BONDS ARE COMPLEX -- there's no doubt about it -- especially if you're a novice investor with little experience in the markets. That's why a lot of people opt for bond funds when they seek to diversify their investments with some fixed-income exposure. Our view is that if you're willing to put in the effort, you're better off buying individual bonds instead of bond funds. But in the real world, a fund is sometimes worth the convenience.
Here's what you have to consider:
Like an equity mutual fund, a bond fund is managed by a professional investor who buys a portfolio of securities and makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile -- 15 year corporates, for instance, or tax-free municipals -- and pay out a coupon to investors -- often monthly, rather than annually or semiannually like a regular bond.
The chief advantage of a bond fund is that it's convenient. It's also true that when it comes to buying corporate and municipal bonds, a professional manager backed by a strong research organization can make better decisions than the average individual investor. Consequently, if you want to dabble in junk bonds or shelter your income with triple-tax-free New York City 30-year bonds, you may be better off going the easy route and picking a good fund.
The disadvantage of a bond fund is that it's not a bond. It has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key characteristics of individual bonds. Then there are the fees and expenses that can cut into returns. Finally, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager.
The other thing about building your own portfolio of bonds is that you can tailor it to meet your circumstances, meaning the bonds will mature precisely when you need them. A bond fund cannot deliver that sort of precision.
Our advice is this: If you lack the time or interest to manage a bond portfolio on your own -- or if you want a mixed portfolio of corporates or municipals -- buy a bond fund. But if you want a tailored portfolio of Treasurys to mature when your kid goes to college -- and you want to avoid the fees and added risk associated with bond funds -- go ahead and take the plunge.
Copyright © 2007 SmartMoney.com
Sunday, 23 December 2007
Creating the Modern Fixed-Income Portfolio
by Ryan Barnes
Fixed-income investing often takes a backseat in our thoughts to the fast-paced stock market, with its daily action and promises of superior returns, but if you're a retired investor, or are approaching retirement, fixed-income investing must move into the driver's seat. At this stage, preservation of capital with a guaranteed income stream becomes the most important goal. In today's ultra-low interest-rate world, fixed-income investing has become much more complex, and gone are the days where one could invest in U.S. Treasuries at 8%, sit back, and let the income roll in.
Today, investors need to mix things up and get exposure to different asset classes to keep their portfolio incomes high, reduce risk and stay ahead of inflation. Even the great Benjamin Graham, the father of value investing, suggested a portfolio mix of stocks and bonds for later-stage investors. If he were alive today, he would probably sing the same tune, especially since the advent of new and diverse products and strategies for income-seeking investors. In this article, we'll lay down the road map for creating a modern fixed-income portfolio.
Some Historical PerspectiveFrom the very beginning, we are taught that stock returns outpace returns from bonds. While this has been shown to be true, the discrepancy between the two returns is not as great as one might think. The Journal of American Finance conducted a study, "Long Term Bonds Vs. Stocks" (2004). Using more than 60 staggered 35-year intervals from 1900-1996, the study showed that stock returns, after inflation was accounted for, measured an increase of about 5.5%. Bonds, on the other hand, showed real returns (after inflation) of roughly 3%.The Long Bond in the Rearview MirrorOne of the most important changes to fixed-income investing in the 1990s and 2000s era is that the long bond (a bond maturing in more than 10 years) has given up its previously substantial yield benefit. For example, take a look at the yield curves for the major bond classes as they stood on November 15, 2006:
Figure 1
Figure 2
Figure 3
There are several conclusions that can be reached from a review of these charts:
The long (20- or 30-year) bond is not a very attractive investment; in the case of treasuries, the 30-year bond currently yields no more than a six month Treasury bill.
High-grade corporate bonds provide an attractive yield pick-up to treasuries (5.57% to 4.56% for 10-year maturities).
In a taxable account, municipal bonds can offer attractive tax-equivalent yields to government and corporate bonds, if not better. This involves an extra calculation to confirm, but a good estimate is to take the coupon yield and divide it by 0.67 to estimate the effects of state and federal tax savings (for a 33% tax bracket investor). With short-term yields so close to those of long-term yields, it simply doesn't make sense to commit to the long bond anymore. Locking up your money for another 20 years to gain a paltry extra 20 or 30 basis points just doesn't pay enough to make the investment worthwhile.This presents an opportunity for fixed-income investors, because purchases can be made in the five- to 10-year maturity range, then reinvested at prevailing rates when those bonds come due. When these bonds mature is also a natural time to reassess the state of the economy and adjust your portfolio as needed. The current relationship between short-term and long-term yields also illustrates the utility of a bond ladder. Laddering means investing in eight to 10 individual issues, with one coming due every year. This can prevent you from having to forecast interest rates into the future, as maturities will be spread out over the yield curve, with opportunities to readjust every year as your visibility gets clearer.
Add Spice to Your Portfolio1. EquitiesAdding some solid, high-dividend paying equities to form a balanced portfolio is becoming a valuable new model for late-stage investing, even for folks well into their retirement years. There are plenty of large, established companies in the S&P 500 that pay yields in excess of current inflation rates (which are running at about 2.5% per year), along with the added benefit of allowing an investor to participate in corporate profit growth. A simple stock screener can be used to find companies that offer high dividend payouts while also meeting certain value and stability requirements, such as those fit for a conservative investor seeking to minimize idiosyncratic (stock-specific) and market risks. Below is a list of companies with the following example screen criteria:
Size - At least $10 billion in market capitalization
High Dividends - All pay a yield of at least 2.8%
Low Volatility - All stocks have a beta of less than 1, which means they have traded with less volatility than the overall market.
Reasonable Valuations - All stocks have a P/E to growth ratio, or PEG ratio of 1.75 or less, which means that growth expectations are reasonably priced into the stock. This filter removes companies whose dividends are artificially high due to deteriorating earnings fundamentals.
Sector Diversification - The chart below contains companies within all of the major sectors of the S&P 500. A basket of stocks from different sectors can minimize certain market risks by investing in all parts of the economy.
Source: Yahoo! Finance
Figure 4: Average Yield = 3.25%
To be certain, investing in equities comes with considerable risks compared with fixed income, but these risks can be mitigated by diversifying within sectors and keeping overall equity exposure below 30-40% of the total portfolio value.Any myths about high-dividend stocks being stodgy, non-performers are just that - myths. Consider that between 1972 and 2005, stocks in the S&P that paid dividends paid a return of over 10% per year annualized, compared with only 4.3% over the same period for stocks that did not pay dividends. Steady amounts of cash income, lower volatility and higher returns? They aren't sounding so stodgy anymore, are they?2. Real EstateReal estate investment trusts (REITs) are another way to get some high-yielding securities in a conservative portfolio. They provide liquidity, trade like stocks and also have the added benefit of being a distinct asset from bonds and equities. REITs are a way to diversify our modern fixed-income portfolio against market risks in stocks and credit risks in bonds.
3. High Yield BondsHigh yield bonds are another potential avenue. The so-called "junk bonds" that offer above-market yields are very difficult to invest in individually with confidence, but by choosing a fund with consistent operating results, you can devote a portion of your portfolio to high-yield bond issues as a way to boost fixed income returns. (To read more, see Junk Bonds: Everything You Need To Know.)Many high-yield funds will be closed-end, which means that the price may trade higher than the net asset value (NAV) of the fund. Look to find a fund with little to no premium over the NAV for an extra margin of safety when investing here.4. Inflation-Protected SecuritiesNext, consider Treasury Inflation-Protected Securities (TIPS). They are a great way to protect against whatever inflation might throw your way in the future. They carry a modest coupon rate (usually between 1 and 2.5%), but the real benefit is that the price will be adjusted systematically to keep pace with inflation.It is important to note that TIPS are best held in non-taxable accounts, as the inflation adjustments are made through additions to the principal amount. This means that they could create large capital gains when sold, so keep the TIPS in that IRA, and you'll be adding some solid inflation-fighting punch with the security that only U.S. Treasuries can provide.5. Emerging Market DebtMuch like with high-yield issues, emerging market debt is best invested in via a mutual fund or exchange-traded fund (ETF). Individual issues can be illiquid and hard to research effectively. But yields have historically been higher than advanced economy debt, and provide a nice diversification from country-specific risks. Like with high-yield funds, many emerging market funds are closed-end, so look for ones that are reasonably priced compared to their NAV.A Sample PortfolioThis sample portfolio would provide valuable exposure to other markets and asset classes. The portfolio below (Figure 5) was created with safety in mind, but is also poised to participate in global growth through investments in equities and real estate assets.
