A bond is an agreement between the lender (investor) and the borrower (issuer). In return for use of up-front cash, the issuer promises to make specific payments to the bondholder on specific dates. Although the repayment schedule varies based upon the bond type, the bond investors can expect fixed payments interest (and sometimes principle), with all of the principal and remaining interest paid upon the bond’s maturity.
Bonds can be issued by governments, agencies, municipalities, or corporations. Their overall risk and return depend on the credit worthiness of the issuing institution. Bonds have a defined maturity, or end date, and can have a fixed or variable rate of interest that dictates the bond's interest. Fixed rates remain the same through the life of the bond, whereas variable rates fluctuate with changes in interest rates.
Online Resources: Bond News and Data
In this section, we will cover the following:
Like most investments, a bond's price is determined by its attractiveness to investors. The key considerations when determining a bond's price are the bond's coupon (the amount of its interest payments) include its maturity date and the credit risk of the issuer. The issue price of a bond is known as its face value or par value.
The value (and therefore price) of bonds changes as current interest rates change. Bonds can sell at its par value or at a discount or premium to par. The market price of outstanding bonds fluctuate inversely to the movement in current interest rates. If interest rates have increased, buyers of bonds can purchase newly issued bonds with a higher rate of interest than outstanding bonds. Therefore, to be competitive with new-issues, owners of outstanding bonds have to lower the price at which they are willing to sell their bonds to such that the bond’s yield increases – that is the bond’s interest rate divided by the bond’s price.
On the other hand, in a declining interest rate environment, outstanding issues of bonds increase in value. Investors who invest in bonds interested only in the interest payments and who are planning on holding the bonds through to their maturity may not care about the fluctuation in bond prices. In particular
Nonetheless, there are two reasons investors should be concerned with movements in bond prices:
On the negative side, bonds can lose value when inflation is high. Because a bond's interest rate is usually not tied to inflation, the inflation can often erode your return. Also, investors should be wary of investing in bonds when interest rates are low because locking in a low rate today can prevent the investor from reaping a higher income should interest rates rise.
Bonds have several attributes that make them an attractive investment. First of all, a holder of bonds can usually expect to receive income from regular interest payments, made either semiannually or annually, depending on the bond. Additionally, the borrower (issuer of the bond) is obligated to return the principal at the end of the term of the bond. Because of these fixed obligations, buying bonds is often perceived as less risky than investing in stocks.
Bonds vary in terms of their issuers, credit quality, length to maturity, interest rates, face values, and repayment schedule. The risk/return profile of each type of bond varies relative to each of the above characteristics relative to the current economic environment. The main bond classifications include:
The largest single borrower in the United States is the US Government, which issues short, medium, and long term debt. The market for government bonds is robust, very liquid and has both a primary and secondary market. All government securities are issued in registered form with interest paid semi-annually to the investor. The US Government Bond Market is the safest of all bond markets because the taxing authority of the US Government backs it. This means that the government can always use money collected through taxes to pay back debt obligations if the need arises.
The US Treasury Department holds quarterly auctions of bonds. The dollar value of bonds offered changes each quarter to reflect the US Government financing needs at that time. Short term and long term government bonds have distinct and specific terms that reflect their different levels of risk and duration.
The two types of treasury securities are Notes and Bonds. Treasury Notes are coupon-bearing securities with maturities between two and ten years and Treasury Bonds are U.S. bonds issued with a thirty-year maturity.
Federal agencies are governmentally established agencies, which are legally authorized to administer selected lending programs on behalf of the US Government. Loan programs are designed to bring private capital to sectors of the economy with inadequate funds, including social and economically disadvantaged areas. The agencies market is very liquid, second only to the US Government Bond market. Securities issued by government-sponsored agencies are not as safe as US government bonds because they are backed by the issuing authority, rather than the US government. This higher risk results in higher returns to the bond-holder. Additionally, there is an implied moral obligation by the US Government to assure that the principal and interest of all agency securities are protected and honored.
