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Bonds:
Four key things to consider before
buying Bonds
There are four key
important factors you need to consider before buying a bond. The first is the
credit rating of the organization issuing the bond. Secondly, the interest you
will receive in exchange for lending your money. The third factor is maturity
date, this is the day when the borrower must pay back the principal to the
lender. And some bonds have redemption, or "call," provisions that
allow or require the issuer to repay the investors' principal at a specified
date before maturity. Any one of these can drastically affect the price of the
bond.
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Credit Quality - Bond
choices range from the highest credit quality U.S. Treasury securities, which
are backed by the full faith and credit of the U.S. government, to bonds that
are below investment-grade and considered speculative. The issuer will affect the
default
risk (it's ability to pay back debt) which in turn affects the
price of the bond. For example, the U.S.
Government is more likely to repay a debt obligation than a corporation
is likely to. This means the corporations must offer a higher return in
order to entice investors. That's why credit quality of the issuer is a
very
important factor when you're considering investing in a fixed-income investment. When a
bond is issued, the issuer is responsible for providing details as to its
financial soundness and creditworthiness. This information is contained in a
document known as an offering document, prospectus or official statement, which
will be provided to you by your investment advisor. It's important to mention
that risk and reward go hand in hand.
But how can you know whether
the company or government entity whose bond you're buying will be able to make
its regularly scheduled interest payments in five, 10, 20 or 30 years from the
day you invest? Rating agencies such as Moody's and Standard & Poor's assign
ratings to many bonds when they are issued and monitor developments
during the bond's lifetime. The bond rating system helps investors
distinguish what credit risk a company may have. Think of a bond rating
as the report card for a company's credit rating. Blue-chip firms that
are a safer investment have a high rating while risky companies have a
low rating. The chart on the left illustrates the
different bond rating scales from the two major rating agencies, Moody's
and Standard and Poors:
Credit quality can also be
enhanced by bond insurance. Specialized insurance firms
serving the fixed-income market guarantee the timely payment of
principal and interest on bonds they have insured. In the United States,
major bond insurers include MBIA, AMBAC, FGIC and FSA.
Most bond
insurers have at least one triple-A rating from a nationally recognized
rating agency attesting to their financial soundness; and insured bonds,
in turn, receive the same rating based on the insurer's capital and
claims-paying resources. While the focus of their underwriting
activities has historically been in municipal bonds, bond insurers also
provide guarantees in the mortgage and asset-backed securities markets
and are moving into other types of securities as well.
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Aaa |
AAA |
Investment |
Lowest Risk
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Aa
|
AA |
Investment |
Low Risk
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|
A |
A |
Investment |
Low Risk
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Baa |
BBB |
Investment |
Medium Risk
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|
Ba, B |
BB, B |
Junk |
High Risk
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Caa/Ca/C |
CCC/CC/C |
Junk |
Highest Risk
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C |
D |
Junk |
In Default
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- Interest (Coupon) -
Bonds pay interest (usually every
six months) that can be fixed, floating or payable at maturity. Most
debt securities carry an interest rate that stays fixed until maturity
and is expressed as a percentage of the face value or par value
(principal) amount. For example, a $1,000 bond with an 10% interest rate
will pay investors $100 a year, in payments of $50 semiannually. When
the bond matures, investors receive the full face value of the bond of
$1,000. Some bonds have an interest rate that is adjustable, and more
closely tracks prevailing market rates. The interest rate on a
floating-rate bond is reset periodically in line with changes in a base
interest-rate index, such as the rate on Treasury bills.
Another type of
bonds are known as zero-coupon bonds, which have no
periodic interest payments. Instead, the investor receives one
large lump sum payment at maturity, that is equal to the face value plus
the total interest earned. They are issued at a substantial discount from their face
amount (par value). For example a zero coupon bond with a $1,000 par
value and 10 years to maturity might be trading at $700. So today you
pay $600 for a bond that will be worth $1000 in 10 years. The difference
between $1,000 and $700 represents the interest ($300) which compounds
at original interest rate automatically until the bond matures. If the
bond is taxable, then the interest is taxed every year as it accrues,
even though it is not paid to the investor before maturity or
redemption.
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Maturity - A bond's maturity refers to the specific future
date (maturity date) on which the investor's principal
will be repaid. Bond maturities generally range from one day up to 30 years. A
bond that matures in less than a year is much more predictable and less risky,
therefore usually lower interest than a bond that matures in 20 years. Also, the
longer time to maturity a bond is the more it will fluctuate in price. Maturity
ranges are often categorized as follows:
- Short-term notes - Maturities
of up to five years.
- Intermediate-term notes/bonds
- Maturities of five to 12 years.
- Long-term bonds - Maturities
of 12 or more years.
Your choice of maturity will depend on when you want or need the principal
repaid and the kind of investment you are seeking within your risk tolerance.
Some individuals might choose short-term bonds for their comparative stability
and safety, although their investment returns will be typically lower than
would be the case with long-term securities. Alternatively, investors seeking
greater overall returns might be more interested in long-term securities
despite the fact that their value is more vulnerable to interest rate
fluctuations and other market risks, as well as credit risk.
- Redemption Features
- Some bonds have redemption, or call, provisions that allow or
require the issuer to repay the investors' principal at a specified date
before maturity. Bonds are commonly called when prevailing interest rates
have dropped significantly since the time the bonds were issued. Before you
buy a bond, always ask if there is a call provision and, if there is, be sure
to obtain the yield to call as well as the yield to maturity. Bonds with
a redemption provision usually have a higher annual return to compensate for
the risk that the bonds might be called early. Conversely, some bonds have puts, which allow the investor the option of
requiring the issuer to repurchase the bonds at specified times prior to
maturity. Investors typically exercise this option when they need cash for
some purpose or when interest rates have risen since the bonds were issued.
They can then reinvest the proceeds at a higher interest rate.
Next==>>
How To Read a Bond Table
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