I AM BRINGING THIS BACK FOR THOSE WITH QUESTIONS ABOUT BONDS, I WROTE THIS FOR THE OTHER SITE 2 YEARS AGO AND I HOPE THIS HELPS YOU ALL.
Alright so let’s jump right in. What are bonds? Oh before we jump in I am not giving you investment advice. The language we are going to use for study is from the investor side as well as the seller side, I am using this language for the sole purpose of explaining how bonds work. Do we all understand that? Alright good let’s get to it.
A bond is a loan that an investor makes to a corporation, government, federal agency or other organization. Consequently, bonds are sometimes referred to as debt securities. Since bond issuers know you aren’t going to lend your hard-earned money without compensation, the issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest. The bond issuer also agrees to repay you the original sum loaned at the bond’s maturity date, though certain conditions, such as a bond being called, may cause repayment to be made earlier.
The vast majority of bonds have a set maturity date—a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities because many pay you interest based on a regular, predetermined interest rate—also called a coupon rate—that is set when the bond is issued. Similarly, the term “bond market” is often used interchangeably with “fixed income market.”
Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds.
Bonds can be also called bills, notes, debt securities, or debt obligations. To simplify matters, we will refer to all of these as “bonds.”
When bonds go to the market there are things that need to be considered both on the selling side and the buying side and this is true of bonds from small municipal size to huge foreign government size. Let’s take a look at those considerations.
Typically, bonds pay interest semiannually, which means they can provide a predictable income stream. Many people invest in bonds for that expected interest income and also to preserve their capital investment.
When you hear the word coupons what does it mean?
A bond’s coupon is the annual interest rate paid on the issuer’s borrowed money, generally paid out semiannually. The coupon is always tied to a bond’s face or par value, and is quoted as a percentage of par. For instance, a bond with a par value of $1,000 and an annual interest rate of 4.5 percent has a coupon rate of 4.5 percent ($45).
Many bond investors rely on a bond’s coupon as a source of income, spending the simple interest they receive.
You can also reinvest the interest, letting your interest gain interest. If the interest rate at which you reinvest your coupons is higher or lower, your total return will be more or less.
There are things to consider before buying bonds for instance you want to Assess the Risk.
All investments carry some degree of risk, which is linked to the return that investment will provide. A good rule of thumb is the higher the risk, the higher the return. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of a bond investment and whether it is an appropriate investment.
Then there is the price.
Bonds are generally issued in multiples of $1,000, also known as a bond’s face or par value. But a bond’s price is subject to market forces and often fluctuates above or below par. If you sell a bond before it matures, you may not receive the full principal amount of the bond and will not receive any remaining interest payments. This is because a bond’s price is not based on the par value of the bond. Instead, the bond’s price is established in the secondary market and fluctuates. As a result, the price may be more or less than the amount of principal and the remaining interest the issuer would be required to pay you if you held the bond to maturity.
The price of a bond can be above or below its par value for many reasons, including:
.. interest rate adjustments;
.. whether a bond credit rating has changed;
.. supply and demand;
.. a change in the creditworthiness of a bond’s issuer;,
.. whether the bond has been called or is likely to be (or not to be) called; or,
.. a change in the prevailing market interest rates.
If a bond trades above par, it is said to trade at a premium. If a bond trades below par, it is said to trade at a discount. For example, if the bond you desire to purchase has a fixed interest rate of 8 percent, and similar-quality new bonds available for sale have a fixed interest rate of 5 percent, you will likely pay more than the par amount of the bond that you intend to purchase, because you will receive more interest income than the current interest rate (5 percent) being attached to similar bonds.
Next thing to consider is the Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Fixed rate bonds carry any interest rate that is established when the bonds are issued (expressed as a percentage of the face amount) with semiannual interest payments. For example, a $1,000 bond with an eight percent interest rate will pay investors $80 a year, in payments of $40 every six months. This $40 payment is called a coupon payment. When the bond matures, investors receive the full face amount of the bond, $1,000.