Local and state issued government bonds are known as municipal bonds or "munis." These governments normally receive grants and subsidies directly from the Federal government, but their financial requirements far outweigh these receipts. Consequently, these authorities have to satisfy much of their own funding requirements by issuing munis.
Like government bonds, munis have a fixed maturity date and make semi-annual coupon payments. Municipals are free from federal and/or state taxation and are therefore attractive to certain investors who wish to shelter their income against taxation. Municipal bonds range widely in their credit quality and are less liquid than government securities.
Asset backed securities are backed by collateral in the form of receivables that are pooled and offered to investors in the form of a bond. The collection payments on the receivables are accumulated and then used as payments on the bonds.
Asset backed securities typically vary based on prepayments of receivables and trade quite differently from straight bonds. Interest rate fluctuations can continually affect the average maturity and outstanding monetary amount of any given pool of securities. Thus, the secondary market for asset backed bonds is dominated by institutional investors who can evaluate the worthiness of these investments with the help of sophisticated computer valuation models and trading tools.
While they can also be backed by payments on credit cards or consumer loans, the most common asset backed securities are Mortgage Backed Securities (MBS), or "Pass-through's". These generally refer to mortgage pools established by the following organizations:
· Fannie Mae: Federal National Mortgage Association ( http://www.fanniemae.com )
· Freddie Mac: The Federal Home Loan Mortgage Corp. ( http://www.freddiemac.com )
· Ginnie Mae: Government National Mortgage Association ( http://www.ginniemae.gov )
The corporate bond market in the United States is the largest corporate bond market in the world in terms of both dollar value issued and turnover. Here's how it works:
The majority of the corporate bonds are straight bonds (bonds with a stated maturity and semi-annual interest payments). However, over the years, corporations have issued zero coupon bonds (bonds with no coupon payments) and deep discount bonds (bonds selling for a discount of more than 20%), depending upon market conditions. The benefit to the corporation for issuing zero coupon bonds is that they can save their cash in the near term by avoiding paying coupon payments. Floating rate or variable rate coupons have also become a popular structure for corporate bonds. All corporate bonds are guaranteed by the borrowing (issuing) company, and the risk depends on the company's ability to pay the loan at maturity.
How risky are corporate bonds? There are bond rating systems that indicate the degree of credit risk for a corporate bond. The rating that is attached to a bond is an indicator of the issuing company's ability to honor its debt. This rating tool enables the investor to evaluate how much credit risk they are willing to assume when investing in a particular bond. There are three major bond rating agencies in the US:
The main factors that determine the issue's rating are:
Highly rated bonds have less risk and will obviously carry a lower yield than lower rated issues. Investment grade issues are those corporate bonds that are considered to be of higher quality and are therefore more secure. On the contrary, high-yield (junk) bonds are issued by corporations whose ability to repay is questionable. Due to their high risk levels, these bonds are also called "junk" bonds by many investors. Returns tend to be more volatile due to the relatively high default risk embodied in the security. What are callable bonds?
Some corporates are issued with a call feature and referred to as "callable bonds." This call feature varies from issue to issue and indicates that the bond may be redeemed at a preset price, at the discretion of the issuer, usually prior to the stated maturity date of the bond.
These bonds are issued with no coupon and the issuer pays all interest and principal when the bond matures. Because the entire payment to the bond holder takes place at maturity, holders are more exposed to valuation swings should interest rates change. Consequently, zero coupon bonds are much more volatile than straight bonds. Also they are treated differently from a taxation point of view, so investors should check with their tax consultant for the appropriate use of these bonds.
Index linked bonds are bonds with their coupon tied to an index (commodity index, inflation rate). This causes the pay-out to generally fluctuate over the life of the bond (index goes up, pay-out goes up; index goes down, pay-out goes down). Index-linked bonds are gaining in popularity because the Treasury introduced an inflation-linked bond, designed to pay a variable rate of interest that reflects a common inflation index.
Convertible bonds are bonds issued by a corporation with an imbedded exchange feature. This means that the bonds can be exchanged for the common stock of the underlying issuer, usually defined by a specific set of circumstances and at a pre-set conversion ratio. Money Market Securities
Money Market securities are some of the safest and most liquid of all investments available. Risk-averse investors that have a quick need for cash often find money market securities a good investment choice. As the MutualFundAlliance.com discusses relative to asset allocation, Money Market securities should have a place in nearly everyone’s portfolio. The only question is what portion of your portfolio should be invested in Money Market securities.
