4 basic knowledge about bonds

Want to strengthen the risk-reward profile of your investment portfolio? Adding bonds can create a more balanced portfolio by increasing diversification and interest rate fluctuations. But even for the most experienced investors, the bond market may seem unfamiliar. Many investors only convert venture capital into bonds because they are confused by the apparent complexity of the market and terminology. In fact, bonds are very simple debt instruments. So how to enter this part of the market? Start your bond investment by learning these basic bond market terms.

Key points

  • Some characteristics of bonds include maturity date, coupon rate, tax status, and redeemability.
  • Several risks associated with bonds include interest rate risk, credit/default risk, and prepayment risk.
  • Most bonds have ratings that describe their investment grade.
  • Bond yields measure their returns.

Basic bond characteristics

Bonds are simply loans obtained by the company. Instead of going to the bank, the company gets funds from investors who bought its bonds. In exchange for capital, the company pays an interest note, which is the annual interest rate paid for the bond, expressed as a percentage of the face value. The company pays interest at predetermined time intervals (usually every year or every six months), and repays the principal on the maturity date to end the loan.

A bond is a form of IOU between the lender and the borrower.

Unlike stocks, bonds may vary greatly due to contract terms, which are legal documents that outline the characteristics of bonds. Since each bond issuance is different, it is important to understand the exact terms before investing. In particular, when considering bonds, there are six important characteristics to look for.

maturity

This is the date when the principal or face value of the bond is paid to investors and the corporate bond obligation ends. Therefore, it defines the life of the bond. The maturity date of a bond is one of the main considerations for investors to weigh their investment objectives and maturity. Maturity is usually divided into three ways:

  • Short-term: bonds in this category tend to mature within one to three years
  • Medium term: The maturity date of this type of bond is usually more than ten years
  • Long-term: These bonds usually mature over a longer period of time

Safe/unsafe

Bonds can be secured or unsecured. If the company is unable to repay the debt, the secured bond pledges certain assets to the bondholders. This asset is also called loan collateral. Therefore, if the bond issuer defaults, the assets will be transferred to investors. Mortgage-backed securities (MBS) are secured bonds backed by the borrower’s home ownership.

On the other hand, unsecured bonds are not backed by any collateral. This means that interest and principal are only guaranteed by the issuing company. Also called bonds, these bonds will hardly return your investment if the company goes bankrupt. Therefore, they are much more risky than covered bonds.

Liquidation priority

When a company goes bankrupt, it will repay investors in a specific order during liquidation. After the company sold all of its assets, it began to pay its investors. Senior debt is debt that must be repaid first, followed by primary (subprime) debt. Shareholders get whatever is left.

coupon

The par value represents the interest paid to the bondholder, usually once a year or every six months. The coupon rate is also called the coupon rate or nominal yield. To calculate the coupon rate, divide the annual payment by the face value of the bond.

Tax status

Although most corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not taxable.The interest on tax-exempt bonds is usually lower than that of equivalent taxable bonds. Investors must calculate the tax-equivalent rate of return to compare the return with the return of the taxable instrument.

Callability

Some bonds can be repaid by the issuer before maturity. If the bond has a redemption clause, the company can choose to pay off at an earlier date, usually at a slightly premium over the face value. If interest rates allow the company to borrow at a better interest rate, the company may choose to redeem its bonds. Callable bonds also attract investors because they offer better coupon rates.

Bond risk

Bonds are a good way to earn income because they are often relatively safe investments. However, just like any other investment, they do carry certain risks. The following are some of the most common risks of these investments.

Interest Rate Risk

Interest rates and bonds are negatively correlated, so when interest rates rise, bonds tend to fall, and vice versa. When interest rates and investors’ expectations change significantly, interest rate risk occurs. If interest rates fall sharply, investors face the possibility of early repayment. If interest rates rise, investors will be trapped by instruments with yields lower than market interest rates. The longer the expiration time, the greater the interest rate risk that investors bear, because it is more difficult to predict future market developments.

