Bonds come in many varieties, however, some characteristics are unique to all of them, and should be understood by any potential bond investor.
The first characteristic of a bond is its face, or par value. This represents the amount of principle that a bondholder will receive at maturity, and is also the value that that a bond is issued for at the time that a company or government first sells them. The majority of corporate bonds today carry a face value of $1,000, but may vary by issuer. Government bonds are often sold with higher face values, some of which can be as high as a hundred thousand or even a million dollars. The face value of a bond should not be confused with the price of a bond observed in the market – the face value is always a given amount, while the price of a bond will fluctuate over time. (We will discuss what influences bond prices in the next section of this tutorial.) When the observed market price of a bond is lower than the stated face value, it is said to be trading at a discount, and when the market price is higher than par it trades at a premium.
The coupon or yield of a bond is the interest rate the issuer agrees to pay its bondholders. Interest payments on corporate bonds are typically paid semi-annually but may also be paid annually or quarterly. Some bonds do not pay a coupon at all (zero-coupon bonds), but are instead sold at an initial discount to be repaid at the full face value at maturity, which has the same net effect as paying interest on a bond sold at face value. The yield is expressed at a percentage of the face value, so a yield of 10% on a $1,000 bond would imply an annual payment of $100 in interest. If the interest rate paid on a bond remains the same for the life of the security it is a fixed rate, while if it floats and changes over time it is referred to as adjustable or variable rate. Variable rates are typically pegged as a spread above some other benchmark rate such as that paid on 10-year government bonds or the LIBOR rate.
The yield of a bond is determined by a number of factors. First, the prevailing interest rate environment, second inflation expectations, and third the chances of being repaid or not. The greater the risk of not being repaid, the higher the yield on the bond. A bond with a shorter maturity is more predicable, therefore than a bond with a long maturity – and therefore a bond with a longer maturity will carry a higher interest rate. A company on an insecure financial footing will also carry a higher interest rate on its bonds since it may be more likely to default than a solid, blue chip company.
The maturity is the date at which the bond’s principle comes due and must be repaid to lenders in full. Maturities for corporate bonds are typically in the range of one to five years, with some bonds maturing in 10 or even 30 years. Occasionally, a company will issue a so-called century bond that matures in 100 years. Government bonds can be short term (a few months) to many years (10 or 30 years). The bond maturity is decided by the issuer, and influences the bond’s yield – the longer the time to maturity, the more chances that a company has to fail to repay, and therefore the higher the yield that it must carry.
The type and quality of the bond issuer is also an important characteristic of a bond, as the issuer's stability is your main assurance of getting paid back in full. For example, the U.S. government is far more secure than any one corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are often referred to as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue to pay its debts through taxation. A company, on the other hand, must continue to make profits, which are far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return tradeoff in action, sometimes known as the “yield spread” between corporate and government bonds.
For corporate bonds, there is a fairly standardized bond rating system, based on the analysis of credit rating agencies, to help investors determine a company's credit or default risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are large, financially secure companies issue bonds that are safer investments, and have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings.
|Ba, B||BB, B||Junk||Speculative|
Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds, or high yield bonds are below investment grade, and are aptly named: they are often the debt issued by companies in some sort of financial difficulty or instability. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.
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