BONDS 101: THE BASICS

Many investors, including seasoned traders, are not that familiar with the bond market. They only invest in bonds because they either want to diversify their portfolio or to know more about its complex nature. But bonds are simple debt instruments if you are going to study it.

Features of a Bond

Bond is a debt instrument taken out by entities for a given time period and at a fixed interest rate. Governments, companies, as well as foreign governments obtain bonds in order to fund various projects and activities. When buying the bonds, investors lend a company money. In exchange, the firm pays an interest coupon at preset intervals, and returns the principal on its maturity. Unlike stocks, bonds vary based on its indenture, a legal document outlining the bond’s features. An investor should know the following features before investing in a bond:

• Maturity - The date when the principal (or par amount) will be paid to investors. It also refers to the day debt obligation will end.

• Secured/Unsecured - A bond has two classifications: secured and unsecured. Secured bonds are bonds in which certain assets are pledged to holders should the firm fail to repay the obligation. Conversely, unsecured bonds are debentures, its interest payments and return of the principal are secured only by the issuing company’s credit.

• Liquidity - In the event of bankruptcy, the bond will pay back money to investors in a specific ranking. After selling off all of its assets, the company begins paying out to investors based on this order: senior debts, junior (subordinated) debts, and lastly, stockholders.

• Coupon - The amount of interest paid to holders, which is usually given annually or semi-annually.

• Tax Status - Most bonds are taxable, but certain government and municipal bonds are tax exempt. Nontaxable bonds have lower interest than taxable ones simply because investors need not to pay taxes on returns.

• Callability - Certain bonds which can be paid off by an issuer prior to its maturity. If a bond has call provision, this can be repaid earlier, normally at a slight premium to parity.

Risks Encompassing Bonds

There are three risks surrounding bonds: credit/default risk, prepayment risk, and interest rate risk.

• Credit/Default Risk - The danger that interest and principal payments will not be settled on or before the defined date.

• Prepayment Risk - The peril a specific bond issue will be met earlier than expected, normally through a call provision.

• Interest Rate Risk - The risk that interest rates will change substantially from the investor’s expectation.

Agencies and Ratings

Fitch, Moody’s, and Standard & Poor’s are the well-known rating agencies for bonds, which rate a firm’s capability to repay its obligations. Their ratings range from ‘AAA’ to ‘aaa’ for high grade issues; ‘D’ rate for those who are currently in default; ‘BBB’ to ‘Baa’ or above for investments that are unlikely to default and tend to remain stable; and ‘BB’ to ‘Ba’ or below are junk bond or those with more likelihood of default. Many companies will not have their bonds rated, so it is up to investors to gauge their repayment ability. And since agencies have their own rating system, which change from time to time, investors should do their research on the agency’s rating for the bond issue you are considering.

Yields

Bond yields are the measures of return. Yield to maturity (YTM) is the most commonly used measurement, but there are also other yield measurements used for bonds.

• Yield to Maturity (YTM) - It gauges the bond’s return if held to maturity and all coupons are reinvested at the YTM rate. Actual returns differ slightly since it is impossible the coupons will be invested again at the same rate.

• Yield to Call (YTC) - The yield of a bond or note if an investor will purchase and hold the security until its call date, which will become valid only if the bond is called before the maturity.

• Realized Yield - Actual amount of return a bond has realized over a time period. The time period refers to the holding period, which may vary from the expected yield at maturity. It also includes returns from reinvested interest, dividends, and other cash distributions.

• Nominal Yield - Simply the bond’s coupon rate, the percentage of interest to be paid periodically. It is computed by dividing the bond’s annual coupon payment by its parity value. Unless the prevailing bond price is the same with its par value, the yield won’t estimate returns accurately.

• Current Yield - This is used to compare the bond’s interest income by the stock’s dividend income. It is determined by dividing the bond’s annual coupon amount by its current price. It is most useful for investors who only look at the current income.