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A Complete Beginner’s Guide to Understanding the Bond Market

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A Complete Beginner’s Guide to Understanding the Bond Market

Most people consider investing in bonds as a way of investing in retirement funds. However, experts advise that anyone who’s interested can invest in bonds. Bonds offer stable returns and are reliable so you can use them to build your portfolio, especially when the markets are volatile.

Before investing in bonds, you need to understand how they fit into your investment strategy. This way, you can strike the best balance between bonds and your stocks.

bond ratings

What Are Bonds?

Bonds are loans. The only difference is that you, the bondholder, is offering this loan to the issuer for a predetermined period, in exchange for the principal value and interest on the bond. A lot of organizations, even governments, issue bonds so they can raise money to finance projects. Companies do this to purchase new equipment while governments do it to raise money for projects like building schools and hospitals.

By participating in the bond issue, you effectively become the creditor to the issuer. You need to understand the difference between bonds and stocks. Assuming you purchase shares in a company, you become part owner of that company instead of the shares you have purchased. This gives you the right to enjoy their profits earned through dividends when their share price appreciates in value.

This, however, is not the case with bonds. As a bondholder, the company doesn’t owe you any share of their profits. No matter how profitable the company is, the only thing they owe you is the principal and interest. This also gives you some closure because you have a guarantee of payment at the term maturity of your bond.

Bonds are offered in dollar denominations. The most common corporate bonds are available at $1,000 par value (face value). This is the principle that you will receive when the bond term matures.

The issue date was the day when the bond was first put for sale. The maturity date is the date when the principal is due. Therefore, bonds are issued for a predetermined period of time, and they mature. In between the issue date and the maturity date, the bondholder will receive interest payments at frequent intervals. These are referred to as coupons.

The interest is referred to as coupon because, before the advent of electronic trade, bondholders would receive paper certificates upon buying bonds, and the certificates had coupons attached indicating their interest payments.

Once the coupon date arrives, investors mail the coupon to the issuer to receive their check or deposit it in their bank account. Coupon payments are automatically credited to the bond holder’s account these days or the account of the brokerage firm they were trading with. The coupon payments are normally made bi-annually depending on the issue date. Assuming the issue date was on December 14th, the interest is earned every year on June 14th and December 14th until the term matures.

Interest Rates

How Bonds Pay Interest

The issuer determines a competitive interest rate for the bond offering based on an analysis of the current market conditions and the maturity date of the bond/ bond ratings chart. The interest rate is referred to as the coupon rate. It’s presented as a percentage of the bond’s par value. If you participate in a $1,000 bond with a 5% semiannual coupon, you will be earning $50 in interest every year in installments of $25 until the bond matures.

Bonds can be issued with floating interest rates or fixed interest rates. Fixed interest rates remain constant through the term of the bond to maturity. In our example above, you will earn 5% of the par value in interest each year until maturity.

Floating interest rates are also referred to as variable interest rates. These rates change from time to time and are usually leveraged against a specific benchmark. Take the London Interbank Offered Rate (Libor) plus 1% as an example. The spread remains constant. However, the bond will earn you 1% more than the Libor at all times.

You also have zero coupon bonds. This type of bond doesn’t pay any interest until the term expires. To make up for this, these bonds are offered at a discount on the par value, but when they mature, the bondholder is paid the full par value. A good example is paying $10,000 for a bond that will yield $30,000 after 15 years. This difference is what you earn as interest. Take note, however, that you will still be required to pay taxes on the interest at the time of maturity.

bond market

How Interest Rates Affect Bond Prices

Issued bonds can be traded on the secondary market between investors. Bonds that were issued earlier trade either at a discount or premium of their par value. This is attributed to fluctuation in the market interest rates, concerning the coupon rate.

Market interest rates and coupon interest rates have a symbiotic relationship. If the market rates go up, so do the coupon rates for new bonds. As a result, old bonds in the market have lower rates which makes them unattractive to investors. Because of this, investors are willing to pay less for older bonds.

If the market rate falls, the coupon older bonds offer better coupons, and their price goes up. Bonds that trade below their par value are referred to as discount bonds while those that trade beyond the par value are premium bonds.

The price of the bond is quoted as a percentage of the par value and expressed in points. Take these examples; a discount bond quoted at 97 points, trading at 97% of the par value. This is equivalent to $970 for a $1,000 value bond. Premium bonds quoted at 105 trades at $1,050.

In some cases, the prices are expressed as fractions, for example, 97¼ which mean 97.25% of par value. Government bonds are often quoted in 1/32 increments while corporate bonds are quoted in 1/8 increments.

bond ratings

Why Invest in Bonds In The Stock Market?

There are three main reasons why you should consider investing in bonds:

  • A steady source of income
  • To potential hedge risk in your portfolio
  • Protect your portfolio in an economic crisis

The term payments for bonds are predetermined at the time of purchase. This way, you know how much you will earn and when it is due. Therefore, bonds can be a good way to prepare for future expenditure like college tuition.

The value of bonds tends to be on the rise when stock prices are doing badly, so it’s a good option to protect your portfolio.

