Bonds can be an effective way to enhance your portfolio by providing diversification and reducing volatility. However, for many investors, the bond market remains unfamiliar and complex. This guide aims to demystify bond investing by explaining how they work and introducing key terms that every investor should know.
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How Bonds Function
Bonds are essentially loans that investors provide to companies or governments. Instead of borrowing from a bank, these entities issue bonds to raise capital from investors. In return, they pay interest, known as a coupon, at set intervals and repay the principal amount on a specified maturity date.
Unlike stocks, they come with specific terms outlined in a document called an indenture. Each bond issue has unique characteristics, so it’s crucial to understand these terms before investing. Here are six important features to consider when evaluating bonds.
Are There Different Types of Bonds?
Corporate
Corporate bonds are debt securities issued by companies to fund their operations and growth. The yield on these depends on the company’s credit rating. High-risk corporate bonds, often referred to as “junk bonds,” offer higher returns but come with greater risk. Interest earned from corporate bonds is subject to both federal and local taxes.
Government
Government bonds, also known as sovereign debt, are issued by national governments to finance their activities. These generally have high credit ratings and low yields due to the low risk of default. In the U.S., these are called Treasuries and are exempt from state and local taxes, though they are subject to federal income tax.
Municipal
Municipal bonds are issued by local governments, such as states or counties, to fund public projects. These often come with tax advantages, such as exemptions from federal and sometimes state and local taxes, making them attractive for investors in higher tax brackets.
Key Terms to Remember about Bonds
Maturity
Maturity refers to the date when the bond’s principal amount is repaid to the investor, ending the issuer’s obligation. Bonds are categorized by their maturity periods:
- Short-term: Matures in one to three years.
- Medium-term: Matures in four to ten years.
- Long-term: Matures in more than ten years.
Secured vs. Unsecured
- Secured Bonds: Backed by specific assets as collateral. If the issuer defaults, these assets are transferred to bondholders.
- Unsecured Bonds: Also known as debentures, these are not backed by collateral and are riskier because repayment relies solely on the issuer’s creditworthiness.
Liquidation Preference
In the event of a company’s bankruptcy, creditors are paid in a specific order. Senior debt is paid first, followed by junior or subordinated debt. Stockholders receive any remaining assets last.
Coupon
The coupon is the interest rate paid to bondholders, typically annually or semiannually, expressed as a percentage of the bond’s face value. It is calculated by dividing the annual interest payment by the bond’s face value.
Tax Status
While most corporate bonds are taxable, some government and municipal bonds are tax-exempt. This means their income is not subject to federal, state, or local taxes. Tax-exempt ones typically offer lower interest rates than taxable bonds. Investors must calculate the tax-equivalent yield to compare returns effectively.
Callability
Some bonds can be repaid by the issuer before the maturity date. Callable bonds can be paid off at a slight premium to par value. Issuers may call bonds to refinance at lower interest rates. Callable bonds often offer higher coupon rates to compensate for this call risk.
Risks of This Type of Investing
Although this type of investing is generally safer than stocks, they still come with risks:
Interest Rate Risk
Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa. This risk is more significant for bonds with longer maturities.
Credit/Default Risk
Credit or default risk is the possibility that the issuer will be unable to make interest or principal payments. Investors should assess the issuer’s financial stability before purchasing this.
Prepayment Risk
Prepayment risk occurs when a bond is repaid earlier than expected, often through a call provision. This typically happens when interest rates decline, forcing investors to reinvest at lower rates.
Bond Ratings
Bond ratings assess the credit quality and their issuers. The most commonly cited rating agencies are Standard & Poor’s, Moody’s, and Fitch Ratings. Ratings range from AAA (highest quality) to D (default). Investment-grade bonds range from AAA to BBB, while the ones rated BB or lower are considered speculative or junk bonds.
Bond Yields
Bond yields measure the return on a bond investment. The most commonly used yield measure is Yield to Maturity (YTM), which calculates the total return if the bond is held until maturity. Other yield measures include:
- Current Yield: Annual coupon payment divided by the bond’s current price.
- Nominal Yield: Annual coupon payment divided by the bond’s face value.
- Yield to Call (YTC): Yield if the bond is called before maturity.
- Realized Yield: Estimated return if the bond is sold before maturity.