Figure 5
A Note on RiskThere are risks associated with each type of investment listed here. Diversification among asset classes, however, has proved to be a very effective way to reduce overall portfolio risk. The biggest danger to an investor seeking principal protection with income is keeping pace with inflation, and a savvy way to reduce this risk is by diversifying among high quality, higher-yielding investments more than standard bonds.Know When To Ask For HelpIf it turns out that an investor's retirement plan will call for a periodic "drawing down" of the principal amounts as well as receiving the cash flows, it is best to visit a certified financial plannerä (CFP), who can assist with both the investing and accounting side of a retirement plan, since the size of the portfolio will need to be measured carefully to determine the optimal level of cash flows, and maximizing tax savings will be crucial. A CFP can also run Monte Carlo simulations to show you how a given portfolio would react to different economic environments, changes in interest rates and other potential factors.
We Live in a World of FundsThere are fund options available for any investment method described here, and deciding whether to use one will come down to how much time and effort an investor wishes to devote to his or her portfolio. Choosing wisely is important here, because fees become crucial at this level - a fund aiming to throw off 5% per year in income or dividends is giving up a big slice of an already small pie with an expense ratio of even 0.5%. So keep an eye out for funds with long track records, low turnover and, above all else, low fees when traveling this route.ConclusionFixed income investing has changed dramatically in just a short period of time. While some aspects have become trickier, Wall Street has responded by providing more tools for the modern fixed income investor to create custom portfolios. Being a successful fixed income investor today just might mean going outside the classical style boxes and using these tools to create a modern fixed income portfolio, one that is fit and flexible in an uncertain world.
Copyright © 2007 Investopedia ULC
Fixed-income investing often takes a backseat in our thoughts to the fast-paced stock market, with its daily action and promises of superior returns, but if you're a retired investor, or are approaching retirement, fixed-income investing must move into the driver's seat. At this stage, preservation of capital with a guaranteed income stream becomes the most important goal. In today's ultra-low interest-rate world, fixed-income investing has become much more complex, and gone are the days where one could invest in U.S. Treasuries at 8%, sit back, and let the income roll in.
Today, investors need to mix things up and get exposure to different asset classes to keep their portfolio incomes high, reduce risk and stay ahead of inflation. Even the great Benjamin Graham, the father of value investing, suggested a portfolio mix of stocks and bonds for later-stage investors. If he were alive today, he would probably sing the same tune, especially since the advent of new and diverse products and strategies for income-seeking investors. In this article, we'll lay down the road map for creating a modern fixed-income portfolio.
Some Historical PerspectiveFrom the very beginning, we are taught that stock returns outpace returns from bonds. While this has been shown to be true, the discrepancy between the two returns is not as great as one might think. The Journal of American Finance conducted a study, "Long Term Bonds Vs. Stocks" (2004). Using more than 60 staggered 35-year intervals from 1900-1996, the study showed that stock returns, after inflation was accounted for, measured an increase of about 5.5%. Bonds, on the other hand, showed real returns (after inflation) of roughly 3%.The Long Bond in the Rearview MirrorOne of the most important changes to fixed-income investing in the 1990s and 2000s era is that the long bond (a bond maturing in more than 10 years) has given up its previously substantial yield benefit. For example, take a look at the yield curves for the major bond classes as they stood on November 15, 2006:
Figure 1
Figure 2
Figure 3
There are several conclusions that can be reached from a review of these charts:
The long (20- or 30-year) bond is not a very attractive investment; in the case of treasuries, the 30-year bond currently yields no more than a six month Treasury bill.
High-grade corporate bonds provide an attractive yield pick-up to treasuries (5.57% to 4.56% for 10-year maturities).
In a taxable account, municipal bonds can offer attractive tax-equivalent yields to government and corporate bonds, if not better. This involves an extra calculation to confirm, but a good estimate is to take the coupon yield and divide it by 0.67 to estimate the effects of state and federal tax savings (for a 33% tax bracket investor). With short-term yields so close to those of long-term yields, it simply doesn't make sense to commit to the long bond anymore. Locking up your money for another 20 years to gain a paltry extra 20 or 30 basis points just doesn't pay enough to make the investment worthwhile.This presents an opportunity for fixed-income investors, because purchases can be made in the five- to 10-year maturity range, then reinvested at prevailing rates when those bonds come due. When these bonds mature is also a natural time to reassess the state of the economy and adjust your portfolio as needed. The current relationship between short-term and long-term yields also illustrates the utility of a bond ladder. Laddering means investing in eight to 10 individual issues, with one coming due every year. This can prevent you from having to forecast interest rates into the future, as maturities will be spread out over the yield curve, with opportunities to readjust every year as your visibility gets clearer.
Add Spice to Your Portfolio1. EquitiesAdding some solid, high-dividend paying equities to form a balanced portfolio is becoming a valuable new model for late-stage investing, even for folks well into their retirement years. There are plenty of large, established companies in the S&P 500 that pay yields in excess of current inflation rates (which are running at about 2.5% per year), along with the added benefit of allowing an investor to participate in corporate profit growth. A simple stock screener can be used to find companies that offer high dividend payouts while also meeting certain value and stability requirements, such as those fit for a conservative investor seeking to minimize idiosyncratic (stock-specific) and market risks. Below is a list of companies with the following example screen criteria:
Size - At least $10 billion in market capitalization
High Dividends - All pay a yield of at least 2.8%
Low Volatility - All stocks have a beta of less than 1, which means they have traded with less volatility than the overall market.
Reasonable Valuations - All stocks have a P/E to growth ratio, or PEG ratio of 1.75 or less, which means that growth expectations are reasonably priced into the stock. This filter removes companies whose dividends are artificially high due to deteriorating earnings fundamentals.
Sector Diversification - The chart below contains companies within all of the major sectors of the S&P 500. A basket of stocks from different sectors can minimize certain market risks by investing in all parts of the economy.
Source: Yahoo! Finance
Figure 4: Average Yield = 3.25%
To be certain, investing in equities comes with considerable risks compared with fixed income, but these risks can be mitigated by diversifying within sectors and keeping overall equity exposure below 30-40% of the total portfolio value.Any myths about high-dividend stocks being stodgy, non-performers are just that - myths. Consider that between 1972 and 2005, stocks in the S&P that paid dividends paid a return of over 10% per year annualized, compared with only 4.3% over the same period for stocks that did not pay dividends. Steady amounts of cash income, lower volatility and higher returns? They aren't sounding so stodgy anymore, are they?2. Real EstateReal estate investment trusts (REITs) are another way to get some high-yielding securities in a conservative portfolio. They provide liquidity, trade like stocks and also have the added benefit of being a distinct asset from bonds and equities. REITs are a way to diversify our modern fixed-income portfolio against market risks in stocks and credit risks in bonds.