Some issuers, however, prefer to issue floating rate bonds, the rate of which is reset periodically in line with interest rates on Treasury bills, the London Interbank Offered Rate (LIBOR), or some other benchmark interest-rate index.
The third type of bond does not make periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the purchase price (principal) plus the total interest earned, compounded at the original interest rate. Known as zero coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an annual interest rate of seven percent, compounded semiannually, until the bond matures. Such future value calculations vary somewhat depending on the specific terms of the bond. Since all the accrued interest and principal are payable only at the bond’s maturity, the prices of this type of bond tend to fluctuate more than those of coupon bonds. If the bond is taxable, the interest is taxed as it accrues, even though it is not paid to the investor before maturity or redemption.
The next consideration is the bond maturity.
A bond’s term, or years to maturity, is usually set when it is issued. Bond maturities can range from one day to 100 years, but the majority of bond maturities range from one to 30 years. Bonds are often referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium- or intermediate-term bonds are generally those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. The borrower fulfills its debt obligation typically when the bond reaches its maturity date, and the final interest payment and the original sum you loaned (the principal) are paid to you.
Next are the Redemption Features
While the maturity date indicates how long a bond will be outstanding, many bonds are structured in such a way so that an issuer or investor can substantially change that maturity date.
One way of doing that is with what is known as a Call Provision
Bonds may have a redemption – or call – provision that allows or requires the issuer to redeem the bonds at a specified price and date before maturity. For example, bonds are often called when interest rates have dropped significantly from the time the bond was issued. Before you buy a bond, always ask if there is a call provision and, if there is, be sure to consider the yield to call as well as the yield to maturity. Since a call provision offers protection to the issuer, callable bonds usually offer a higher annual return than comparable non-callable bonds to compensate the investor for the risk that the investor might have to reinvest the proceeds of a called bond at a lower interest rate.
Another option is known as a Put Provision
A bond may have a put provision, which gives an investor the option to sell the bond to an issuer at a specified price and date prior to maturity. Typically, investors exercise a put provision when they need cash or when interest rates have risen so that they may then reinvest the proceeds at a higher interest rate. Since a put provision offers protection to the investor, bonds with such features usually offer a lower annual return than comparable bonds without a put to compensate the issuer.
Another option is known as a Conversion. This particular type of a bond is what we will really be focusing on in coming chapters so read this paragraph 2x slow ok?
Some corporate bonds, known as convertible bonds, contain an option to convert the bond into common stock instead of receiving a cash payment. Convertible bonds contain provisions on how and when the option to convert can be exercised. Convertibles offer a lower coupon rate because they have the stability of a bond while offering the potential upside of a stock.
An investor also wants to look at Principal Payments and Average Life
Certain bonds are priced and traded on the basis of their average life rather than their stated maturity. In purchasing mortgage-backed securities, for example, it is important to consider that homeowners often prepay mortgages when interest rates decline, which may result in an earlier than expected return of principal, reducing the average life of the investment. If mortgage rates rise, the reverse may be true: homeowners will be slow to prepay and investors may find their principal committed longer than expected.
Bonds and Interest Rates
When it comes to how interest rates affect bond prices, there are three cardinal rules:
When interest rates rise—bond prices generally fall.
When interest rates fall—bond prices generally rise.
Every bond carries interest rate risk.
Interest rate changes are among the most significant factors affecting bond return.
To find out why, we need to start with the bond’s coupon. This is the interest the bond pays out. How does that original coupon rate get established? One of the key determinants is the federal funds rate, which is the prevailing interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. The Fed sets a target for the federal funds rate and maintains that target interest rate by buying and selling U.S. Treasury securities.
When the Fed buys securities, bank reserves rise, and the federal funds rate tends to fall. When the Fed sells securities, bank reserves fall, and the federal funds rate tends to rise. While the Fed doesn’t directly control this rate, it effectively controls it through the buying and selling of securities. The federal funds rate, in turn, influences interest rates throughout the country, including bond coupon rates.