In the event of major economic upheavals, the economy will be sluggish. As the inflation falls, the purchasing power of future bond payments increases. At the same time, a slow economy will reduce the yield on stocks. As a result, the investors will stay away from stocks and go for bonds instead, and the demand will push the prices up.

Interest Rates

How Are Bonds Rated?

Before an entity issues a bond, they have to file their prospectus with the SEC. This is a document that indicates their terms of the bond offer. It’s to guide investors so that they can diligently determine whether the bond fits their financial plan.

Bonds and bond ratings lookup are assigned unique identification numbers called CUSIP. This is the number you use to research a specific bond issue. You can also use features like the time to maturity to search for a bond issue in some screeners.

The short-term bonds expire in 3 years, 4-10 years for medium-term bonds and more than 10 years for long-term bonds. Long-term bonds are risky instruments because of the uncertainty of adversities affecting the economy. Things like increasing interest rates often affect the value of the bond through its term. Instead of this, long-term bonds have more attractive coupon rates.

Credit agencies rate bonds depending on their risk profile. They look at the creditworthiness of the bond issuer. They will delve into the financial history of the issuer to see whether they have a good history of repaying their debt, things like their cash flow, and their business trajectory is given the nature of upheavals that are projected for that specific industry. From this information, they are able to assign a credit rating.

The ratings start from AAA to D. There are modifiers assigned like – and + between AA and CCC. Each credit agency uses a specific rating guideline for the bonds based on the company profiles. From these ratings, you can tell whether the bond is worth investing in or not. Bonds that are worth investing in are rated Baa or BBB and above. These are safe, given the current financial position of the company, and the projection for the future in their industry. Non-investment grade bonds are very low quality, carry a lot of risks and are simply not worth your time. These are the bonds that are referred to as junk or speculative bonds. They offer very high coupon rates to hedge against their risk profile. This also explains why they are referred to as high-yield bonds.

bond market

Types of Bonds

The bond market in the US is one of the largest in the world.

There are three types of bonds:

  • Municipal bonds
  • Treasury bonds
  • Corporate bonds

The US government issues treasury bonds. These are supported by the creditworthiness of the US government. There’s a very low possibility that the US government will default on its debt, making these among the safest investment options you can get your hands on.

Corporate bonds are issued by companies (public and private). They are traded in $1,000 denominations and have different term lives and coupon rates. Corporate bonds actually make up a major portion of the bond market in the US, only second to treasury bonds.

The only investment instruments that maintained their value during the Great Depression were the treasury bonds. This is because the US government was among the few institutions that were trusted to hold their end of the bargain in this uncertain economic situation.

bond ratings

There are different types of treasury bonds:

Bills that mature in 52 weeks. These are short-term zero coupon bonds that are traded at discount value.

2, 3, 5, 7 or 10-year treasury notes that earn interest every 6 months.

Treasury bonds that mature in 30 years, earning interest every 6 months.

Treasury securities that are protected from inflation. These bonds and notes have the principal adjusted based on the current inflation level. They pay interest on the adjusted principal value every 6 months. Upon maturity, the investor will earn the biggest percentage of the original principal or the adjusted principal value.

Floating rate notes. These earn variable interest rates on the 13-week treasury bill interest rates. They mature in 2 years, and interest is earned quarterly.

Low-risk savings bonds that mature in 30 years or less, with all the interest earned upon maturity.

You can purchase these investment instruments in $100 value increments, apart from savings bonds, which are often sold in penny investments of at least $25.

Credit Risk

Bonds are generally safe investment instruments. However, this doesn’t mean they don’t carry any risk. Perhaps the biggest risk when investing in bonds is that the issuer might not be able to pay their dues on time. You should look at the credit rating for the bond before investing. The lower the rating is, the higher the risk.

 

Downgrade Risk

Over the course of the bond’s term life, the risk of default changes. Credit agencies will evaluate any issues arising and make adjustments to their original rating over time. This is downgrade risk or the risk that the value of your bond might be downgraded by any of the credit agencies. The downgrade doesn’t mean the issuer will default on payment. However, it causes a drop in the price of the bond as the prospective buyers react to the risk level.

Interest Rate Risk

This is the risk that the price of the bond will fall as interest rates rise. Longer-term bonds that carry low coupon rates are very sensitive to this type of risk because of the high probability that the rates might exceed the coupon rate during the term of the bond.

Sensitivity to interest rate risk is determined by the duration of the bond, leveraged against the present value of the bond based on the cash flows as a result of the principal repayment and interest. Longer-term bonds are more sensitive to changes in the rates. Assuming the rate goes up by 1%, the value of a 4-duration bond will drop by 4%. A 6-duration bond will drop by 6%.

However, these fluctuations affect only individual investors who often cash in their bonds before they mature. If you hold the security until the term expires, and the issuer makes good on their payment, you will receive your principal and interest, irrespective of the prevailing market price.

Liquidity Risk

If you choose to sell the bond before the term expires, you will incur liquidity risk. This is the risk that you might be unable to find either a buyer for the bond or a desirable price for it. For bonds that aren’t traded frequently, the risk is higher, especially if the bond is not traded in exchange.

Inflation affects the purchasing power of the payments you receive from the bond. This explains why high inflation pushes interest rates higher. Long-term bonds have a higher inflation risk than short-term bonds.