3. High Yield BondsHigh yield bonds are another potential avenue. The so-called "junk bonds" that offer above-market yields are very difficult to invest in individually with confidence, but by choosing a fund with consistent operating results, you can devote a portion of your portfolio to high-yield bond issues as a way to boost fixed income returns. (To read more, see Junk Bonds: Everything You Need To Know.)Many high-yield funds will be closed-end, which means that the price may trade higher than the net asset value (NAV) of the fund. Look to find a fund with little to no premium over the NAV for an extra margin of safety when investing here.4. Inflation-Protected SecuritiesNext, consider Treasury Inflation-Protected Securities (TIPS). They are a great way to protect against whatever inflation might throw your way in the future. They carry a modest coupon rate (usually between 1 and 2.5%), but the real benefit is that the price will be adjusted systematically to keep pace with inflation.It is important to note that TIPS are best held in non-taxable accounts, as the inflation adjustments are made through additions to the principal amount. This means that they could create large capital gains when sold, so keep the TIPS in that IRA, and you'll be adding some solid inflation-fighting punch with the security that only U.S. Treasuries can provide.5. Emerging Market DebtMuch like with high-yield issues, emerging market debt is best invested in via a mutual fund or exchange-traded fund (ETF). Individual issues can be illiquid and hard to research effectively. But yields have historically been higher than advanced economy debt, and provide a nice diversification from country-specific risks. Like with high-yield funds, many emerging market funds are closed-end, so look for ones that are reasonably priced compared to their NAV.A Sample PortfolioThis sample portfolio would provide valuable exposure to other markets and asset classes. The portfolio below (Figure 5) was created with safety in mind, but is also poised to participate in global growth through investments in equities and real estate assets.
Figure 5
A Note on RiskThere are risks associated with each type of investment listed here. Diversification among asset classes, however, has proved to be a very effective way to reduce overall portfolio risk. The biggest danger to an investor seeking principal protection with income is keeping pace with inflation, and a savvy way to reduce this risk is by diversifying among high quality, higher-yielding investments more than standard bonds.Know When To Ask For HelpIf it turns out that an investor's retirement plan will call for a periodic "drawing down" of the principal amounts as well as receiving the cash flows, it is best to visit a certified financial plannerä (CFP), who can assist with both the investing and accounting side of a retirement plan, since the size of the portfolio will need to be measured carefully to determine the optimal level of cash flows, and maximizing tax savings will be crucial. A CFP can also run Monte Carlo simulations to show you how a given portfolio would react to different economic environments, changes in interest rates and other potential factors.
We Live in a World of FundsThere are fund options available for any investment method described here, and deciding whether to use one will come down to how much time and effort an investor wishes to devote to his or her portfolio. Choosing wisely is important here, because fees become crucial at this level - a fund aiming to throw off 5% per year in income or dividends is giving up a big slice of an already small pie with an expense ratio of even 0.5%. So keep an eye out for funds with long track records, low turnover and, above all else, low fees when traveling this route.ConclusionFixed income investing has changed dramatically in just a short period of time. While some aspects have become trickier, Wall Street has responded by providing more tools for the modern fixed income investor to create custom portfolios. Being a successful fixed income investor today just might mean going outside the classical style boxes and using these tools to create a modern fixed income portfolio, one that is fit and flexible in an uncertain world.
Copyright © 2007 Investopedia ULC
Saturday, 8 December 2007
Common Mistakes by Fixed-Income Investors
By: Glenn Curtis
Individuals seeking income and/or the preservation of capital often consider adding bonds to their investment portfolios. Unfortunately, most investors don't realize the potential risks that go along with an investment in a debt instrument. In this article, we'll take a look at some of the more common mistakes made - and issues overlooked - by fixed-income investors.
Interest Rate VariabilityInterest rates and bond prices have an inverse relationship. As rates go up, bond prices decline, and vice versa. This means that in the period prior to a bond's redemption on its maturity date, the price of the issue could and will vary widely as interest rates fluctuate. Many investors don't realize this.Is there a way to protect against such price volatility?The answer is no. The volatility is inevitable. For this reason, fixed-income investors, regardless of the length of the maturity of the bonds they hold, should be prepared to maintain their positions until the actual date of redemption. If you have to sell the bond prior to maturity, you may end up doing so at a loss if the interest rate has moved against you
Not Knowing the Claim Status or Features of the BondIn the event of bankruptcy, bond investors have first claim to a company's assets. In other words, at least theoretically, they have a better chance of being made whole if the underlying company goes out of business.The trouble is that not all bonds are created equal. There are senior notes, which often are backed by collateral (such as equipment) that are given first claim. There are also subordinated debentures, which still rank ahead of the common stock in terms of claim preference, but below that of the senior holder. It is important to understand which you own, especially if the issue you are buying is in any way speculative.How can you tell what type of bond you own?If you have the certificate in front of you, it will likely say the words "senior note", or indicate the bond's status in some other fashion on the document. Alternatively, the broker that sold you the note should be able to provide that information, as should the underlying company's financial documents, such as the 10-K or the prospectus (if it is an initial issue).In addition, one or all of these sources should be able to tell you the following as well:
The coupon rate: the rate of interest to be paid on the bond.
The maturity date: the date at which the security will be redeemed.
The call provisions: the outline of options the company may have to buy back the debt at a later date.
The call information: This is particularly important to know because of the numerous pitfalls that can be associated with this feature. For example, suppose interest rates decline sharply after you purchase the bond. The good news is that the price of your holding will increase; the bad news is that the company that issued the debt may now be able to go into the market, float another bond and raise money at a lower interest rate and then use the proceeds to buy back, or call your bond. Typically, the company will offer you a small premium for you to sell the note back to them before maturity. But where does that leave you? After your bond is called, you may owe a big tax liability on your gains, and you will probably be forced to reinvest the money you received at the prevailing market rate, which may have declined since your initial investment.
Interest CoverageJust because you own a bond or because it is highly regarded in the investment community doesn't guarantee that you will earn a dividend payment, or that you will ever see the bond redeemed. In many ways investors seem to take this process for granted.But rather than make the assumption that the investment is sound, the investor should review the company's financials and look for any reason it won't be able to service its obligation. They should look closely at the income statement and then take the annual net income figure and add back taxes, depreciation and any other non-cash charges. This will help you to determine how many times that figure exceeds the annual debt service number. Ideally, there should be at least two times coverage in order to feel comfortable that the company will have the ability to pay down its debt.
Market PerceptionAs mentioned above, bond prices can and do fluctuate. One of the biggest sources of volatility is the market's perception of the issue and the issuer. If other investors don't like the issue or think the company won't be able to meet its obligations, or if the issuer suffers a blow to its reputation, the price of the bond will decrease in value. The opposite is true if Wall Street views the issuer or the issue favorably.A good tip for bond investors is to take a look at the issuer's common stock to see how it is being perceived. Why? Because if it is disliked, or there is unfavorable research in the public domain on the equity, it will likely spill over and be reflected in the price of the bond as well.Issuer's HistoryIt is important that an investor peruse old annual reports and review a company's past performance to determine whether it has a history of reporting consistent earnings and that its has made all interest, tax and pension plan obligation payments in the past.Specifically, a potential investor should read the company's management discussion and analysis (MD&A) section for this information. Also read the proxy statement - it, too, will yield clues about any problems or a company's past inability to make payments. It may also indicate future risks that could have an adverse impact on a company's ability to meet its obligations or service its debt
The goal of this homework is to gain some level of comfort that the bond you are holding isn't some type of experiment. In other words, that the company has paid its debts in the past and, based upon its past and expected future earnings, that it is likely to do so in the future.Ignoring InflationWhen bond investors hear reports of inflation trends, they need to pay attention. This is because inflation can eat away a fixed income investor's future purchasing power quite easily.
