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.
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.
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.
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 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 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 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.
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.)
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.