An Introduction to Bond Investments

Types of bonds

There are many different types of bonds available; here’s a brief overview of the more commonly traded ones in the U.S. market. These include debt securities issued by the U.S. Treasury, municipal bonds, corporate bonds and other government bonds.

U.S. Treasury debt securities

The U.S. Treasury issues debt securities (bonds) in order to finance various federal government endeavors. There are several different varieties, with Treasury bills (T-Bills), Treasury notes (T-Notes) and Treasury bonds (T-Bonds) being the most common.

T-Bills are considered by some to be among the least risky investments available. They mature in one year or less and are known as zero-coupon bonds since they don’t pay interest before maturity. Instead they are issued in the primary market at a discount and then pay their full face value at maturity.

T-Notes mature in two to 10 years and pay a coupon every six months. T-Bonds mature in 20 to 30 years, and like T-Notes pay a coupon every six months.

Interest received from U.S. Treasury debt securities is taxable at the federal level, not at the state level. However, if you purchase a Treasury debt security in the secondary market at a deeper discount than you’d receive if buying at auction, and then you resell it at a profit or receive full face value at maturity, those gains are taxable at both the federal and state level. These things can get tricky, so consult your tax adviser for more information.

How T-Bills earn a return at maturity

Here’s a quick example:

You buy a 30-day T-Bill for $998 on May 1

On June 1, the T-Bill matures and you receive $1,000

Your yield is $2 over 30 days, or 0.1%

(annual yield of 1.2% with $2 every month for 12 months)

Note the price of a T-Bill is quoted in units of $10, so a bill purchased for $998 would be quoted as $99.80. Simply multiply the quote by 10 to get the total amount you’ll pay per T-Bill.

Municipal bonds

Municipal bonds (also known as munis) are issued by states, cities, counties and other municipalities, which use the money for public improvements like highways, bridges, schools, hospitals, sewer systems and other projects.

There are two varieties of municipal bonds: General obligation bonds (GO for short) and revenue bonds. General obligation bonds are backed by the issuer’s ability to collect taxes, while revenue bonds are issued by entities like water companies or sewage treatment plants that generate revenue over time, and then use this income to make interest payments and repay the loan in its entirety on the maturity date. A double-barreled credit is a municipal bond which is a blend of these two types. Typically, municipal bonds pay periodic interest every six months, or twice per year until the bond matures.

Many municipal bonds are tax-exempt at the federal level. They are usually also tax-exempt at the state and local level if the investor resides in the same geographic area issuing the bond _ which is why that scenario is often called triple tax-exempt. Tax-exempt munis generally pay a lower coupon than taxable bonds. So when comparing yields of tax-exempt bonds with taxable bonds, be sure to do so on an after-tax basis.

Corporate bonds

Corporations issue bonds in order to expand their business, for example, to build a new factory or obtain new equipment. Corporate bonds, or corporates for short, tend to have a higher risk of default than government or municipal bonds, and as a result they generally pay higher yields. However, some corporates involve more risk than others, so don’t be tempted by a high coupon. Interest on corporate bonds is taxable at both the federal and state level.

Although they may accompany nearly any type of bond, corporate bonds are often riddled with fine-print clauses which require your close consideration before investing. In addition to somewhat common clauses like call and put features, corporate bonds may have equity components, floating coupons or other unique features. This list is by no means exhaustive.

Convertible bonds are a type of security which combines a debt investment with an equity component. The investor receives coupon payments and expects face value at maturity, just like the average bondholder. In addition, convertibles give you the right to exchange your corporate bond for a predetermined number of the issuer’s shares of common stock at a predetermined price. Typically this conversion would occur after the issuer’s common stock had risen to a price which made converting the bond advantageous to the bondholder. Prices for convertible corporate bonds tend to be more volatile than their nonconvertible cousins, since these bonds’ value is more closely tied to the stock’s activity.

Corporate bonds sold with equity warrants attached offer additional enticement to invest in these bonds. Warrants provide the investor the right to buy the issuer’s common shares at an attractive price some time in the future.

Floating-rate notes or bonds, termed floaters, also pay periodic interest and return face value upon maturity. However, the coupon rate adjusts higher or lower over time. The rate of interest is reset periodically, based on a benchmark such as short term Treasurys or LIBOR (London Interbank Offered Rate).

