Fixed-Income Investing Tools: Bonds
By Nick Mango | July 11, 2019
Any risk-minded investment portfolio will typically consist of three core asset classes: Equities (stocks, ETFs, etc.), bonds and fixed-income, and cash/cash equivalents. While bonds and fixed-income investments may lack the flair and excitement of those high-flying growth stocks, there are reasons for them to remain an indispensable part of any diversified, well-balanced portfolio of investments.
Now admittedly, bonds were much maligned by the artificially low-interest-rate environment which prevailed from 2008-2015 as the Fed became ultra-vigilant in the aftermath of the Great Recession, which officially ended in June 2009. During this time, interest rates remained at virtually zero (0 – 0.25%). However, as interest rates rise bonds should get a little bit of their groove back. This could again give a wide range of investors, from millennials and beginners all the way to baby boomers and late-stage retirees, a relatively safe and steady income, which is what made bonds a go-to investment in the first place.
So here’s what bonds are and how they function, the important language and considerations for current and prospective bond investors to know and understand, and the various choices investors have when selecting bond investments for their respective portfolios.
Using Bonds as Practical Investing Tools
In essence, a bond is like an I.O.U. between an issuer—perhaps a government or corporate institution—and the investor/bondholder. Across the investment community, bonds are considered loans or promissory notes, or even debt instruments with practical applications for most types of investors.
Bond issuers, then, are interested in raising short-term capital for expansion, maintaining operations or paying back debts. As a result, issuers are willing to pay investors periodic interest, plus the initial value of the bond at a predetermined, future date in return for the rights to borrow capital and put it to work in the present day.
Investors, on the other hand, might opt for bonds over equities or other fixed-income investments on account of their perceived safety, stability and particularly the promise of durable income. Bonds are attractive to investors because, while bond rates and values vary, these are clearly stated up front, much to the delight of conservative-minded investors who may ameliorate the variable or even negative returns produced by the equity markets in favor of predictable (but often smaller) bond yields.
Key Bond Terms Explained
Most investors are likely aware that there are different types of bonds (Treasuries, corporate, etc.), as well as certain variations in the way that individual bonds function. However, there are also universal bond terms and metrics that are common to all, and that are used to analyze the risk, value and overall attractiveness of a given bond as an investment.
- Coupon Rate or Yield: Percentage of principal that the bond issuer will pay the bondholder on the face value of the bond. This is commonly referred to as “interest”. Bond yields are typically payable twice annually, though some use a different coupon schedule.
- Face/Par Value: Principal amount of a given bond and what it will be worth at its maturity date.
- Maturity Date: Predetermined date when bond issuer is required to pay bondholder the face value of the bond.
- Issue Price: Initial price for which the bond issuer originally sells bonds to investors.
- Zero-Coupon Bonds: Rather than paying twice-annual yields, zero-coupon bonds are issued at a discount to their face value, which allows the bondholder to collect a premium once the bond reaches maturity. US Treasuries, for example, are zero-coupon bonds.
- Convertible Bonds: Allow bondholders to convert their bond(s) into equity (such as stock) depending on certain conditions. Convertible bonds might be advantageous to investors who hope to profit from future appreciation in a company’s stock price, and who may be willing to forego a higher yield in return for the right to convert their bond(s) into equity instead.
- Callable Bonds: Can be bought back by the bond issuer prior to maturity date, perhaps if interest rates decline or bond value increases. Callable bonds are comparatively higher risk for investors due to the increased likelihood they will be called if the value increases.
- Puttable Bonds: Can be sold back to the issuer prior to maturity. This added flexibility could be valuable for bondholders in a rising interest rate environment, as the bondholder could secure payment before their bond(s) decreased in value. Puttable bonds tend to sell at a premium because of the protection they offer bondholders.
- Duration: Contrary to how it sounds, duration isn’t a measure of time until maturity. Instead, in the bond universe, duration is a measure of how much a bond’s price will rise or fall as a result of changing interest rates.
Impact of Interest Rate Fluctuations on Bond Investments
Among the most significant determinants of bond yield, pricing and overall value, are factors like the issuer’s credit rating, the length of time until the bond reaches maturity and, of course, the interest rate environment.
Typically, the bond market exhibits an inverse relationship with prevailing interest rates, with bond prices decreasing and yields rising as interest rates rise, and vice versa. In an environment of rising interest rates, for example, bonds previously purchased by other investors with lower yields would become less valuable if newer bonds were issued with higher coupon rates in response to an increase in interest rates.
Conversely though, if interest rates decreased and so, too, did the yields on new bond issues, investors holding previous bond issues with higher rates would see appreciation in those assets and might elect to sell such bond holdings (at a premium) to other investors. Declining rates, however, might also prompt bond issuers to buy back callable bonds and ultimately save money by reissuing new bonds at a lower coupon rate consistent with the new, lower interest rate at the time.
Understanding the Major Types of Bonds
US treasuries probably represent the most well-known bond category. They are the easiest to purchase since willing investors can buy direct from the Treasury by way of a bank or by using a licensed broker or dealer.
But bond investors have a range of other choices outside of treasuries as well. Foreign countries, municipalities like state and local governments and corporations large and small also act as bond issuers. While it’s necessary (or at least recommended) to work with a reputable broker to access the bond market outside of US treasuries, bonds aren’t especially difficult to purchase. Corporate bonds can even be purchased over-the-counter on major exchanges.
Before purchasing, however, it’s important to consider the investment choices carefully, as there are many types of bonds available to suit most any investor’s needs and risk profile.
All government bonds, whether issued by the US or foreign governments, tend to be referred to as treasuries since they’re issued by the Treasury in the nation from which they originate. Varying maturity dates, however, result in some different names for these treasuries. Typically, bonds with a year or less to maturity are called bills, those with one to ten years to maturity are called notes and bonds with ten or more years to maturity are called treasury bonds.
A nation’s credit rating plays a central role in determining bond price and yield. Fiscally strong nations like the US will issue bonds that are widely considered relatively secure and low risk. As such, prices tend to be comparatively higher and yields lower than investors may find elsewhere. Bonds issued by nations with less-favorable credit ratings tend to cost less and pay higher yields in order to compensate investors for accepting relatively higher risk.
State and local government bond issues might offer investors the potential for tax-free coupon income, which is a big part of these bonds’ attractiveness. Municipal, or muni bonds, however, could carry a higher overall risk profile than US treasuries or corporate bonds issued by strongly rated companies.
Particularly when accessing the municipal bond market, it’s both necessary and advantageous to work with a qualified broker who is able to help investors analyze risk and discern opportunities that suit their own, unique objectives.
Conservative investors who like the relative safety and security of treasuries but want higher returns might be wise to explore the corporate bond market. There, companies, including fiscally strong and stable blue chips and cash-rich utilities, issue investment-grade bonds that could enable higher yields and overall returns without requiring outsized risk.
The range of companies issuing bonds can be expansive, which offers investors a range of choices. But for safety-minded bond investors, the prudent advice would be to avoid junk bonds, less-established issuers, and companies with unfavorable credit ratings.
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