For example, if inflation is growing at an annual rate of 4%, this means that each year it will take a 4% greater return to maintain the same purchasing power. This is important, particularly for investors that buy bonds at or below the rate of inflation, because they are actually guaranteeing they'll lose money when they purchase the security!Of course, this is not to say that an investor shouldn't buy a low yielding bond from a highly rated corporation. But investors should understand that in order to defend against inflation, they must obtain a higher rate of return from other investments in their portfolio such as common stocks or high yielding bonds.LiquidityFinancial newspapers, quote services, brokers and a company's website may provide information about the liquidity of the issue you hold. More specifically, one of these sources may yield information about what type of volume the bond trades on a daily basis.Why is this important?It is important because bondholders need to know that if they want to dispose of their position, adequate liquidity will ensure that there will be buyers in the market ready to assume it. Generally speaking, the stocks and bonds of large, well-financed companies tend to be more liquid than those of smaller companies. The reason for this is simple: Larger companies are perceived as having a greater ability to repay their debts.Is there a certain level of liquidity that is recommended? No. But if the issue is traded daily in large volumes, is being quoted by the large brokerage houses and has a fairly narrow spread, it is probably suitable. Bottom LineContrary to popular belief, fixed income investing involves a great deal of research and analysis. Those who don't do their homework run the risk of suffering low or negative returns.
Copyright © 2007 Investopedia ULC
Individuals seeking income and/or the preservation of capital often consider adding bonds to their investment portfolios. Unfortunately, most investors don't realize the potential risks that go along with an investment in a debt instrument. In this article, we'll take a look at some of the more common mistakes made - and issues overlooked - by fixed-income investors.
Interest Rate VariabilityInterest rates and bond prices have an inverse relationship. As rates go up, bond prices decline, and vice versa. This means that in the period prior to a bond's redemption on its maturity date, the price of the issue could and will vary widely as interest rates fluctuate. Many investors don't realize this.Is there a way to protect against such price volatility?The answer is no. The volatility is inevitable. For this reason, fixed-income investors, regardless of the length of the maturity of the bonds they hold, should be prepared to maintain their positions until the actual date of redemption. If you have to sell the bond prior to maturity, you may end up doing so at a loss if the interest rate has moved against you
Not Knowing the Claim Status or Features of the BondIn the event of bankruptcy, bond investors have first claim to a company's assets. In other words, at least theoretically, they have a better chance of being made whole if the underlying company goes out of business.The trouble is that not all bonds are created equal. There are senior notes, which often are backed by collateral (such as equipment) that are given first claim. There are also subordinated debentures, which still rank ahead of the common stock in terms of claim preference, but below that of the senior holder. It is important to understand which you own, especially if the issue you are buying is in any way speculative.How can you tell what type of bond you own?If you have the certificate in front of you, it will likely say the words "senior note", or indicate the bond's status in some other fashion on the document. Alternatively, the broker that sold you the note should be able to provide that information, as should the underlying company's financial documents, such as the 10-K or the prospectus (if it is an initial issue).In addition, one or all of these sources should be able to tell you the following as well:
The coupon rate: the rate of interest to be paid on the bond.
The maturity date: the date at which the security will be redeemed.
The call provisions: the outline of options the company may have to buy back the debt at a later date.
The call information: This is particularly important to know because of the numerous pitfalls that can be associated with this feature. For example, suppose interest rates decline sharply after you purchase the bond. The good news is that the price of your holding will increase; the bad news is that the company that issued the debt may now be able to go into the market, float another bond and raise money at a lower interest rate and then use the proceeds to buy back, or call your bond. Typically, the company will offer you a small premium for you to sell the note back to them before maturity. But where does that leave you? After your bond is called, you may owe a big tax liability on your gains, and you will probably be forced to reinvest the money you received at the prevailing market rate, which may have declined since your initial investment.
Interest CoverageJust because you own a bond or because it is highly regarded in the investment community doesn't guarantee that you will earn a dividend payment, or that you will ever see the bond redeemed. In many ways investors seem to take this process for granted.But rather than make the assumption that the investment is sound, the investor should review the company's financials and look for any reason it won't be able to service its obligation. They should look closely at the income statement and then take the annual net income figure and add back taxes, depreciation and any other non-cash charges. This will help you to determine how many times that figure exceeds the annual debt service number. Ideally, there should be at least two times coverage in order to feel comfortable that the company will have the ability to pay down its debt.
Market PerceptionAs mentioned above, bond prices can and do fluctuate. One of the biggest sources of volatility is the market's perception of the issue and the issuer. If other investors don't like the issue or think the company won't be able to meet its obligations, or if the issuer suffers a blow to its reputation, the price of the bond will decrease in value. The opposite is true if Wall Street views the issuer or the issue favorably.A good tip for bond investors is to take a look at the issuer's common stock to see how it is being perceived. Why? Because if it is disliked, or there is unfavorable research in the public domain on the equity, it will likely spill over and be reflected in the price of the bond as well.Issuer's HistoryIt is important that an investor peruse old annual reports and review a company's past performance to determine whether it has a history of reporting consistent earnings and that its has made all interest, tax and pension plan obligation payments in the past.Specifically, a potential investor should read the company's management discussion and analysis (MD&A) section for this information. Also read the proxy statement - it, too, will yield clues about any problems or a company's past inability to make payments. It may also indicate future risks that could have an adverse impact on a company's ability to meet its obligations or service its debt
The goal of this homework is to gain some level of comfort that the bond you are holding isn't some type of experiment. In other words, that the company has paid its debts in the past and, based upon its past and expected future earnings, that it is likely to do so in the future.Ignoring InflationWhen bond investors hear reports of inflation trends, they need to pay attention. This is because inflation can eat away a fixed income investor's future purchasing power quite easily.
For example, if inflation is growing at an annual rate of 4%, this means that each year it will take a 4% greater return to maintain the same purchasing power. This is important, particularly for investors that buy bonds at or below the rate of inflation, because they are actually guaranteeing they'll lose money when they purchase the security!Of course, this is not to say that an investor shouldn't buy a low yielding bond from a highly rated corporation. But investors should understand that in order to defend against inflation, they must obtain a higher rate of return from other investments in their portfolio such as common stocks or high yielding bonds.LiquidityFinancial newspapers, quote services, brokers and a company's website may provide information about the liquidity of the issue you hold. More specifically, one of these sources may yield information about what type of volume the bond trades on a daily basis.Why is this important?It is important because bondholders need to know that if they want to dispose of their position, adequate liquidity will ensure that there will be buyers in the market ready to assume it. Generally speaking, the stocks and bonds of large, well-financed companies tend to be more liquid than those of smaller companies. The reason for this is simple: Larger companies are perceived as having a greater ability to repay their debts.Is there a certain level of liquidity that is recommended? No. But if the issue is traded daily in large volumes, is being quoted by the large brokerage houses and has a fairly narrow spread, it is probably suitable. Bottom LineContrary to popular belief, fixed income investing involves a great deal of research and analysis. Those who don't do their homework run the risk of suffering low or negative returns.
Copyright © 2007 Investopedia ULC
Corporate Bonds: An Introduction to Credit Risk
By: David Harper, CFA, FRM
Corporate bonds offer a high yield compared to some other investments, but the higher yield is not free. Most corporate bonds are debentures, meaning they are not secured by collateral. Investors of such bonds must assume not only interest rate risk but also credit risk, the chance that the corporate issuer will default on its debt obligations. Therefore, it is important that investors of corporate bonds know how to assess credit risk and its potential payoffs: while rising interest rate movements can reduce the value of your bond investment, a default can almost eliminate it (holders of defaulted bonds can recover some of their principal, but it is often pennies on the dollar).