Other government bonds

Government-sponsored enterprises bonds and government agency bonds are issued by private entities that are backed by the U.S. government: Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Company (Freddie Mac), the Federal Home Loan Bank, the Federal Farm Credit Bank, and the Student Loan Association (Sallie Mae). These bonds are typically tax-exempt at the state and local level, but are subject to federal tax. Check with your tax adviser for the specific implications of these bonds.

How the bond market works

Like stocks, there are two main avenues through which bonds are sold: the primary and secondary markets. The primary market is where the issuer sells new bonds to the public for the first time. In the secondary market, investors buy or sell bonds from other investors with no involvement from the issuing firm.

Primary market

The primary market for bonds is similar to the primary market for stocks where initial public offerings (IPOs) occur. Investors buy bonds from an underwriter, with the underwriter acting as the middleman between the issuer and the public. The underwriter then collects the money from bond sales and gives it to the issuer, after taking a commission, or underwriting fee.

The investor’s price per bond is usually equal to the face value, plus any transaction costs—e.g., commissions from your broker. (Exceptions to this rule include zero-coupon bonds, which are sold at a deep discount to face value.) It’s important to note that when you buy a bond you don’t have to wait until it reaches its maturity date. As with other forms of securities, you can typically buy and sell them. However, the mechanism for bonds is quite different. That’s where the secondary bond market comes into play.

Secondary market

In the secondary bond market, bonds are bought and sold day in and day out by individual investors and institutions. When you buy a bond in the secondary market, you’re buying it from another investor (likely a large institution) instead of the original issuer.

Buying or selling bonds in the secondary market in some ways is similar to the trading of equities after the initial public offering (IPO). Since market conditions fluctuate, so do the prices of bonds. The bond’s coupon (interest paid) compared to current and expected future interest rates, the credit rating of the issuer, economic conditions, the liquidity of a particular bond, and other factors all impact the price of a bond in the secondary market.

However, in the case of equities, nearly all of the transactions in a particular stock are centralized. Meaning, buyers and sellers come together to do business in one place, either in person or through agents as with the New York Stock Exchange (NYSE), or through virtually centralized electronic marketplaces, like the NASDAQ. Although some bonds are listed on the NYSE and trade in the fashion just described, this is only true for a small number of bond issues.

The secondary market for nearly all bond issues is handled through a huge decentralized network of independent dealers, generally organized by type of security. The bond market is an over-the-counter market (OTC), as opposed to an exchange, or even a group of exchanges. Although you may sell your bond investments before maturity, this is not as easy as it is when selling stock holdings. What’s more, it’s possible to incur a capital loss if selling a bond before maturity. To give you some perspective, there are thousands of stock issues that trade nearly continuously during regular market hours. The bond market has millions of bond issues, with many trading very infrequently, which explains why many bond issues are illiquid.

Understanding bond prices in the over-the-counter market

Much of the time a bond’s face value will be $1,000. Bond prices are expressed as a percentage of the face value. For example, if a $1,000 bond is trading in the secondary market at a price of $98.475, you’ll pay $984.75, or 98.475% of the bond’s face value.

Because bonds primarily trade over-the-counter, pricing is not as straightforward as in the stock market. In the equities market, it’s possible to know the stock price of Acme Gimcrack Corp. at any given time by obtaining a stock quote. No matter where you are, or with which broker you have your account, everyone pays the same price for this stock at any given time, with only variation in the commission charged. With bonds things work much differently.

To get a quote on Drive Rite Motors’ ten-year bonds maturing on June 29, 2020, you or your broker would call several dealers. Not every dealer has access to every issue. From the dealers that would provide a quote, it’s possible all the quotes would be different. Why the different quotes? A bond dealer’s quote stems from the quantity of that dealer’s inventory, the cost incurred when accumulating that inventory, how many bonds are to be traded, and how much profit is desired when selling the inventory (termed markup). A dealer’s cost and markup is not public knowledge. To add to this, many bonds trade infrequently, which makes obtaining a quote more difficult.

Factors that affect bond pricing over time

In the secondary market bond prices are not set in stone. They can fluctuate over time for a number of reasons. Some factors affecting price include, but aren’t limited to:

• Current and estimated future interest rates compared to the coupon
• Credit rating of the issuer
• Economic conditions _ inflation and stock market performance

The interest rate environment and the coupon are key

The most important factor that influences a bond’s price is its coupon rate compared to current or expected future interest rates. A bond’s coupon may be favorable or unfavorable compared to the interest you could receive on other investments. Bond prices have an inverse relationship to prevailing interest rates in the economy. In other words, as prevailing interest rates go down, a bond’s price in the secondary market will usually go up. As prevailing interest rates go up, typically a bond’s price will go down. Call this the see-saw, or inverse, relationship between bond prices and interest rates.