Another rate that heavily influences a bond’s coupon is the Fed’s Discount Rate, which is the rate at which member banks may borrow short-term funds from a Federal Reserve Bank. The Fed directly controls this rate. Say the Fed raises the discount rate by one-half of a percent. The next time the U.S. Treasury holds an auction for new Treasury bonds, it will quite likely price its securities to reflect the higher interest rate.
What happens to the Treasury bonds you bought a couple of months ago at the lower interest rate? They’re not as attractive. If you want to sell them, you’ll need to discount their price to a level that equals the coupon of all the new bonds just issued at the higher rate. In short, you’d have to sell your bonds at a discount.
It works the other way, too. Say you bought a $1,000 bond with a 6 percent coupon a few years ago and decided to sell it three years later to pay for a trip to visit your ailing grandfather, except now, interest rates are at 4 percent. This bond is now quite attractive compared to other bonds out there, and you would be able to sell it at a premium.
Basis Point Basics
You often hear the term basis points—bps for short—in connection with bonds and interest rates. A basis point is one one-hundredth of a percentage point (.01). One percent = 100 basis points. One half of 1 percent = 50 basis points. Bond traders and brokers regularly use basis points to state concise differences in bond yields. The Fed likes to use bps when referring to changes in the federal funds rate.
There are two types of bond yields: current yield and yield to maturity (or yield to call).
Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought a $1,000 bond at par and the annual interest payment is $80, the current yield is 800 bps or 8% ($80 / $1,000). If you bought the same bond for $900 and the annual interest payment is $80, the current yield is 889 bps or 8.89% ($80 / $900). Current yield does not take into account the fact that, if you held the bond to maturity, you would receive $1,000 even though you only paid $900.
Yield to maturity (YTM) is the total return you will receive by holding the bond until it matures. This figure is common to all bonds and enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity, including interest earned plus any gain or loss of principal.
Yield to call (YTC) is the total return you will receive by holding the bond until it is called – or paid off before the maturity date – at the issuer’s discretion. In many cases, an issuer will pay investors a premium for the right to call the bonds prior to maturity. Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive the face value of the bond plus any premium on the call date.
Alright is everyone still with me? Now we are going to look at the link between Price and Yield
From the time a bond is originally issued until the day it matures or is called, its price in the marketplace will fluctuate depending on the particular terms of that bond as well as general market conditions, including prevailing interest rates, the bond’s credit and other factors. Because of these fluctuations, the value of a bond will likely be higher or lower than its original face value if you sell it before it matures.
In general, when interest rates fall, prices of outstanding bonds with higher rates rise. The inverse also holds true: when interest rates rise, prices of outstanding bonds with lower rates fall to bring the yield of those bonds into line with higher-interest bearing new issues. Take, for example, a $1,000 bond issued at eight percent. If during the term of that bond interest rates rise to nine percent, it is expected that the price of the bond will fall to about $888, so that its yield to maturity will be in line with the market yield of nine percent ($80 / $888 = 9.00%)
When interest rates fall, prices of outstanding bonds rise until the yield of older bonds match the lower interest rate on new issues. In this case, if interest rates fall to seven percent during the term of the bond, the bond price will rise to about $1,142 to match the market yield of seven percent ($80 / $1,142 = 7.00%).
What is the link between Interest Rates and Maturity?
Changes in interest rates do not affect all bonds equally. Generally, the longer a bond’s term, the more its price may be affected by interest rate fluctuations. Investors, generally, will expect to be compensated for taking that extra risk. This relationship can be best demonstrated by drawing a line between the yields available on similar bonds of different maturities, from shortest to longest. Such a line is called a yield curve.
A yield curve could be drawn for any bond market but it is most commonly drawn for the U.S. Treasury market, which offers bonds of comparable credit quality for many different terms.
