We’re all familiar with debt; many of us have taken out a loan to buy something that we want to pay for later. We borrow the money, and promise to pay back the amount of the loan, plus interest. We agree to a specific interest rate and agree to pay on a set schedule.
Corporations and government entities also need to borrow money for improvements or day-to-day operations. When a company or the government needs to borrow money, they issue bonds.
Typically, banks or securities firms form a syndicate and buy all the bonds from the borrower, then sell the bonds to investors in increments that are affordable for the average person, usually starting at one thousand dollars. When you buy a bond, you are lending your money to the big guys, with interest.
Bond Terminology
- The bondholder is the lender.
- The issuer is the borrower.
- The coupon is the interest rate. Bonds used to come as a certificate with coupons attached; the bondholder would have to clip off the coupons to claim their interest payment.
- Maturity date is when the bondholder is to be repaid. Bonds may have a maturity date of one to thirty or more years.
- The term is the length of time from the purchase date to the maturity date.
- Coupon date is the day the interest payments are made, usually semi-annually.
- Zero-coupon bonds credit you with interest, but don’t actually pay it out until the maturity date. Series EE Savings Bonds are an example.
- The face amount, or principal, is also known as the par value.
- A bond that is paid off before the maturity date is being called.
Types of Bonds
- Federal bonds are backed by the U.S Government and are the safest investment around. U.S. Treasury securities include savings bonds and Treasury bills (T-Bills).
- Agency bonds are issued by government-sponsored entities such as the Federal Home Loan Mortgage Corporation, also known as Freddie Mac, and the Federal National Mortgage Association, AKA Fannie Mae. While there is no safer investment than federal bonds, these come in a close second, since it is highly unlikely that our government would allow these agencies to default.
- City and state governments issue municipal bonds; improvements such as roads, parks, and bridges are often funded this way.
- Companies issue corporate bonds. Corporate bonds may be secured with the company’s assets, just as your auto loan is secured by your vehicle, or may be unsecured, just like a personal loan at your bank would be. Many companies issue bonds as well as stock.
Risks Associated with Bonds
- The risk of default - When loaning money to anyone, it is prudent to consider how likely it is that the borrower may not pay you back. Consumers have a credit score that tells lenders whether or not we’re a safe bet, and people with lower credit scores pay higher interest rates on their loans. Bonds also get a credit score, and pay coupon rates in tune with their credit rating. U.S. Treasury securities pay the lowest interest rates, since they are the safest. High-yield bonds, also known as “junk bonds” pay higher coupon rates because they are more likely to default and therefore are much more risky. The two well-known bond-rating agencies are Moody’s and Standard & Poor’s Corporation, and they grade the quality of bonds based on likeliness of repayment. Bonds can be classified as either investment grade, which is the only kind of bonds banks will buy, or speculative grade, the high-risk junk bonds. To be considered investment grade, the bond must have a grade of Moody’s (Aaa, Aa, A, Baa), or S&P (AAA, AA, A, BBB). Be sure to check the bond’s rating before you invest, and be aware of the risk involved in that particular bond.
- The risk that a bond is called when interest rates fall - Most bonds have the chance of being paid off early on a specified date before the maturity date. When interest rates begin to drop, the bond issuer may call the bond so that they can reissue the bond at a lower coupon rate. Think about when a homeowner refinances his house with a different lender to get a lower rate. The original lender misses out on all the interest that they would have earned if the mortgage had not been paid off early, and the homeowner is just doing what it takes to get better rates. Bond issuers do the same thing; they will refinance for a loan with lower interest rates to save money. If the bond is called when interest rates are low, you will have missed out on the higher rate of interest you were looking forward to and be forced to reinvest your money in a bond with a lower coupon rate, or you may have to look at other investment alternatives.
- The risk that interest rates go up after you invest in a bond - The value of your bonds could be worth less than your investment price due to rising interest rates. Bonds are commonly purchased at a fixed rate that does not change for the term of the bond. Because of this, bonds respond to interest-rate movements by changes in price. For example, a one thousand dollar bond with a 6% coupon rate earns less, so it is worth less than a one thousand dollar bond that pays 9%. To sell his 6% bond, the bondholder would have to sell at a price discounted enough so that the new buyer’s profit on the bond would equal the 9% that is available on the current market. Just remember that interest rates and bond prices go in opposite directions, when one falls, the other rises, and vice versa.
Tax Considerations
Some bonds may be exempt from certain taxes; you can use them to your advantage in your tax strategy. Consult a tax professional for advice about your situation.
- Interest earned on corporate bonds is fully taxable by the federal and local governments.
- Interest earned on municipal bonds is mostly exempt from federal tax and exempt from state tax, if you reside in the state the bond was issued.
- Interest from agency bonds is taxable by the federal government, but some are exempt from state tax.
- Treasury bonds are taxable by the federal government, but exempt from local tax.
Bonds Round Out Your Portfolio
Quality bonds are a sound way to invest and receive better rates than a savings or money market account. Bonds are safer than stocks; even if a corporation goes bankrupt, the investor will usually get some of their investment back, where a stockholder may be left with nothing.
Bonds are generally such a safe investment that they really are too safe to be an investor’s only holdings. Bonds have never matched the stock market for overall performance, and it’s highly unlikely that they ever will. In general, an investment portfolio of mostly bonds is good for retirees, others seeking income, or for an otherwise very conservative investor.
Bonds do play an important role in wise asset allocation. For the majority of the more aggressive investors, bonds are a smaller part of an investment portfolio, consisting of mostly stocks and stock mutual funds, and 40% or less in bonds, bond funds, real estate, and cash. Bonds offer a balance to the stocks in your portfolio; when stocks are falling, bonds usually do better. Bonds are a way to reduce the risk of investing, a small part of the big picture in your investments.
Sources:
Kiplinger's Practical Advise About Managing Your Money
Wikipedia.com