Here’s an example: if a bond pays a 6% coupon and the prevailing interest rate drops below 6%, that bond pays comparatively better than the alternatives. Therefore it will increase in value, and will usually trade higher than its face value, or at a premium. If the prevailing interest rate rises above 6%, the bond will pay comparatively worse than the alternatives, so its value will decrease and it will usually trade lower than its face value, or at a discount.

Credit where credit is due: checking a bond’s credit rating

Just as individuals receive credit ratings based on their past borrowing habits and ability to pay off debts, bonds and their issuers are rated by independent companies based on the likelihood that issuers will be able to meet their obligations—that is, to pay the coupon over time and return the principal at maturity.

Of the main bond types, corporate bonds involve the most risk, followed by municipal bonds. Treasury bonds, by contrast, are considered a virtually risk-free investment. In fact, investors consider them so bullet-proof that all other bonds are rated with Treasurys as a benchmark.

Bond ratings are based on the issuer’s financial stability, and they’re the key indicator of how much risk is assumed when buying a particular bond. Bonds issued by entities with a high probability of meeting obligations are known as investment grade. Since they entail relatively low risk, they generally pay a lower coupon. Riskier bonds are referred to as high-yield or junk bonds, and usually pay a higher coupon.

There are three main companies that issue bond ratings: Moody’s, Standard & Poor’s, and Fitch. The ratings they use are listed in the table below. The first column delineates whether the bond is considered investment grade or junk. The final three columns are the specific ratings assigned by the evaluating companies.

So how do ratings affect bond prices over time? It’s important to understand that a bond’s rating is not static. If the issuer’s financial stability improves over the life of the bond, then the rating will improve and the value of the bond will generally increase. If the issuer’s stability deteriorates, then the rating will go down and the value of the bond will generally decrease. Just remember: whenever you buy a bond, it’s important to stay informed about its rating throughout the life of your investment.

In general, the lower the bond rating, the higher the interest paid. But beware. Don’t get suckered in by high interest if the bond has a lousy rating.

Economic conditions

Inflation plays an important role in bond values. Like interest rates, inflation is inversely proportional to bond prices. Because higher inflation deteriorates the real dollars a bond’s coupon provides, the bond’s coupon becomes comparatively worth less. So the higher inflation goes, the price of a bond decreases. If inflation gets too high, the concern is it will outpace the rate of interest received from the bond investment. To combat high inflation, bond investors may be forced to turn to other investments with more risk such as stocks, since equities may provide the opportunity for higher returns.

The price of bonds may also be affected by other conditions in the overall marketplace. For example, if the stock market is performing poorly, more people may want to invest in bonds, and prices in the bond market will tend to rise. If the stock market is performing very well, people may be less inclined to invest in a relatively low-yield investment vehicle like bonds, so prices will tend to fall.

It’s all about the yield

When comparing bonds with different prices, coupons and maturity dates, it’s difficult to know how to compare bonds to one another when researching potential investments. The first thing most investors look at is the yield. Simply put, the yield is the percentage of the bond’s price you’ll receive over time. (This is different from the bond’s coupon rate.) Yield gives some basic information. However, yield to maturity is the critical figure used to compare bonds on an apples-to-apples comparison.

Current yield

Say you’ve bought a bond at par (face value of $1,000) with a 6% coupon. Since 6% of 1,000 is 60, you’ll receive $60 a year in interest. Here, the coupon and yield are equal.

But what if you bought the bond in the secondary market for $800? In this case, yield and the coupon are different. Let’s run through an example. To determine the bond’s current yield, simply divide the annual interest payment by your cost basis. In this case:$60 interest per year êš $800 cost basis = 0.075, so your current yield is 7.5%.

Conversely, if you bought the same bond at a premium of $1200, your current yield will be lower than the specified coupon rate.

Yield to maturity

A bond’s yield to maturity (YTM) is a complex calculation that can only be determined with a bond calculator. YTM takes into account the actual price paid for the bond (not the face value) along with the coupon payments received over time, among other factors.

