,500.

4.5.4. Interest Payments¶

Interest on bonds is usually paid every six months. On the highest rated bonds, these semi-annual payments are a reliable source of income. Bonds with the least risk pay lower rates of return. The higher risk bonds, in order to attract lenders (buyers), pay a higher return but are less reliable.

When bond prices decline, the interest rate increases because the bond costs less, but the interest rate remains the same as its initial offering. Conversely, when the price of a bond goes up, the effective yield declines. Long term bondsusually offer a higher interest rate because of the unpredictability of the future. A company’s financial stability and profitability may change over the long term and not be the same as when it first issued its bonds. To offset this risk, bonds with long maturity dates pay a higher interest.

A callable or redeemable bond is a bond that may be redeemed by the issuing company before the maturity date. The downside for investors, if a high yield bond is called, is the loss of interest return for the years remaining in the life of the bond. Sometimes, however, a firm calling a bond will pay a cash premium to the bond holder.

Bond prices are listed in many newspapers, including Barron’s, Investor’s Business Daily and The Wall Street Journal. The prices listed for bonds are for recent trades, usually for the previous day, so keep in mind that prices fluctuate and market conditions may change quickly. An alternative to investing in individual corporate bonds is to invest in a professionally managed bond fund or an index-pegged fund, which is a passive fund tied to the average price of a “basket” of bonds.

The Bottom Line

A well-diversified investment portfolio should hold a percentage of the total amount invested in highly-rated bonds of various maturities. Although no corporate bond is entirely risk free, and may sometimes even result at a lossbecause of changing market conditions, highly-rated corporate bonds could reasonably assure a steady income stream over the life of the bond.

4.6. Introduction to Treasury Securities¶

When it comes to conservative investments, nothing says safety of principal like Treasury securities. These instruments have stood for decades as a bastion of safety in the turbulence of the investment markets — the last line of defense against any possible loss of principal.

The guarantees that stand behind these securities are indeed regarded as one of the key cornerstones of both the domestic and international economy, and they are attractive to both individual and institutional investors for many reasons.

4.6.1. Basic Characteristics of Treasury Securities¶

Treasury securities are divided into three categories according to their lengths of maturities. These three types of bonds share many common characteristics, but also have some key differences. The categories and key features of treasury securities include:

T-Bills – These have the shortest range of maturities of all government bonds. Among bills auctioned on a regular schedule, there are five terms: 4 weeks, 8 weeks, 13 weeks, 26 weeks, and 52 weeks. Another bill, the cash management bill, isn’t auctioned on a regular schedule. It is issued in variable terms, usually of only a matter of days. These are the only type of treasury security found in both the capital and money markets, as three of the maturity terms fall under the 270-day dividing line between them. T-Bills are issued at a discount and mature at par value, with the difference between the purchase and sale prices constituting the interest paid on the bill.
T-Notes – These notes represent the middle range of maturities in the treasury family, with maturity terms of 2, 3, 5, 7 and 10 years currently available. The Treasury auctions 2-year notes, 3-year notes, 5-year notes, and 7-year notes every month. The agency auctions 10-year notes at original issue in February, May, August, and November, and as reopenings in the other eight months.Treasury notes are issued at a $1,000 par value and mature at the same price. They pay interest semiannually.
T-Bonds – Commonly referred to in the investment community as the “long bond”, T-Bonds are essentially identical to T-Notes except that they mature in 30 years. T-Bonds are also issued at and mature at a $1,000 par value and pay interest semiannually. Treasury bonds are auctioned monthly. Bonds are auctioned at original issue in February, May, August, and November, and then as reopenings in the other eight months.

4.6.2. Auction Purchase of Treasury Securities¶

All three types of Treasury securities can be purchased online at auction in $100 increments. However, not every maturity term for each type of security is available at every auction. For example, the 2, 3, 5 and 7-year T-Notes are available each month at auction, but the 10-year T-Note is only offered quarterly.

All maturities of T-Bills are offered weekly except for the 52-week maturity, which is auctioned once each month. Employees who wish to purchase Treasury securities may do so through the TreasuryDirect Payroll Savings Plan. This program allows investors to automatically defer a portion of their paychecks into a TreasuryDirect account. The employee then uses these funds to purchase treasury securities electronically.

