Key Bond Investment Considerations, part 1
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 your bond investment and whether it is an appropriate investment for you.
The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par (100 percent of the face, or principal, value). Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates, credit quality, general economic conditions, and supply and demand. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
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.
Bond calculators are widely available on websites such as this one and www.investinginbondseurope.org.
A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Generally, bond terms range from one year to 30 years. Term ranges are often categorized as follows:
- Short-term: maturities of up to 5 years
- Medium-term: maturities of 5 - 12 years
- Long-term: maturities greater than 12 years
The choice of term will depend on when an investor wants the initially invested principal repaid and on risk tolerance. Short-term bonds, which generally offer lower returns, are considered comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term bonds provide greater overall returns to compensate investors for greater pricing fluctuations and other market risks.
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.
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 . (These terms are discussed below and are defined in the glossary). 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.
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.
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.
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.
A bond's yield is the return earned on the bond, based on the price paid and the interest payment received. Usually, yield is quoted in basis points, or bps. One basis point is equal to one one-hundredth of a percentage point or 0.01%. For example, 8.00% = 800 bps (8.00% / 0/01% = 800 bps).
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 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 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. You should ask your investment advisor for the yield to maturity and the yield to call on any bond you are considering purchasing.
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 bonds 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%).