Fixed income is an important asset class for most people’s portfolios. For a variety of reasons, many people rely on bond funds to fulfill this function. This is unfortunate as individually-held bonds offer some advantages over the bond funds. One of the more notable is that individually-held bonds (purchased at par or less) are not at risk for capital losses in a rising interest rate environment, provided the bonds are held to maturity. In bond funds, rolling the bonds to maintain the fund’s duration can cause losses to be incurred in some situations. To help investors develop more interest in bonds (pun intended!), it is first necessary to know a few of the bond basics.
Bonds are essentially a loan to governments or corporations. The bonds issued by governments are often guaranteed or insured, but not always. Bonds issued by corporations are not guaranteed or insured as a rule. To help investors gauge the quality of a particular bond, most bonds carry a credit rating. This rating is determined by independent researchers such as Standard & Poor’s, Moody’s and/or Fitch. By evaluating the issuer’s balance sheet, cash flow, debt levels, etc., the rating agencies assign a credit quality grade to the issuer and its bonds. If the issuer is in good financial condition and appears able to repay its debts, it will receive one of the “investment grade” ratings. These are bonds that have a high probability of paying its interest and repaying the principal at maturity.
On the other hand, if an issuer’s financials are questionable or in actual jeopardy, one of the “speculative grade” ratings will be assigned. Bonds that carry speculative ratings are sometimes referred to as high-yield or junk bonds. The reason is that this class of bonds carries a higher probability of default. And with the lowest grades, the issuer may already be in default or bankruptcy proceedings. The key takeaway here is to focus one’s attention on investment grade bonds. You will sleep better knowing there is a low chance for large losses.
Bond Maturity Dates and Interest
Next, most bonds have a maturity date. Between the time of purchase and the maturity date, the bond pays interest, usually every six months. At the maturity date, the bond then pays back the principal, or face value. For corporate bonds, the face value is typically $1,000 per bond. This is another aspect of bonds I appreciate. Provided the issuer does not default, bonds have a known outcome. We know that at maturity, the face value is repaid, and until then, interest is collected. Simple! Contrast this with stocks that have largely unknown outcomes. No one can predict the future value of a stock with any certainty. This makes risk management for bonds much easier than for stocks. (For related reading, see: Corporate Bonds or Stocks: Which Is Better Now?)
Another aspect is a bond’s price. Most bonds trade in $1,000 increments and are priced at one-tenth of that, or $100. So, buying one bond priced at $101 will cost $1,010 plus accrued interest. Once a bond is issued, its price is determined by a number of factors such as prevailing interest rates, time to maturity, material events, etc. So, most bonds trade either above or below the $100 par value. When a bond is priced above $100, it is said to be trading at a premium. When it is priced below $100, it is called discount. And, don’t think that a premium bond is necessarily better, like premium gasoline! As a rule of thumb, I typically prefer bonds trading at a small discount or at par. Premium bonds will experience capital losses over the life of the bond, although this is often partially offset by a higher coupon rate.
Coupon Rates Are Important
Since bonds are purchased for their interest, the coupon rate is important. This is stated for each bond. A bond with a coupon rate of 5% will pay $50 per year to the holder, regardless of the purchase price of the bond. The actual interest paid is the coupon rate times the face value of the bond. And this is where the term yield comes into play. A bond purchased at a discount will have a yield that is higher than the coupon rate whereas a bond purchased at a premium will have a yield that is lower than the coupon rate. Why? The yield is calculated using the coupon payment divided by your purchase price, not the face value of the bond.
Individual bonds purchased with the intention of holding them until maturity can be a key component to one’s investment strategy. There are a few things to know (as is the case with much of life), but with some education and a bit of practice, this asset class can be readily mastered.
(For more from this author, see: The Path to Financial Abundance Starts With This Concept.)
To learn more about bonds and account management, you can register for a free webinar on Saturday, May 6 at 10:00 AM CST, or receive a recording of the presentation.