Credit/default risk

Credit or default risk refers to the risk that the interest and principal of a debt will not be paid as required. When investors buy bonds, they expect the issuer to repay the interest and principal like other creditors.

When investors study corporate bonds, they should weigh the possibility that the company may default. Safety usually means that the company has higher operating income and cash flow compared to debt. If vice versa and debt exceeds available cash, investors may want to stay away.

Early repayment risk

Early repayment risk refers to the risk that a particular bond issuance will be paid off earlier than expected, usually through redemption clauses. This may be bad news for investors, because companies only have the incentive to repay their debts early when interest rates fall sharply. Investors no longer continue to hold high-interest investments, but reinvest their funds in a low interest rate environment.

Bond rating

Most bonds have a rating that outlines their credit quality. That is, the strength of the bond and the ability to pay principal and interest. Ratings are published and used by investors and professionals to judge their value.

mechanism

The most frequently cited bond rating agencies are Standard & Poor’s, Moody’s Investor Services, and Fitch Ratings. They rate the company’s ability to repay debt. High-level issues with a rating ranging from AAA to Aaa are likely to be repaid to D for the current default.

Bonds from BBB to Baa or above are called investment grade. This means that they are unlikely to default and tend to maintain stable investments. Bonds rated BB to Ba or below are called junk bonds-they are more likely to default, and they are more speculative and susceptible to price fluctuations.

The company will not rate its bonds, in this case, it is entirely up to investors to judge the company’s ability to repay. Since the rating system of each institution is different and changes from time to time, please study the rating definition of the bond issuance you are considering.

Bond yield

Bond yields are all measures of return. Yield to maturity is the most commonly used metric, but it is important to understand the other yield metrics used in certain situations.

Yield to maturity (YTM)

As mentioned above, the yield to maturity (YTM) is the most commonly cited yield measure. If the bond is held to maturity and all coupons are reinvested at the YTM rate, it measures the bond’s return. Since coupons are unlikely to be reinvested at the same interest rate, the actual return for investors will be slightly different. Calculating YTM manually is a long process, so it is best to use Excel’s RATE or YIELDMAT functions (starting with Excel 2007). There is also a simple function on the financial calculator.

Current rate of return

The current yield can be used to compare the interest income provided by bonds with the dividend income provided by stocks. This is calculated by dividing the bond’s annual coupon by the bond’s current price. Please remember that this gain only includes the income portion of the return, ignoring possible capital gains or losses. Therefore, this rate of return is most useful for investors who only care about current income.

Nominal output

The nominal yield of a bond is just a percentage of the bond interest paid on a regular basis. It is calculated by dividing the annual coupon payment by the face value or face value of the bond. It is worth noting that unless the current bond price is the same as its face value, the nominal yield will not accurately estimate the return. Therefore, the nominal rate of return is only used to calculate other return indicators.

Yield (YTC)

Callable bonds always have a certain possibility of being redeemed before the maturity date. If the redeemed bonds are repaid at a premium, investors will realize a slightly higher yield. Investors in such bonds may want to know how much benefit will be realized if the bond is redeemed on a specific redemption date to determine whether the risk of early repayment is worthwhile. It is easiest to use Excel’s YIELD or IRR function or financial calculator to calculate the return rate to be called.

Realized benefits

If the investor plans to hold the bond for a period of time instead of maturity, then the realized rate of return on the bond should be calculated. In this case, the investor will sell the bond and must estimate this projected future bond price for calculation. Since future prices are difficult to predict, this measure of yield is only an estimate of return. It is best to use Excel’s YIELD or IRR function or use a financial calculator to perform this rate of return calculation.

Bottom line

Although the bond market looks complicated, it is actually driven by the same risk/return trade-offs as the stock market. Once investors have mastered these basic terms and metrics to reveal familiar market dynamics, they can become competent bond investors. Once you master the jargon, the rest is easy.

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