The money market itself operates through dealers, Money Center Banks, and the Open Market Trading Desk at the New York Federal Reserve Bank. The five basic money market securities we'll cover are:
The most common of the money market instruments available today are Treasury Bills, or T-Bills. Treasury bills are short-term obligations of the US government, highly liquid and considered the safest of all securities issued. They are issued by the Federal Reserve Bank on behalf of the US Treasury Department with maturities of thirty, sixty, ninety, and 180 day, as well as a maturity of one full year. Be careful not to confuse Treasury Bills with Treasury Bonds. Treasury Bonds have maturities greater than one year.
Being backed by the US government means that they are low risk and therefore offer a lower return than would normally be found with a riskier security. Nonetheless, there is a risk to your principal if you need to sell it before its maturity. If you need access to your principal and you decide to sell your Treasury Bill before its maturity date and current interest rates are higher than the interest rate on your T-Bill, you are likely to only be able to sell your T-Bill to another investor for less than you paid. This is because an investor could purchase a current T-Bill with the same principal and earn a higher interest rate.
In contrast to T-Bills that are backed by the government, CD's are obligations of individual Banks. CD's carry the bank's guarantee to repay the principal and interest at an agreed upon rate after a set period of time – usually from seven days to ten years. Generally the more you save or the longer the term this higher the interest rate. These obligations are negotiable and extremely liquid – meaning that ownership can be transferred or sold to another party.
The quality of the bank's balance sheet and its financial strength will generally determine the interest rate that one bank will pay purchasers of CD’s relative to another. The higher the quality of the institution, the lower the risk, and therefore the lower the rate of interest offered to the CD purchaser.
In addition, since CD’s are issued by banks, they usually carry the insurance of the Federal Deposit Insurance Corporation (FDIC). But please keep in mind that although a CD may have FDIC insurance does not mean that it is risk free. If a bank fails and you have to rely on insurance, your principal will be tied up for a significant amount of time and there are limits to how much insurance you may be eligible for relative to the size of your deposits at that bank.
Commercial paper is a short-term promissory note issued by a corporation to raise working capital. The paper carries a life of no more than 270 days and is secured by a corporate IOU.
Commercial paper is perceived to be riskier than government backed security, so the rate paid by the issuing corporation will reflect a premium over the T-Bill rate. Like CD’s, this interest rate premium is dependent upon both the financial strength, and the credit quality of the corporate issuer.
Money market funds are mutual funds that invests in a number of money market vehicles such as Commercial Paper and T-bills. Like a savings account, these funds are designed to pay the owner interest, as well as provide the owner with the ability to sell at anytime. Money market funds will often offer features similar to savings or checking accounts, such as the ability to write checks or use a debit card.
Like mutual funds, money market funds have a daily Net Asset Value (NAV). The fund manager usually manages the fund in an attempt to maintain an NAV of $1 per share.
The fund manager's are primarily concerned with holding's credit quality, tax implications of investments, and investor safety. But like all investments investors need to choose their money market funds carefully. Money market funds are not like checking accounts in that they are rarely FDIC insured. And there have been instances over the years when investors have lost their principal on their investments in money market funds – and from reputable fund companies. Therefore, you should determine how much risk you are willing to take to get a higher interest rate and do your research to make sure that that particular money market fund meets your objectives.
Money market funds are also useful as a holding place for cash while you are between investments. Therefore, you can still earn interest while you may be temporarily waiting for the market to trigger another investment. In addition, many mutual fund companies offer many different types of places to hold your cash. Be sure to ask your fund company where you should park your cash while you are between investments. For example, Fidelity will automatically park you cash in their Core Cash account which earns less in interest than the Fidelity Cash Reserves Money Market. But if you ask, you can have Fidelity “sweep” your account into Cash Reserves.
Online Resources: Interest Rate Data