Review Of Yield By yield, we mean yield to maturity, which is the total yield resulting from all coupon payments and any gains from a "built-in" price appreciation. The current yield is the portion generated by coupon payments, which are usually paid twice a year, and, it accounts for most of the yield generated by corporate bonds. For example, if you pay $95 for a bond with a $6 annual coupon ($3 every six months), your current yield is about 6.32% ($6 ÷ $95). The built-in price appreciation contributing to yield to maturity results from the additional return the investor makes by purchasing the bond at a discount and then holding it to maturity to receive the par value. It is also possible for a corporation to issue a zero-coupon bond, whose current yield is zero and whose yield to maturity is solely a function of the built-in price appreciation. Investors whose primary concern is a predictable annual income stream look to corporate bonds, whose yields will always exceed government yields. Furthermore, the annual coupons of corporate bonds are more predictable and often higher than the dividends received on common stock. Assessing Credit Risk Credit ratings published by Moody's, Standard and Poor's and Fitch IBCA are meant to capture and categorize credit risk. (For more on this topic, see the article What Is A Corporate Credit Rating?) But institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis. Many tools can be used to analyze and assess credit risk, but two traditional metrics are interest-coverage ratios and capitalization ratios.Interest-coverage ratios answer the question, "How much money does the company generate each year in order to fund the annual interest on its debt?" A common interest-coverage ratio is EBIT (earnings before interest and taxes) divided by annual interest expense. Clearly, as a company should generate enough earnings to service its annual debt, this ratio should well exceed 1.0 - and the higher the ratio, the better. Capitalization ratios answer the question, "How much interest-bearing debt does the company carry in relation to the value of its assets?" This ratio, calculated as long-term debt divided by total assets, assesses the company's degree of financial leverage. This is analogous to dividing the balance on a home mortgage (long-term debt) by the appraised value of the house. A ratio of 1.0 would indicate there is no "equity in the house" and would reflect dangerously high financial leverage. So, the lower the capitalization ratio, the better the company's financial leverage. Broadly speaking, the investor of a corporate bond is buying extra yield by assuming credit risk. He or she should probably ask, "Is the extra yield worth the risk of default?" or "Am I getting enough extra yield for assuming the default risk?" In general, the greater the credit risk, the less likely it is that you should buy directly into a single corporate bond issue. In the case of junk bonds (i.e. those rated below S&P's BBB), the risk of losing the entire principal is simply too great. Investors seeking high yield can consider the automatic diversification of a high-yield bond fund, which can afford a few defaults while still preserving high yields. Other Risks Investors should be aware of some other risk factors affecting corporate bonds. Two of the most important ones are call risk and event risk. If a corporate bond is callable, then the issuing company has the right to purchase (or pay off) the bond after some minimum time period. If you hold a high-yielding bond and prevailing interest rates decline, a company with a call option will want to call the bond in order to issue new bonds at lower interest rates (in effect, to refinance its debt). Not all bonds are callable, but if you buy one that is, it is important to note the terms of the bond. It is important that you be compensated for the call provision with a higher yield. Event risk is the risk that a corporate transaction, natural disaster or regulatory change will cause an abrupt downgrade in a corporate bond. Event risk tends to vary by industry sector. For example, if the telecom industry happens to be consolidating, then event risk may run high for all bonds in this sector. The risk is that the bondholder's company may purchase another telecom company and possibly increase its debt burden (financial leverage) in the process. Credit Spread: The Payoff For Assuming Credit Risk The payoff for assuming all these extra risks is a higher yield. The difference between the yield on a corporate bond and a government bond is called the credit spread (sometimes just called the yield spread).
As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at each point of maturity (for a review of the yield curve, see this section of the Advanced Bond tutorial). As such, the credit spread reflects the extra compensation investors receive for bearing credit risk. So, the total yield on a corporate bond is a function of both the Treasury yield and the credit spread, which is greater for lower-rated bonds. If the bond is callable by the issuing corporation, the credit spread increases more, reflecting the added risk that the bond may be called. How Changes In The Credit Spread Affect The Bondholder Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions. For example, a credit upgrade on a specific corporate bond, say from S&P BBB to A, will narrow the credit spread for that particular bond because the risk of default lessens. If interest rates are unchanged, the total yield on this "upgraded" bond will go down in an amount equal to the narrowing spread, and the price will increase accordingly. After purchasing a corporate bond, the bondholder will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds. This in turn drives up the price of the bondholder's corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price. So, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with high credit spreads offer the prospect of a narrowing spread, which, in turn, will create price appreciation. But interest rates and credit spreads can move independently. In terms of business cycles, a slowing economy tends to widen credit spreads as companies are more likely to default, and an economy emerging from a recession tends to narrow the spread as companies are theoretically less likely to default in a growing economy. However, in an economy that is growing out of a recession, there is also a possibility for higher interest rates, which would cause Treasury yields to increase. This is a factor that offsets the narrowing credit spread, so the effects of a growing economy could produce either higher or lower total yields on corporate bonds. Conclusion If the extra yield is affordable from a risk perspective, the corporate bond investor is concerned with future interest rates and the credit spread. Like other bondholders, he or she is generally hoping that interest rates hold steady or, even better, decline. Additionally, he or she generally hopes that the credit spread either remains constant or narrows but does not widen too much. Because the width of the credit spread is a major determiner of your bond's price, make sure you evaluate whether the spread is too narrow, but also make sure you evaluate the credit risk of companies with wide credit spreads.
Copyright © 2007 Investopedia ULC
Smoothing Out the Ride
WHETHER YOU are just starting your investing career or have already amassed a tidy nest egg, your portfolio needs some steady and reliable income. For younger people, that income will balance out the periodic dips in a stock-dominated asset mix; for those in retirement, it will provide money to live on.
We're talking here about a long-term investment -- a core commitment to the fixed-income arena that is unaffected by your view of the current state of the bond market or inflation. The strategy is to buy and hold your bonds until maturity, so the foundation should be safe, liquid government bonds -- in particular, intermediate-term Treasurys (those that mature in two to 10 years).
Why not long-term bonds? Because as it turns out, long bonds actually underperform intermediates on a buy-and-hold basis. Using data spanning the past 30 years from investment-research firm Ibbotson Associates, SmartMoney calculated that over a 10-year holding period, a portfolio of Treasury notes with a constant average maturity of five years outperformed a portfolio of 20-year bonds (the standard benchmark back in the 1960s). The five-year notes returned 8.5% averaged annually, while the 20-year bonds returned 8%. In addition, intermediate notes are roughly half as volatile as long bonds. And in terms of balancing your overall portfolio, intermediates are less closely correlated to the ups and downs of the stock market.
Treasury DirectIf you are just starting out, you can simply buy five-year Treasurys, or -- if you have a lot of assets allocated for bonds -- you can put together a so-called ladder of Treasurys. Either way, your best bet for buying bonds is the government's commission-free Treasury Direct program, which allows you to bypass brokers and their fees. An application to open an account may be obtained online by linking to the New York Federal Reserve's Web site or by contacting your nearest Federal Reserve Bank. You can also call the U.S. Bureau of Public Debt at 202-874-4000.
Two- and three-year notes are available for a $5,000 minimum investment, while five- and 10-year notes have $1,000 minimums. You can set up an account online. If for some reason you need to sell the Treasurys in this account before they mature, you will have to have them transferred to a broker, who will charge at least $50 per transaction. In addition, Treasury Direct accounts of $100,000 or more face an annual $25 maintenance fee.
Agency BondsAlso extremely safe and liquid, but offering a slightly higher yield, are government-agency bonds issued by the likes of the Tennessee Valley Authority, Farm Credit Financial Assistance Corp., the Federal National Mortgage Association and the Government National Mortgage Association. (These debentures should not be confused with the mortgage-backed bonds that are also issued by FNMA and GNMA; mortgage-backed securities are extremely sensitive to fluctuations in interest rates and should be avoided.)