Taxpayers can also funnel their income tax refunds directly into a TreasuryDirect account for the same purpose. Paper certificates are no longer issued for Treasury securities, and all accounts and purchases are now recorded in an electronic book-entry system.

4.6.3. Risk and Reward of Treasury Securities¶

The greatest advantage of Treasury securities is that they are, of course, unconditionally backed by the full faith and credit of the U.S. government. Investors are guaranteed the return of both their interest and the principal that they are due, as long as they hold them to maturity. However, even Treasury securities come with some risk.

Like all guaranteed financial instruments, Treasuries are vulnerable to both inflation and changes in interest rates. The interest rates paid by T-Bills and Notes are also among the lowest of any type of bond or fixed-income security, and typically only exceed the rates offered by cash accounts such as money market funds.

The 30-year bond pays a higher rate because of its longer maturity and may be competitive with other offerings with shorter maturities. However, Treasury securities no longer come with call features, which are commonly attached to many corporate and municipal offerings. Call features allow bond issuers to call back their offerings after a certain time period, such as 5 years, and then reissue new securities that may pay a lower interest rate.

The vast majority of Treasury securities also trade in the secondary market in the same manner as other types of bonds. Their prices rise accordingly when interest rates drop and vice-versa. They can be bought and sold through virtually any broker or retail money manager as well as banks and other savings institutions. Investors who purchase Treasury securities in the secondary market are still guaranteed to receive the remaining interest payments on the bond plus its face value at maturity (which may be more or less than what they paid the seller for them).

4.6.4. Tax Treatment of Treasury Securities¶

The same tax rules apply for all three types of Treasury securities. The interest paid on T-bills, T-notes and T-bonds is fully taxable at the federal level, but is unconditionally tax-free for states and localities. The difference between the issue and maturity prices of T-Bills is classified as interest for this purpose.

Investors who also realize profits or losses on Treasuries that they traded in the secondary markets must report short- or long-term capital gains and losses accordingly. Each year, the Treasury department sends investors Form 1099-INT, which shows the taxable interest that must be reported on the 1040.

4.6.5. Who Buys Treasury Securities?¶

Treasury securities are used by virtually every type of investor in the market. Individuals, institutions, estates, trusts and corporations all use Treasury securities for various purposes. Many investment funds use Treasuries to meet certain objectives while satisfying their fiduciary requirements, and individual investors often purchase these securities because they can count on receiving their principal and interest according to the specified schedule — without fear of them being called out prematurely.

Fixed-income investors who live in states with high-income tax rates can also benefit from the tax exemption of Treasuries at the state and local levels.

The Bottom Line

Treasury securities comprise a significant segment of the domestic and international bond markets. For more information on Treasury securities, visit www.treasurydirect.gov. This useful website contains a wealth of information on T-Bills, T-notes and T-bonds, including complete auction schedules, a system search for those who need to inquire whether they still own bonds, a list of all bonds that have stopped paying interest and a plethora of other resources.

4.7. The Basics of Municipal Bonds¶

If your primary investing objective is to preserve capital while generating a tax-free income stream, municipal bonds are worth considering. Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of your original investment is returned to you.

4.7.1. Taxes¶

While municipal bonds are available in both taxable and tax-exempt formats, the tax-exempt bonds tend to get the most attention because the income they generate is, for most investors, exempt from federal and, in many cases, state and local income taxes. Investors subject to the alternative minimum tax (AMT) must include interest income from certain munis when calculating the tax and should consult a tax professional prior to investing.

KEY TAKEAWAYS

Municipal bonds are good for people who want to hold on to capital while creating a tax-free income source.
General obligation bonds are issued to raise funds right away to cover costs, while revenue bonds are issued to finance infrastructure projects.
Both general obligation bonds and revenue bonds are tax-exempt and low-risk, with issuers very likely to pay back their debts.
Buying municipal bonds is low-risk, but not risk-free, as the issuer could fail to make agreed-upon interest payments or be unable to repay the principal upon maturity.

4.7.2. Types of Municipal Bonds¶

Municipal bonds come in the following two varieties:

general obligation bonds (GO)
revenue bonds

General obligation bonds, issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.

