Key Bond Investment Considerations, part 2
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.
By watching the yield curve, as reported in the daily financial press, and online at sites such as this one and www.investinginbondseurope.org, you can gain a sense of where the market perceives interest rates to be headed, which is an important factor that could affect the price of bonds.
A normal yield curve would show a fairly steep rise in yields between short- and intermediate-term issues and a less pronounced rise between intermediate- and long-term issues. This curve shape is considered normal because, usually, the longer an investment is at risk, the more that investment should earn.
The yield curve is said to be steep, if the yields on short-term bonds are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a shorter maturity bond. On the other hand, the yield curve is flat if the difference between short- and long-term rates is relatively small. This means that there is little reward for owning longer-dated maturities.
When yields on short-term issues are higher than those on longer-term issues, the yield curve is inverted. This suggests that investors expect interest rates to decline in the future and/or short term rates are unusually high for some reason, e.g., a credit crunch.. An inverted yield curve is often indicative of a recession.
As a bond investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation and deflation. As a general rule, the bond market, and the overall economy benefit from steady, sustainable growth rates. Such moderate economic growth benefits the financial strength of governments, municipalities and corporate issuers which, in turn, strengthens the credit of those bonds you may hold.
But steep rises in economic growth can also lead to higher interest rates because, in response, the Federal Reserve Bank may raise interest rates in order to prevent inflation and slow growth. An increase in interest rates will erode a bond’s price or value. Fear of this pattern is what causes the bond market to fall after the government releases positive economic news, for instance about job growth or housing starts. Since rising interest rates push bond prices down, the bond market tends to react negatively to reports of strong and potentially inflationary, levels of economic growth, The converse is also true: negative economic news may indicate lower inflation and expected interest rate cuts and, therefore, may be positive for bond prices.
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.
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. This document is usually provided by your investment advisor and helps an investor evaluate whether the bond issuer will be able to make its regularly scheduled interest payments for the term of the bond. While no single source of information should be relied on exclusively, rating agencies, securities firms and bank research staff monitor corporate, government and other issuers' financial conditions and their ability to make interest and principal payments when due. Your investment advisor, or sometimes the issuer of the bond, can supply you with current research.
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 rating agencies make their ratings available to the public through their ratings information desks and online through their respective websites. In addition, their published reports and ratings are available in many local libraries. Rating agencies continuously monitor issuers and may change their ratings of such issuer’s bonds based on changing credit factors. Usually, rating agencies will signal they are considering a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings).
Not all credit rating agency evaluations result in the same credit rating, so it is important to review all available credit ratings. It is also important to read the credit reports and related updates to properly evaluate the underlying credit risks. You should bear in mind that ratings are opinions, and you should understand the context and rationale for each opinion. Investors should not rely solely on credit ratings as a measure of credit risk but, instead, use a multitude of resources to assist in their evaluation and decision making. Additional sources of information include recent independent news reports, formal issuer press releases, research reports and company financial statements.
In early April 2010, Fitch Ratings overhauled the way it assigns grades to the credit quality of state and local governments, re-calibrating ratings on 40 states, the District of Columbia, the Virgin Islands and Puerto Rico. The move affects some 38,000 municipal bond issues. The rating agency's wholesale re-calibration is in part recognition that municipalities were being held to a higher standard than corporate and sovereign debt. Municipalities historically exhibit stronger repayment patterns than corporate borrowers in the same credit rating bracket. The municipal rating re-calibrations are a way to align municipal bonds with debt from other sectors.
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. For more information on the role of bond insurance, see additional sources on this web site and www.investinginbondseurope.org.
Some bonds offer special tax advantages. For example, interest from U.S. Treasury bonds is not subject to state or local income tax. Many municipal bonds are triple tax-free; that is, for investors who live in the same state as the issuer, the interest received from the bond may be exempt from federal, state and/or local income tax. However, in certain cases, the interest received may be subject to the individual federal alternative minimum income tax or may have to be taken into account in calculating the taxable portion of social security benefits. Furthermore, a portion of the interest on certain tax-exempt obligations earned by certain corporations may be included in the calculation of adjusted current earnings for purposes of the corporate federal alternative minimum tax, and interest income may also be subject to (i) a federal branch profits tax imposed on certain foreign corporations doing business in the United States or (ii) a federal tax imposed on excess net passive income of certain S corporations. The choice between taxable and tax-exempt bond income depends on one’s income tax bracket as well as the difference between what can be earned from taxable versus tax-exempt bonds at the time of and through the entire period of the investment.
You may access a yield calculator on this web site and your investment advisor can help you compare the various tax alternatives. For example, the decision about whether to invest in a taxable bond or a tax-exempt bond can also depend on whether you will be holding the bonds in an account that is already tax-preferred or tax-deferred, such as a pension account, 401(k) or IRA.