Want to improve your portfolio's risk/return profile? Adding bonds creates a more balanced portfolio, strengthening diversification and calming volatility. You can get your start in bond investing by learning a few basic bond market terms.

On the surface, the bond market may seem unfamiliar, even to experienced stock investors. Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the market. Bonds are actually very simple debt instruments, if you understand the terminology. Let's take a look at that terminology now.

Tutorial: Bond Basics

1. Basic Bond Characteristics
A bond is simply a type of loan taken out by companies. Investors lend a company money when they buy its bonds. In exchange, the company pays an interest "coupon" at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.

Unlike stocks, bonds can vary significantly based on the terms of the bond's indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.

The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the company's bond obligation will end.

A bond can be secured or unsecured. Unsecured bonds are called debentures; their interest payments and return of principal are guaranteed only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.

Liquidation Preference
When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and stockholders get whatever is left over. (To learn more, read An Overview of Corporate Bankruptcy.)

The coupon amount is the amount of interest paid to bondholders, normally on an annual or semiannual basis.

Tax Status
While the majority of corporate bonds are taxable investments, there are some government and municipal bonds that are tax exempt, meaning that income and capital gains realized on the bonds are not subject to the usual state and federal taxation. (To learn more, read The Basics of Municipal Bonds.)

Because investors do not have to pay taxes on returns, tax-exempt bonds will have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.

Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. (To learn more, read Callable Bonds: Leading A Double Life.)

2. Risks of Bonds

Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. (To learn more, read Corporate Bonds: An Introduction To Credit Risk.)

Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment.

Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future. (To learn more, read Managing Interest Rate Risk.)

3. Bond Ratings

The most commonly cited bond rating agencies are Standard & Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its obligations. Ratings range from 'AAA' to 'Aaa' for "high grade" issues very likely to be repaid to 'D' for issues that are in currently in default. Bonds rated 'BBB' to 'Baa' or above are called "investment grade"; this means that they are unlikely to default and tend to remain stable investments. Bonds rated 'BB' to 'Ba' or below are called "junk bonds", which means that default is more likely, and they are thus more speculative and subject to price volatility.

Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm's repayment ability. Because the ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering. (To learn more, read The Debt Ratings Debate.)

4. Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.

Yield to Maturity (YTM)
As said above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor's actual return will differ slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excel's RATE or YIELDMAT (Excel 2007 only) functions for this computation. A simple function is also available on a financial calculator. (Keep reading on this subject in Microsoft Excel Features For The Financially Literate.)

Current Yield
Current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bond's annual coupon amount by the bond's current price. Keep in mind that this yield incorporates only the income portion of return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.

Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.

Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate this yield using Excel's YIELD or IRR functions, or with a financial calculator. (For more insight, see Callable Bonds: Leading A Double Life.)

Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel's YIELD or IRR functions, or by using a financial calculator.

Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. An investor need only master these few basic terms and measurements to unmask the familiar market dynamics and become a competent bond investor. Once you've gotten a hang of the lingo, the rest is easy.

Related Articles
  1. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  2. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  3. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  4. Professionals

    Credit Risk Analyst: Job Description and Average Salary

    Learn what credit risk analysts do every day and how much money they make on average, and identify the skills and education needed for this career.
  5. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  6. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  7. Investing

    The Pros and Cons of High-Yield Bonds

    Junk bonds are more volatile than investment-grade bonds but may provide significant advantages when analyzed in-depth.
  8. Entrepreneurship

    Creating a Risk Management Plan for Your Small Business

    Learn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
  9. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  10. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  3. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  4. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  5. Do hedge funds invest in bonds?

    Hedge funds have the freedom to deploy their capital in virtually any manner. They can use leverage, invest in non-publicly ... Read Full Answer >>
  6. Do mutual funds pay dividends or interest?

    Depending on the type of investments included in the portfolio, mutual funds may pay dividends, interest, or both. Types ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center