When investors talk about yield, most of the time they’re referring to yield to maturity or YTM. This figure makes some basic assumptions; however, these assumptions may not pan out. The point of this number is not to estimate how your bond investment will perform; rather this figure allows you to make an apples-to-apples comparison to other bonds when selecting a fixed income investment.

What are the main underlying assumptions when calculating YTM? It assumes that the bond will be held until maturity. It also assumes all interest and principal payments will be made to the investor on time.

Yield to call

Some bonds grant the issuer the right, but not the obligation, to buy back or call the bond at a specific time before the maturity date. Yield to call makes the assumption that the issuer will indeed exercise the right to buy the bond back early. It’s calculated much the same way as yield to maturity, but since there will be less time to receive interest payments, generally yield to call will reflect a lower return to the investor. However, a bond’s call price will oftentimes slightly exceed its face value. This additional amount may offset at least some of the foregone coupon payments once the bond has been called.

Yield to put

Yield to put is similar to yield to call, except in this case it is the investor who has the right to sell the bond back early. Again, when calculating this number the assumption is made that this right will be exercised.

Yield to worst

When bonds are callable, puttable, or have other such features it’s prudent to examine the yield to worst. This is the worst-case yield figure, short of the truly worst-case scenario of the bond issuer actually defaulting. It will be the lowest possible yield out of yield to maturity, yield to call or yield to put.

How to calculate an equivalent yield

Fully taxable corporate bonds usually generate higher interest payments than fully tax-exempt municipal bonds. But that doesn’t automatically mean these higher-coupon bonds are a sweeter deal when all’s said and done. Assuming all other factors are equal, you need to examine the yields of these bonds under equal tax conditions in order to make a fair comparison.

Depending on the information you have available at the time, this will involve one of two formulas: calculating the after-tax yield of a taxable corporate bond or calculating a taxable yield for a tax-exempt muni bond. To determine the after-tax yield of a taxable bond, here’s the formula:

Laddering your bonds

In deciding to invest in bonds, your first big decision is what percentage of your assets to allocate to bonds versus stocks. When you’ve got that figured out, step two is deciding which fixed income strategies work best for you, such as buying Treasurys, municipal bonds, corporate bonds, preferred stock, buying an income fund, or buying a money market fund, for starters.

Step three involves choosing a blend of bonds that spread your risk over a series of different maturities, while maintaining an average maturity that suits your investment goal’s time horizon. How can you best accomplish that? Set up a bond ladder – a series of bonds with a range of maturities.

Here’s how it works. Say you bought equal amounts of Treasurys due to mature in one, three, five, seven and nine years respectively. Your portfolio would have an average maturity of five years (1+3+5+7+9 / 5 = 5). When the first batch matures the following year, you’d build the next rung of the ladder by putting the money into new ten-year notes. Your portfolio would then have an average maturity of six years. Two years after that, when the three-year notes matured, you would buy more ten-year notes, and continue to do so whenever a note matures until you’ve reached your financial goal. Bottom line: laddering keeps this batch of Treasurys’ average maturity in the five- to six-year range.

Laddering and coupon reinvestment go hand in hand. As each bond investment throws off its periodic coupon payments, save those payments in a bank account. When you’re ready to add the next rung in your ladder, apply those saved coupon payments to your next bond investment.

One benefit of laddering is that you don’t need to worry as much about fluctuating interest rates. If rates do rise soon after you bought this year’s bonds, soon enough you’ll have money coming available to reinvest at the higher rate. Similarly, if rates decline after you buy, at least you’ve locked in the higher rates for one part of your portfolio.

Building a bond ladder

How many rungs should your ladder have? That depends on your investment goals and time horizon. If you’re looking at a ten- to 15-year horizon, you might ladder in two-year increments. If your horizon is shorter – say, two to three years – you might lean toward rungs every three months. If your timeframe is even shorter than that, it may not make sense to ladder at all. Laddering does increase your commission costs, but the trade-off may be worth it for balancing risk with longer-term goals.

Building a ladder with Treasurys is relatively simple, since these bonds are highly liquid and available in increments of $1,000. Treasurys are available with maturities as short as a few days, up to 30 years.

A handy alternative to laddering – particularly if your investment capital is limited – is simply investing in a low-fee bond fund. Money managers typically stagger bonds within their funds so that different maturities come due at different times.

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