Now we will look at Default
Default is the failure of a bond issuer to pay principal or interest when due. Defaults can also occur for failure to meet obligations unrelated to payment of principal or interest, such as reporting requirements, or when a material problem occurs for the issuer, such as bankruptcy.
Bondholders are creditors of an issuer, and therefore, have priority to assets before equity holders (e.g., stockholders) when receiving a payout from the liquidation or restructuring of an issuer. When default occurs due to bankruptcy, the type of bond you hold will determine your status.
Secured bonds are bonds backed by collateral. If the bond issuer defaults, the secured debt holder has first claim to the posted collateral.
Unsecured bonds are not backed by any specific collateral. In the event of a default, bond holders will need to recover their investment from the issuer. Unsecured debt will generally offer a higher interest rate than those offered by secured debt due to a higher level of risk.
Some bonds, such as senior bonds, have priority in making claims over those who hold subordinated bonds; a subordinated bond will typically offer a higher interest rate due to the higher level of risk.
Now we will look at Credit Quality
The array of credit quality choices available in the bond market ranges from the highest credit quality Treasury bonds, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment-grade and considered speculative, such as bond issues by a start-up company or a company in danger of bankruptcy. Since a bond may not reach maturity for years to come, credit quality is an important consideration when evaluating investment in a bond. When a bond is issued, the issuer is usually responsible for providing details as to its financial soundness and creditworthiness.
This information can be found in a document known as an offering document, official statement or prospectus, which is the document that explains the bond’s terms, features and risks that investors should know about before investing.
What is the Credit Ratings of the issuer?
In the United States, major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower ratings are considered high yield, or speculative.
Lower ratings are indicative of a bond that has a greater risk of default than a bond with higher ratings. It is important to understand that the high interest rate that generally accompanies a bond with a lower credit rating is being provided in exchange for the investor taking on the risk associated with a higher likelihood of default.
The last thing we will look at in this chapter is Bond Insurance
The credit quality of a bond can be enhanced by bond insurance, which is provided by a specialized insurance firm that guarantees the timely payment of principal and interest on bonds in exchange for a fee. Insured bonds receive the same rating as a corporate rating of the insurer, which is based on the insurer’s capital and claims-paying resources.
How are we doing so far, is everyone still with me? There is glossary of terms I would like you to read and keep fresh in your mind, you are going to hear these terms going forward I give you this link so you can read and understand what these words mean. This link is for FINRA and they are the Financial Industry Regulatory Authority. http://www.finra.org/investors/bond-glossary
Take your time studying these terms, you do not need to memorize them but you should be familiar with the terms going forward.
Bonds are bought and sold in huge quantities in the U.S. and around the world. Some bonds are easier to buy and sell than others—but that doesn’t stop investors from buying and selling all kinds of bonds virtually every second of every trading day.
The way you buy and sell bonds often depends on the type bond you select. Treasury and savings bonds may be bought and sold through an account at a brokerage firm, or by dealing directly with the U.S. government. New issues of Treasury bills, notes and bonds—including TIPS—can be bought through a brokerage firm, or directly from the government through auctions at the U.S. Treasury Department.
Savings bonds can also be purchased from the government, or through banks, brokerages and many workplace payroll deduction programs.
Corporate and municipal bonds may be purchased, like stock, through full-service, discount or online brokers, as well as through investment and commercial banks. Once new-issue bonds have been priced and sold, they begin trading on the secondary market, where buying and selling is also handled by a broker.
Now you have the basics of bonds, we will be moving onto the types of bonds next, so take your time and read this over as many times and you need to
Once you understand debt you will understand how everything else works. Because remember without debt you cannot have profit. The entire global monetary system is driven by debt and has been since the first generation down from the trees.
This practice will never ever change and it is not something to be afraid of if you understand it. so please take the time to understand it so you will not be afraid and you will not fall for some nonsense being peddled out there. Change is upon us and the time to understand is here. One more thing to remember is the more things change the more they stay the same. Aha so let’s get more into that in the coming chapters.
LOVE TO ALL…MY LADIES
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