It's hard, however, to gain any edge with these bonds over Treasurys. That's because they're generally available only through brokers and thus incur commission costs that cut into their yield. How much? The standard retail brokerage fee comes out to 0.5%, or, in the lingo of the bond world, 50 basis points. Even if you have $100,000 to invest and negotiate a lower commission, perhaps 20 basis points, the advantage over Treasurys will probably come to only around $50 a year.
The exception is if you have a very large portfolio and can sink perhaps $1 million into agency bonds; you might then be able to get the institutional-commission rate of just 10 basis points. Or, at a more modest level, you might be able to hook up with a financial adviser who specializes in making bulk government-agency-bond purchases directly from banks, lumping clients' investments together in order to build million-dollar packages of agency debentures.
Muni Bonds?Investors with substantial income should also consider combining tax-free municipal bonds with their Treasurys. While the stated yields of munis are lower than those of Treasurys, the effective return for investors in high tax brackets is almost always better. As with treasurys, individual muni bonds can also be laddered to limit your interest-rate exposure. But because they tend to trade in fairly large lots (usually $25,000) and because, as a precaution against default risk, investors should spread their money among a variety of different locales, building a muni portfolio requires a commitment of $100,000 at a bare minimum.
If you don't have enough now to build a muni ladder, the next best option is to look to a series of municipal-bond mutual funds. The best are Vanguard's Municipal Limited-Term and Intermediate-Term funds (which both have a minimum initial investment of $3,000; call 800-662-7447 for information). They maintain a low 0.22% expense ratio and are run with minimal maturity fluctuation and risk-taking.
What About Corporates?While investors have traditionally been steered to these vehicles because they offer higher interest income than government bonds, we are dubious about endorsing them. In part, it's a question of costs eating into those higher yields. First there are the taxes: Income from corporates is fully taxed at all levels. If your state and local rates (which are not applicable to government bonds) are a mere 6%, that would cut the effective return of an 8% yield to 7.5%. Next come the transaction costs: both brokerage commissions and the cut taken by the bond dealers (known as the spread). All told, they can easily eat up 1% or more of your investment.
Perhaps most important, though, is that the best bonds are usually callable by the issuer, meaning the corporation can, at its discretion, pay off its obligation at a stated price and stop paying interest. That becomes a heads-you-win, tails-I-lose proposition for investors. If interest rates decline and the value of the bonds goes up, the corporation may call them, disrupting your expected income stream and cutting off a potential capital gain. Meanwhile, if interest rates rise, you are stuck holding a less valuable security that is yielding below-market rates.
Copyright © 2007 SmartMoney.com. All Rights Reserved.
The Basics of the Bond Ladder
When portfolio managers talk about strategies for success, they will often refer to risk diversification and money management. These strategies separate those investors who are successful because of knowledge and skill from those who are merely lucky. Now, don't be mistaken, luck isn't a bad thing to have, but possessing foundational skills will ultimately lead to success. In this article we'll discuss the bond ladder, a bond investing strategy that is based on a relatively simple concept that many investors (and professionals) fail to use or even understand. (If you aren't too familiar with bonds, check out the Bond Basics tutorial before reading further.)
A bond ladder is a strategy that attempts to minimize risks associated with fixed-income securities while managing cash flows for the individual investor. Specifically, a bond ladder, which attempts to match cash flows with the demand for cash, is a multi-maturity investment strategy that diversifies bond holdings within a portfolio. It reduces the reinvestment risk associated with rolling over maturing bonds into similar fixed-income products all at once. It also helps manage the flow of money, ensuring a steady stream of cash flows throughout the year. In simpler terms, a bond ladder is the name given to a portfolio of bonds with different maturities. It means that you buy a collection of bonds with different maturities spread out over your investment time frame. For instance, in a ten-year laddered portfolio, you might purchase bonds that mature in 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10 years. Suppose you had $50,000 to invest in bonds. By using the bond ladder approach, you could buy five different bonds each with a face value of $10,000 or even 10 different bonds each a with face value of $5,000. Each bond, however, would have a different maturity. One bond might mature in one year, another in three years and the remaining bonds might mature in five-plus years - each bond would represent a different rung on the ladder. Why Use A Bond Ladder? The rationale behind laddering isn't complicated. When you buy bonds with short-term maturities, you have a high degree of stability -- but because these bonds are not very sensitive to changing interest rates, you have to accept a lower yield. When you buy bonds with long-term maturities, you can receive a higher yield, but you must also accept the risk that the prices of the bonds might change. By spreading out the maturities of your portfolio, you get protection from interest rate changes. There are two main reasons to use the ladder approach. First, by staggering the maturity dates, you won't be locked into one particular bond for a long duration. A big problem with locking yourself into a bond for a long period of time is that you can't protect yourself from bull and bear bond markets. If you invested the full $50,000 into one single bond with a yield of 5% for a term of 10 years, you wouldn't be able to capitalize on increasing or decreasing interest rates. For example, if interest rates hit a bottom five years (at maturity) after purchasing the bond, then your $50,000 would be stuck with a low interest rate if you wanted to buy another bond. By using a bond ladder, you smooth out the fluctuations in the market because you have a bond maturing every year (or thereabouts). The second reason for using a bond ladder is that it provides investors with the ability to adjust cash flows according to their financial situation. For instance, going back to the $50,000 investment, you can guarantee a monthly income based upon the coupon payments from the laddered bonds by picking ones with different coupon dates. This is more important for retired individuals because they depend on the cash flows from investments as a source of income. If you are not dependent on the income, by having steadily maturing bonds, you will have access to relatively liquid money. If you suddenly lose your job or unexpected expenses arise, then you will have a steady source of funds to use as required. How To Create A Bond Ladder The ladder itself is very simple to create - just picture an actual ladder:
Rungs - By taking the total dollar amount that you are planning to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio, or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one company defaulting on bond payments.
Height of the ladder - The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher the average return should be in your portfolio since bond yields generally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money.
Materials - Just like real ladders, bond ladders can be made of different materials. One straightforward approach to reducing exposure to risk is investing in different companies, but investments in products other than bonds are sometimes more advantageous depending on your needs. Debentures, government bonds, municipal bonds, Treasuries and certificates of deposit - each having different strengths and weaknesses - are all different products that you can use to make the ladder. One important thing to remember is that the products in your ladder should not be redeemable (or callable) by the issuer. This would be the equivalent to owning a ladder with collapsible rungs.
Conclusion It's been said that a bond ladder shouldn't be attempted if investors do not have enough money to fully diversify their portfolio by investing in both stocks and bonds. The money needed to start a ladder that would have at least five rungs is usually between $10,000 - $20,000. If you don't have this recommended amount, purchasing products such as bond funds might be more prudent, as the charges related to the product will be offset by the benefits of diversity that they provide. In either case, make sure that all your eggs aren't in one basket, so that you can control risk exposure, have greater access to emergency funds and have the opportunity to capitalize on ever-changing market conditions
Sources:
http://www.Investorama.com
http://www.Investopedia.com
When Yield Goes Up, Price Goes Down
ALL RIGHT, we might as well dive right into the yield and price mess. Since the first bond hit Wall Street, it's the thing that has most confused beginning investors. You've probably heard the mantra at least once before: When yield goes up, price goes down, and vice versa. But if you're like most people, you haven't the faintest clue why.
Well, here goes...
So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that, but many others -- including the pros -- buy and sell them on the open market before they reach maturity. Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to sell a bond for "par," or 100% of its face value.
We'll explore what drives price changes in the next lecture, but for now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and its ultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6% ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal -- you're getting the same payout for $400 less.
OK, So What Does 'Yield' Mean?
Yield -- a bondspeak standard -- is a figure that captures this change in value. It's the percentage return your bond investment promises at any given price.