4.7.3. Credit Risk¶

Although buying municipal bonds is low-risk, they are not entirely without risk. If the issuer is unable to meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer’s creditworthiness, ratings agencies (such as Moody’s Investors Service and Standard & Poor’s) analyze a bond issuer’s ability to meet its debt obligations and issue ratings from ‘Aaa’ or ‘AAA’ for the most creditworthy issuers to ‘Ca’, ‘C’, ‘D’, ‘DDD’, ‘DD’, or ‘D’ for those in default. Bonds rated ‘BBB’, ‘Baa’, or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.

Every year, Moody’s publishes a report on more than 10,000 municipal bond issuers. The most recent report was released in September 2018 and covered defaults in 2017. The report showed seven of 10 Moody’s-rated municipal defaults in 2017 were related to the Commonwealth of Puerto Rico debt crisis. Overall, the total default volume for 2017 was $31.5 billion, a rise of about 15% from $22.6 billion in the previous year—and the highest in the 48-year study period, according to Moody’s.

According to Moody’s data, there continues to be a very clear delineation in default rates beginning in 2007. Between 1970 and 2007, Moody’s reported an average of only 1.3 defaults per year in the muni bond sphere. That number quadrupled after 2007, highlighted by seven defaults in 2013.

FAST FACT

Moody’s most recent annual report on municipal bonds shows the rating agency expects defaults in 2018 and 2019 to drop from 2017 levels and the total default volume to dwindle after it hit a 48-year high in the most recent report.

4.7.4. Tax Bracket Changes¶

Municipal bonds generate tax-free income and therefore pay lower interest rates than taxable bonds. Investors who anticipate a significant drop in their marginal income-tax rate may be better served by the higher yield available from taxable bonds.

4.7.5. Call Risk¶

Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date. The investor’s capital is returned with a premium added in exchange for the early debt retirement. While you get your entire initial investment plus some back if the bond is called, your income stream ends earlier than expected.

4.7.6. Market Risk¶

The interest rate of most municipal bonds is paid at a fixed rate. This rate doesn’t change over the life of the bond. However, the underlying price of a particular bond will fluctuate in the secondary market due to market conditions. Changes in interest rates and interest rate expectations are generally the primary factors involved in municipal bond secondary market prices.

When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive. Investors who want the higher yield may be willing to pay more to get it.

Likewise, if interest rates rise, newly issued bonds will pay a higher yield than existing issues. Investors who buy the older issues are likely to do so only if they get them at a discount.

If you buy a bond and hold it until maturity, market risk is not a factor because your principal investment will be returned in full at maturity. Should you choose to sell prior to the maturity date, your gain or loss will be dictated by market conditions, and the appropriate tax consequences for capital gains or losses will apply.

4.7.7. Buying Strategies¶

The most basic strategy for investing in municipal bonds is to purchase a bond with an attractive interest rate, or yield, and hold the bond until it matures. The next level of sophistication involves the creation of a municipal bond ladder. A ladder consists of a series of bonds, each with a different interest rate and maturity date. As each rung on the ladder matures, the principal is reinvested into a new bond. Both of these strategies are categorized as passive strategiesbecause the bonds are bought and held until maturity.

Investors seeking to generate both income and capital appreciation from their bond portfolio may choose an active portfolio management approach, whereby bonds are bought and sold instead of held to maturity. This approach seeks to generate income from yields and capital gains from selling at a premium.

4.7.8. Evaluating Stability vs. Fit¶

Stability is relative in the municipal bond market. Municipal bonds tend to be safer than many other types of investments, but they are less safe than U.S. Treasury bonds. You can also trade in multiple kinds of municipal bonds, such as assessment bonds, revenue bonds, or general obligation bonds.

The issuer of the bond also matters; bonds issued from municipal authorities in a city with strong financials would be considered more stable than those from a city whose credit rating has been downgraded or has recently filed for bankruptcy.

Plenty of investors make an understandable mistake during tough or uncertain times and develop tunnel vision about stability and safety. In their flight from risk, however, they fail to consider how an investment fits in their financial plans.

Municipal bonds can be a tax haven, often generating higher returns than Treasuries. They can still lose to inflation and tie up large sums of money for much longer than a recession typically lasts.

