As a financial professional, you already know why investing is important. But occasionally you meet a client who doesn't understand even the most basic concepts and tools of successful investing. What do you say? The following is an easy to follow explanation to help you explain to clients why they should invest.

Explaining Bonds to a Client

Most of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need money for everything from infrastructure to social programs.

The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market, where thousands of investors then each lend a portion of the capital needed. Therefore a bond is really nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer.

The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date.

Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity. If you buy a bond with a face value of $1,000, a coupon of 8% and a maturity of 10 years, then you'll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years (typically in two $40 biannual payments). When the bond matures after a decade, you'll get your $1,000 back.

Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are considered to be risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is 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.

The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue-chip firms, which are safer investments, 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 United States: Moody's, Standard and Poor's and Fitch Ratings.

Bond Rating

Grade

Risk

Moody\'s

S&P/ Fitch

Aaa

AAA

Investment

Highest Quality

Aa

AA

Investment

High Quality

A

A

Investment

Strong

Baa

BBB

Investment

Medium Grade

Ba, B

BB, B

Junk

Speculative

Caa/Ca/C

CCC/CC/C

Junk

Highly Speculative

C

D

Junk

In Default

Types of Bonds

In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:

  • Bills - debt securities maturing in less than one year.
  • Notes - debt securities maturing in one to 10 years.
  • Bonds - debt securities maturing in more than 10 years.

There are three main types of bonds: government, municipal and corporate. Each type has slightly different characteristics and advantages and disadvantages.

Government Bonds
These are specifically issued in the form of bills, notes and bonds with corresponding maturities. The U.S. Treasury also issues savings bonds in the form of EE bonds, I bonds and Treasury Inflation Protected Securities (TIPS). Government bonds are considered to be the safest type of security on earth, and financial analysts consider the rate of interest being paid by the T-Bill to be the risk-free rate of return. However, they also typically pay very low rates of interest.

Municipal Bonds
Municipal bonds, known as "munis", are the next step up the risk to reward ladder. Cities don't go bankrupt very often, but it can happen. The major advantage to munis is that their interest is typically nontaxable at the federal level for all investors and state and local tax-free for those who live under the jurisdiction of the municipality. Consequently the yield on a muni is usually lower than that of a taxable bond, and muni interest typically benefits high-income investors more than others.

Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years and long term is over 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The company's credit quality is very important; the higher the quality, the lower the interest rate the investor receives. Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity. Corporate bond interest is always fully taxable at all levels.

Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years.

The Bottom Line

It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market, and their guarantee of principal plus interest provides peace of mind for conservative investors. Of course, it is possible for the issuer to default on a bond, which is why bonds are rated according to the financial stability of the issuer. The lower an issuer is ranked, the greater the chance of default.

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