In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price. When you buy a bond for face value, the yield is simply the coupon, or interest rate. But when the price fluctuates, the yield grows or shrinks to compensate in either direction.
Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts Yield to Maturity
Unfortunately, it gets even more complicated. In the real world, when people talk about yield, they're really talking about another figure, called "yield to maturity." This represents the total return you can expect if you buy a bond at a given price and hold it until it matures.
Yield to maturity includes the fact that the bond you bought for $800 will pay you $1,000 when it's due. It also assumes you reinvest the coupons at the same rate and figures in the compounding effect. If, in the above example, you add that $200 difference and the effects of reinvested coupons, the yield to maturity calculates out to 7.73% -- a significantly better deal than the original coupon of 6%.
Once you've grasped the inverse relationship between price and yield, you're ready to take on the bond market's next puzzler: If yields and prices move in opposite directions, how come both high yields and high prices are considered good things?
The answer depends on your perspective. If you're a bond buyer, high yields are what you're after, because you want to pay $800 for that $1,000 bond. Once you own the bond, however, you're rooting for price. You've already locked in your yield, and if the price rises, it can only be a good thing -- especially if you need cash someday and want to sell the bond to get at it.
Copyright © 2007 SmartMoney.com. All Rights Reserved.
Well, here goes...
So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that, but many others -- including the pros -- buy and sell them on the open market before they reach maturity. Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to sell a bond for "par," or 100% of its face value.
We'll explore what drives price changes in the next lecture, but for now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and its ultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6% ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal -- you're getting the same payout for $400 less.
OK, So What Does 'Yield' Mean?
Yield -- a bondspeak standard -- is a figure that captures this change in value. It's the percentage return your bond investment promises at any given price.
In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price. When you buy a bond for face value, the yield is simply the coupon, or interest rate. But when the price fluctuates, the yield grows or shrinks to compensate in either direction.
Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts Yield to Maturity
Unfortunately, it gets even more complicated. In the real world, when people talk about yield, they're really talking about another figure, called "yield to maturity." This represents the total return you can expect if you buy a bond at a given price and hold it until it matures.
Yield to maturity includes the fact that the bond you bought for $800 will pay you $1,000 when it's due. It also assumes you reinvest the coupons at the same rate and figures in the compounding effect. If, in the above example, you add that $200 difference and the effects of reinvested coupons, the yield to maturity calculates out to 7.73% -- a significantly better deal than the original coupon of 6%.
Once you've grasped the inverse relationship between price and yield, you're ready to take on the bond market's next puzzler: If yields and prices move in opposite directions, how come both high yields and high prices are considered good things?
The answer depends on your perspective. If you're a bond buyer, high yields are what you're after, because you want to pay $800 for that $1,000 bond. Once you own the bond, however, you're rooting for price. You've already locked in your yield, and if the price rises, it can only be a good thing -- especially if you need cash someday and want to sell the bond to get at it.
Copyright © 2007 SmartMoney.com. All Rights Reserved.
Advantages of Bonds
Have you ever heard co-workers talking around the water cooler about a hot tip on a bond? We didn't think so. Tracking bonds can be about as thrilling as watching a chess match, whereas watching stocks can have some investors as excited as NFL fans during the Superbowl. But don't let the hype (or lack thereof) mislead you. Both stocks and bonds have their pros and cons, and in this article we will explain the advantages of bonds and why you might want to include them in your portfolio.
A Safe Haven For Your Money Those just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt, and stocks represent equity ownership. (If you are unfamiliar with the differences between these two securities or need a quick refresher on the subject, check out the stock and bond tutorials.) This difference brings us to the first main advantage of bonds: in general, investing in debt is safer than investing in equity. The reason for this is the priority that debtholders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to get paid. In a worst-case scenario such as bankruptcy, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment. In terms of safety, bonds from the U.S. government (Treasury bonds) are considered "risk-free". (There are no stocks that are considered as such.) If capital preservation - which is a fancy term for "never losing any money" - is your primary goal, then a bond from a stable government is your best investment. But keep in mind that although bonds are safer as a general rule, that doesn't mean they are all completely safe. Very risky bonds are known as junk bonds. Slow and Steady - Predictable Returns If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It's not unusual for stocks to lose 10% or more in a year, so when bonds comprise a portion of your portfolio, they can help smooth out the bumps when a recession comes around. There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market! By owning bonds, retirees are able to predict with a greater degree of certainty how much income they'll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities. Better Than The Bank… Sometimes bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts. As a result, if you are saving and you don't need the money in the short term, bonds will give you the greatest return without posing too much risk. College savings are a good example of funds you want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it's not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they'll have to contribute to accumulate their tuition nest egg by the time college rolls around.
How Much Should You Put Towards Bonds? There really is no easy answer to this question. Quite often you'll hear an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a person's assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20 year old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of assets in stocks and 65% in bonds and cash. That being said, guidelines are just guidelines. Determining the asset allocation of your portfolio involves many factors including your investing timeline, risk tolerance, future goals, perception of the market and income. Unfortunately, exploring the various factors affecting risk is beyond the scope of this article. Conclusion Hopefully, this article has cleared up some misconceptions about bonds and demonstrated when they are appropriate. The bottom line is that bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are great vehicles for saving when you don't want to put your money at risk.
Source:
http://www.Investopedia.com
A Safe Haven For Your Money Those just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt, and stocks represent equity ownership. (If you are unfamiliar with the differences between these two securities or need a quick refresher on the subject, check out the stock and bond tutorials.) This difference brings us to the first main advantage of bonds: in general, investing in debt is safer than investing in equity. The reason for this is the priority that debtholders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to get paid. In a worst-case scenario such as bankruptcy, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment. In terms of safety, bonds from the U.S. government (Treasury bonds) are considered "risk-free". (There are no stocks that are considered as such.) If capital preservation - which is a fancy term for "never losing any money" - is your primary goal, then a bond from a stable government is your best investment. But keep in mind that although bonds are safer as a general rule, that doesn't mean they are all completely safe. Very risky bonds are known as junk bonds. Slow and Steady - Predictable Returns If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It's not unusual for stocks to lose 10% or more in a year, so when bonds comprise a portion of your portfolio, they can help smooth out the bumps when a recession comes around. There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market! By owning bonds, retirees are able to predict with a greater degree of certainty how much income they'll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities. Better Than The Bank… Sometimes bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts. As a result, if you are saving and you don't need the money in the short term, bonds will give you the greatest return without posing too much risk. College savings are a good example of funds you want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it's not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they'll have to contribute to accumulate their tuition nest egg by the time college rolls around.
How Much Should You Put Towards Bonds? There really is no easy answer to this question. Quite often you'll hear an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a person's assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20 year old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of assets in stocks and 65% in bonds and cash. That being said, guidelines are just guidelines. Determining the asset allocation of your portfolio involves many factors including your investing timeline, risk tolerance, future goals, perception of the market and income. Unfortunately, exploring the various factors affecting risk is beyond the scope of this article. Conclusion Hopefully, this article has cleared up some misconceptions about bonds and demonstrated when they are appropriate. The bottom line is that bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are great vehicles for saving when you don't want to put your money at risk.
Source:
http://www.Investopedia.com
Bond
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity) longer than ten years. U.S Treasury securities issue debt with life of ten years or more, which is a bond. New debt between one year and ten years is a "note", and new debt less than a year is a "bill".
A bond is simply a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Certificates of deposit (CDs) or commercial paper are considered money market instruments.
In some nations, both bonds and notes are used irrespective of the maturity. Market participants normally use bonds for large issues offered to a wide public, and notes for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities with three years or less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations have less risk, and are associated with shorter term obligations.
Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e. bond with no maturity).
Issuers
The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:
Supranational agencies, such as the European Investment Bank or the Asian Development Bank issue supranational bonds.