4.8. What Are the Risks of Investing in a Bond?¶

The most well-known risk in the bond market is interest rate risk – the risk that bond prices will fall as interest rates rise. By buying a bond, the bondholder has committed to receiving a fixed rate of return for a set period. Should the market interest rate rise from the date of the bond’s purchase, the bond’s price will fall accordingly. The bond will then be trading at a discount to reflect the lower return that an investor will make on the bond.

4.8.1. Interest Rate Risk Factors For Bonds¶

Market interest rates are a function of several factors, including the demand for and supply of money in the economy, the inflation rate, the stage that the business cycle is in, and the government’s monetary and fiscal policies.

From a mathematical standpoint, interest-rate risk refers to the inverse relationship between the price of a bond and market interest rates. To explain, if an investor purchased a 5% coupon, a 10-year corporate bond that is selling at par value, the present value of the $1,000 par value bond would be $614. This amount represents the amount of money that is needed today to be invested at an annual rate of 5% per year over a 10-year period, in order to have $1,000 when the bond reaches maturity.

Now, if interest rates increase to 6%, the present value of the bond would be $558, because it would only take $558 invested today at an annual rate of 6% for 10 years to accumulate $1,000. In contrast, if interest rates decreased to 4%, the present value of the bond would be $676. As you can see from the difference in the present value of these bond prices, there truly is an inverse relationship between the price of a bond and market interest rates, at least from a mathematical standpoint.

From the standpoint of supply and demand, the concept of interest-rate risk is also straightforward to understand. For example, if an investor purchased a 5% coupon and 10-year corporate bond that is selling at par value, the investor would expect to receive $50 per year, plus the repayment of the $1,000 principal investment when the bond reaches maturity.

Now, let’s determine what would happen if market interest rates increased by one percentage point. Under this scenario, a newly issued bond with similar characteristics as the originally issued bond would pay a coupon amount of 6%, assuming that it is offered at par value.

For this reason, under a rising interest rate environment, the issuer of the original bond would find it difficult to find a buyer willing to pay par value for their bond, because a buyer could purchase a newly issued bond in the market that is paying a higher coupon amount. As a result, the issuer would have to sell her bond at a discount from par value in order to attract a buyer. As you can probably imagine, the discount on the price of the bond would be the amount that would make a buyer indifferent in terms of purchasing the original bond with a 5% coupon amount, or the newly issued bond with a more favorable coupon rate.

The inverse relationship between market interest rates and bond prices holds true under a falling interest-rate environment as well. However, the originally issued bond would now be selling at a premium above par value, because the coupon payments associated with this bond would be greater than the coupon payments offered on newly issued bonds. As you may now be able to infer, the relationship between the price of a bond and market interest rates is simply explained by the supply and demand for a bond in a changing interest-rate environment.

4.8.2. Reinvestment Risk for Bond Investors¶

One risk is that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided. For example, imagine that an investor bought a $1,000 bond that had an annual coupon of 12%. Each year the investor receives $120 (12% * $1,000), which can be reinvested back into another bond. But imagine that over time the market rate falls to 1%. Suddenly, that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate of the original bond.

4.8.3. Call Risk for Bond Investors¶

Another risk is that a bond will be called by its issuer. Callable bonds have call provisions, which allow the bond issuer to purchase the bond back from the bondholders and retire the issue. This is usually done when interest rates have fallen substantially since the issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell low-rate bonds in a bid to lower debt costs.

4.8.4. Default Risk for Bond Investors¶

This risk refers to an event wherein the bond’s issuer is unable to pay the contractual interest or principal on the bond in a timely manner, or at all. Credit rating services such as Moody’s, Standard & Poor’s and Fitch give credit ratings to bond issues, which helps to give investors an idea of how likely it is that a payment default will occur. For example, most federal governments have very high credit ratings (AAA); they can raise taxes or print money to pay debts, making default unlikely. However, small emerging companies have some of the worst credit (BB and lower). They are much more likely to default on their bond payments, in which case bondholders will likely lose all or most of their investments.

4.8.5. Inflation Risk for Bond Investors¶

This risk refers to an event wherein the rate of price increases in the economy deteriorates the returns associated with the bond. This has the greatest effect on fixed bonds, which have a set interest rate from inception. For example, if an investor purchases a 5% fixed bond, and then inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. The interest rates of floating-rate bonds (floaters) are adjusted periodically to match inflation rates, limiting investors’ exposure to inflation risk.