To even the most experienced equity investors, the world of bond investing can be a bit of a mystery. Today, after you read this post, our goal is to provide more understanding of the bond market by introducing you to bond terms and concepts, the various types of bonds, how bonds react to different interest rate environments, and a couple of bond investment strategies.
What is a bond?
A bond is a fixed income investment in which the purchaser lends money to an entity for a specific period of time and with a specific interest rate.
Here are terms commonly associated with bonds:
Par Value – The face value of a bond. A bond is typically issued in $1,000 increments.
Coupon – The interest rate of a bond; typically represents the amount of annual interest paid over the life of a bond.
Yield to Maturity – The total return that can be expected if a bond is held to maturity.
Yield to Worst – The lowest potential yield that can be earned on a bond without it defaulting.
Callable Bond – A bond that can be redeemed prior to maturity by its issuer. Callable bonds typically pay investors a higher rate than standard bonds.
Duration – A measure of a bond’s sensitivity to interest rate movements. The duration indicates the number of years it takes to receive a bond’s true cost, weighing in the present value of all future coupon and principal payment.
Premium – Describes a bond trading above its face value. It costs more than the face value of the bond.
Discount – When the price of a bond is lower than its principal amount due at maturity.
Types of Bonds
Treasuries – Fixed Income instruments that are issued by the federal government, and are considered to be the safest investment you can make, because all Treasuries are backed by the “full faith and credit of the US Government.”
The categories of Treasuries are all follows:
Treasury Bills: non-interest bearing short-term instruments with maturities up to 1 Year. They trade at a discount and you get full par value back at maturity.
Treasury Notes: Treasuries with maturities of between 2 – 10 year.
Treasury Bonds: long-term interest-bearing securities issued with a 30 year maturity.
TIPS – Treasury instruments that are issued with maturities of 5, 10, and 30 years that pay interest that is adjusted semiannually for changes in inflation.
U.S. Government Bonds – Also known as “Agency” bonds, these are issued or guaranteed by U.S federal government agencies and by government-sponsored enterprises. Examples are bonds issued by government agencies such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage (Freddie Mac).
Municipal Bonds – Bonds issued by states, cities and other municipalities to raise money for projects such as building roads, schools, hospitals, and a host of other projects for the common good. These bonds offer favorable tax treatment for investors, as they are the only securities that may pay interest that is free from federal tax. Also, if one purchases municipal bonds within their state of residence, the interest paid is also free from state income tax.
Corporate Bonds – These are bonds issued by companies to raise money for capital expenditures, operations, and acquisitions. Corporate bonds are typically categorized as investment or high yield. Investment grade bonds are issued by companies that are highly rated. Non-investment grade bonds, also referred to as “junk” bonds, pay higher yields than Treasuries and investment grade corporate bonds, but also carry a higher level of risk.
Mortgage Backed Securities – Bonds secured by home and other real estate loans. MBS carry the guarantee of the issuing organization to pay interest and principal payments on a regular basis. This is where MBS differ from other types of bonds. Instead of receiving regular interest and repayment of principal at maturity, you receive both interest and principal payments, with the cash flow at the beginning being primarily from interest, but with gradually more and more of the proceeds coming from principal over time. This is why MBS are often referred to as having a “pass-through” structure.
International and Emerging Market Bonds – As their name implies, International and Emerging Markets bonds are issued by foreign governments.
A bond rating is a grade given to a bond by various ratings services that indicates its credit quality. While there are various rating agencies each using slightly different ratings systems, the factors they commonly take into consideration are a bond issuer’s financial strength and its ability to pay a bond’s principal and interest in a timely fashion. Moody’s, Standard & Poor’s, and Fitch are the three primary rating agencies. As a rule of thumb, similar to a report card, “A’s” in bond ratings represent the highest quality issuers, while “B’s” represent lower quality, “C” represent bonds of the lowest quality, and bonds that are “D” rated, denote a bond issuer that is in default and no longer able to pay interest or its principal. The rating agencies will also differentiate bonds within each of the tiers. As an example, Standard and Poor’s uses plusses to designate bonds that are rated at the higher range of a tier and minuses for bonds at the bottom of tier. As with anything that carries lower risk, the highly rated bonds tend to carry the lowest coupon rates. You have probably heard the term “junk bonds” or “non-investment grade bonds” – these are speculative bonds that typically are rated at the very low end of the “B” tier.
Now that we have covered the basic bond terms and concepts, please stay tuned for next week’s post which will build upon this knowledge and provide more detail about the ways that one can invest in bonds, provide more insight into the current bond market, and discuss various bond investment strategies.