Characteristics, Uses and Taxation of Investments - Individual bonds

Bonds are loans that are traded. There exist many types and issuers, but all of them have, more or less, several features in common which are discussed here. Because the discipline of fixed income management forms a moat that is so wide and deep, the discussion will focus on the practical application of using bonds in individual investors portfolios and the essential criteria for measuring value and volatility. They usually pay a fixed amount of interest [1] at regular intervals and have a term-to-maturity, at the end of which, they repay the principal to the bondholders and the bond issue ceases to exist. Bonds exist in registered and bearer form. Registered bonds are payable to the owner of record, whereas bearer bonds are as transferable as cash. There is no owner of record, but rather whoever holds bonds in these forms is able to receive income from them. This latter form of ownership is rare in the United States. Issuers are varied, including companies, countries and governmentalities (states, cities, counties, etc.).

Bond prices move inversely to interest rates. When rates increase, bond prices decrease and vica versa. An example illustrates why this is so. Inasmuch as the price of a bond represents the present value of its cash flows, then that price adjusts to reflect the required yield based upon market circumstances. Assume that an investor purchases a 15 year bond at face (par) value yielding 6.5%. Assume as well that just after this purchase, market interest rates rise to 7% and that the bondholder wants to sell the bond at par value yielding 6.5%. Investors could purchase bonds in the open market yielding 7%. The investor can only sell the bond at a price that yields 7%. This price would be adjusted downward to below par to reflect the present value of the cash flows of the new higher required yield. Conversely, assume a scenario where the investor purchases a 15 year bond at par yielding 7% and that interest rates decrease to 6.5%. In order to sell this bond, the investor would have to adjust the price upward to reflect the present value of the lower required yield in the marketplace.

Yield relationships and calculations are a staple of the planner's tool kit. Nominal yield is set at issuance and appears on the bond's certificate; current yield is the bond's coupon payment divided by the market price; yield to maturity is the internal rate of return on the bond assuming all cash flows are reinvested at the coupon rate to maturity; yield to call assumes reinvestment of the coupon until the bond's call date. The relationships of the yields when bonds trade at a discount or premium appear as follows. When a bond is trading at a premium to its par value, its yields rank in the following descending order: coupon yield, current yield, yield to maturity, yield to call (if the bond is callable). Conversely, if a bond trades at a discount, its yields rank in the following ascending order: coupon yield, current yield, yield to maturity, yield to call (if applicable).

Central to the discussion on fixed income are the concepts of duration and convexity. These are measures of bond price volatility. Duration is the weighted average term to maturity of a bond's cash flows. In common parlance, it measures how quickly the bond holder (creditor) receives his or her money back. A bond with a lower coupon or interest payment and or longer term to maturity is a greater risk as it is subject to greater price fluctuation and pays less interest to the holder. Its duration is, thus, higher. Convexity measures how great an increase or decrease in a bond's price will occur as a result of a change in interest rates.

Credit quality is an important input in bond valuation. With the exception of United States government bonds and certain agency securities, all bonds are subject to credit risk in some measure. The greater the risk, the higher the yield that a bond must pay to compensate investors for that risk and vica versa.

[ footnote 1] Bonds are also referred to as fixed interest securities.

U.S. Government Bonds and Agency Securities
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