National Governments issue government bonds in their own currency. They also issue sovereign bonds in foreign currencies.
Sub-sovereign, provincial, state or local authorities (municipalities). In the U.S. state and local government bonds are known as municipal bonds.
Government sponsored entities. In the U.S., examples include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Banks. The bonds of these entities are known as agency bonds, or agencies.
Companies (corporates) issue corporate bonds.
Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities.
Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. Government bonds are typically auctioned.
Features of bonds
The most important features of a bond are:
nominal, principal or face amount—the amount over which the issuer pays interest, and which has to be repaid at the end.
issue price—the price at which investors buy the bonds when they are first issued, typically $1,000.00. The net proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount.
maturity date—the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
short term (bills): maturities up to one year;
medium term (notes): maturities between one and ten years;
long term (bonds): maturities greater than ten years.
coupon—the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
coupon dates—the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.
indenture or covenants—a document specifying the rights of bond holders. In the U.S., federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.
Optionality: a bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
callability—Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
puttability—Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option.
call dates and put dates—the dates on which callable and puttable bonds can be redeemed early. There are four main categories.
A Bermudan callable has several call dates, usually coinciding with coupon dates.
A European callable has only one call date. This is a special case of a Bermudan callable.
An American callable can be called at any time until the maturity date.
A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
Convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
Exchangeable bond allows for exchange to shares of a corporation other than the issuer.
Types of bond
Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
Floating rate notes (FRN's) have a coupon that is linked to a money market index, such as LIBOR or Euribor, for example three months USD LIBOR + 0.20%. The coupon is then reset periodically, normally every three months.
High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds.
Zero coupon bonds do not pay any interest. They trade at a substantial discount from par value. The bond holder receives the full principal amount as well as value that has accrued on the redemption date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. government. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently.
Inflation linked bonds, in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
Other indexed bonds, for example equity linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
Perpetual bonds are also often called perpetuities. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero.
Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets.[1] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.[2]
Bear bond, often confused with Bearer bond, is a bond issued in Russian roubles by a Russian entity in the Russian market.
Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.
Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.[3]
Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.
War bond is a bond issued by a country to fund a war.
Bonds issued by foreign entities
Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some of these bonds are called by their nicknames, such as the "samurai bond".
Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S.[citation needed]
Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the Australian market
Maple bond, a Canadian Dollar-denominated bond issued by a non-Canadian entity in the Canadian market
Samurai bond, a Japanese Yen-denominated bond issued by a non-Japanese entity in the Japanese market
Yankee bond, a US Dollar-denominated bond issued by a non-US entity in the US market
Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or government
Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or government
Matrioshka Bond, a Russian rouble-denominated bond issued in the Russian Federation by non-Russian entities. The name deries from the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia
Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean market[4]
Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean market.[5]
Ninja loan, a Japanese yen syndicated loan by a foreign borrower [1]
Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the Taiwan market[6]
Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's Republic of China market[7]
State of Israel bond, a bond denominated in multiple currencies issued by the State of Israel through the Development Corporation of Israel.
Trading and valuing bonds
See also: Bond valuation
The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer.
These factors are likely to change over time, so the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par when they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of £100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.
The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.
The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is sometimes known as the Clean price.
The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).
Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve.
Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.
Bond markets also differ from stock markets in that investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.
Investing in bonds
Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households.
As a rule, bond markets rise (while yields fall) when stock markets fall. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid — it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks — and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can be risky:
Fixed rate bonds are subject to interest rate risk, meaning their market price will decrease in value when the generally prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds.
However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.
Bond prices can become volatile if one of the credit rating agencies like Standard & Poor's or Moody's upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
Bond indices
See also: Bond market index
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.
http://www.wikipedia.com
A bond is simply a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Certificates of deposit (CDs) or commercial paper are considered money market instruments.
In some nations, both bonds and notes are used irrespective of the maturity. Market participants normally use bonds for large issues offered to a wide public, and notes for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities with three years or less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations have less risk, and are associated with shorter term obligations.
Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e. bond with no maturity).
Issuers
The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:
Supranational agencies, such as the European Investment Bank or the Asian Development Bank issue supranational bonds.
National Governments issue government bonds in their own currency. They also issue sovereign bonds in foreign currencies.
Sub-sovereign, provincial, state or local authorities (municipalities). In the U.S. state and local government bonds are known as municipal bonds.
Government sponsored entities. In the U.S., examples include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Banks. The bonds of these entities are known as agency bonds, or agencies.
Companies (corporates) issue corporate bonds.
Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities.
Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. Government bonds are typically auctioned.
Features of bonds
The most important features of a bond are:
nominal, principal or face amount—the amount over which the issuer pays interest, and which has to be repaid at the end.
issue price—the price at which investors buy the bonds when they are first issued, typically $1,000.00. The net proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount.
maturity date—the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
short term (bills): maturities up to one year;
medium term (notes): maturities between one and ten years;
long term (bonds): maturities greater than ten years.
coupon—the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
coupon dates—the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.
indenture or covenants—a document specifying the rights of bond holders. In the U.S., federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.
Optionality: a bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
callability—Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
puttability—Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option.
call dates and put dates—the dates on which callable and puttable bonds can be redeemed early. There are four main categories.
A Bermudan callable has several call dates, usually coinciding with coupon dates.
A European callable has only one call date. This is a special case of a Bermudan callable.
An American callable can be called at any time until the maturity date.
A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
Convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
Exchangeable bond allows for exchange to shares of a corporation other than the issuer.
Types of bond
Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
Floating rate notes (FRN's) have a coupon that is linked to a money market index, such as LIBOR or Euribor, for example three months USD LIBOR + 0.20%. The coupon is then reset periodically, normally every three months.
High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds.
Zero coupon bonds do not pay any interest. They trade at a substantial discount from par value. The bond holder receives the full principal amount as well as value that has accrued on the redemption date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. government. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently.
Inflation linked bonds, in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
Other indexed bonds, for example equity linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
Perpetual bonds are also often called perpetuities. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero.
Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets.[1] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.[2]
Bear bond, often confused with Bearer bond, is a bond issued in Russian roubles by a Russian entity in the Russian market.
Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.
Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.[3]
Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.
War bond is a bond issued by a country to fund a war.
Bonds issued by foreign entities
Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some of these bonds are called by their nicknames, such as the "samurai bond".
Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S.[citation needed]
Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the Australian market
Maple bond, a Canadian Dollar-denominated bond issued by a non-Canadian entity in the Canadian market
Samurai bond, a Japanese Yen-denominated bond issued by a non-Japanese entity in the Japanese market
Yankee bond, a US Dollar-denominated bond issued by a non-US entity in the US market
Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or government
Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or government
Matrioshka Bond, a Russian rouble-denominated bond issued in the Russian Federation by non-Russian entities. The name deries from the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia
Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean market[4]
Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean market.[5]
Ninja loan, a Japanese yen syndicated loan by a foreign borrower [1]
Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the Taiwan market[6]
Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's Republic of China market[7]
State of Israel bond, a bond denominated in multiple currencies issued by the State of Israel through the Development Corporation of Israel.
Trading and valuing bonds
See also: Bond valuation
The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer.
These factors are likely to change over time, so the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par when they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of £100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.
The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.
The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is sometimes known as the Clean price.
The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).
Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve.
Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.
Bond markets also differ from stock markets in that investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.
Investing in bonds
Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households.
As a rule, bond markets rise (while yields fall) when stock markets fall. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid — it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks — and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can be risky:
Fixed rate bonds are subject to interest rate risk, meaning their market price will decrease in value when the generally prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds.
However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.
Bond prices can become volatile if one of the credit rating agencies like Standard & Poor's or Moody's upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.
Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.
Bond indices
See also: Bond market index
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.
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