4 essential things to know about bonds
Do you want to strengthen the risk and return profile in your portfolio? Adding bonds can create a more balanced portfolio by adding diversification and calming volatility. But the bond market may seem unfamiliar to even the most experienced investors. Many investors only pass projects to bonds because they are confused by the apparent complexity of the market and terminology. In fact, bonds are very simple debt instruments. So how do you enter this part of the market? Start investing in bonds by learning these basic terms of the bond market.
Main sockets
Some characteristics of bonds include their maturity date, coupon rate, tax status, and callability.
Several types of risk associated with bonds include interest rate risk, credit/default risk, and prepayment risk.
Most bonds come with ratings that describe their investment grade.
Bond yields measure their yields.
Basic bond properties
A bond is simply a loan that a company receives. Instead of going to a bank, the company gets money from investors who buy its bonds. In exchange for capital, the company pays an interest coupon, which is the annual interest rate paid on the bond expressed as a percentage of the face value. The company pays interest at predetermined intervals (usually annually or semi-annually) and returns the capital on the maturity date, and the loan ends.
A bond is a form of IOU between a lender and a borrower.
Unlike stocks, bonds can vary significantly based on the terms of their contract, which is a legal document that defines the characteristics of a bond. Since each bond issue is different, it is important to understand the exact terminology before investing. In particular, there are six important features to look for when considering a bond.
maturity
This is the date on which the principal or nominal amount of the bond is paid to investors and the company's commitment to the bonds ends. Therefore, it determines the age of the bond. The maturity of a bond is one of the primary considerations that an investor weighs against his investment objectives and prospects. Ripening is most often classified in three ways:
Short term: Bonds that fall into this category tend to mature within one to three years
Medium-term: The maturity dates of these types of bonds are usually more than ten years
Long-term: These bonds generally mature over longer periods of time
Locked / Unlocked
The bond can be secured or unsecured. A secured bond undertakes specific assets to bondholders if the company is unable to repay the obligation.
This asset is also called collateral on a loan.
So if the issuer of the bonds defaults, the asset is transferred to the investor.
Mortgage-backed securities (MBS) are one type of secured bond backed by borrowers' home title deeds.
Unsecured bonds, on the other hand, are not backed by any collateral. This means that the interest and principal amount are only guaranteed by the issuing company. Also known as bonds, these bonds return a little of your investment if the company fails. As such, they are riskier than secured bonds.
Liquidation preference
When a company goes bankrupt, it pays investors in a certain order during its liquidation. After the company sells all its assets, it starts paying its investors. A large debt is the debt that must be repaid first, followed by a small (secondary) debt. Shareholders get all the rest.
Voucher
The voucher amount represents the interest paid to bondholders, usually annually or semi-annually. The voucher is also called the coupon price or nominal return. To calculate the coupon rate, divide the annual payments by the face value of the bond.
Tax status
While the majority of corporate bonds are taxable investments, some state and municipal bonds are tax-deductible, so income and capital gains are not taxable. 1 Tax-free bonds usually have less interest than taxable equivalent bonds. The investor must calculate the tax-equivalent yield to compare the yield with the return on taxable instruments.
Connectivity
The issuer can repay some bonds before maturity. If a bond includes a call clause, it may be paid at earlier dates, at the company's option, usually at an equally minor premium. A company may choose to call its bonds if interest rates allow it to borrow at a better rate. Callable bonds also attract investors because they offer better coupon rates.
Bond Risk
Bonds are a great way to earn income because they tend to be relatively safe investments. But, like any other investment, it involves certain risks. Here are some of the most common risks with these investments.
Interest Rate Risk
Interest rates share an inverse relationship with bonds, so when interest rates rise, bonds tend to fall and vice versa. Interest rate risk comes when prices change significantly from what an investor expected. If interest rates drop significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will still be stuck in an instrument that yields lower returns than market prices. The higher the maturity time, the higher the interest rate risk that the investor bears, since it is difficult to predict future market developments.
Credit/Default Risk
Credit or default risk is the risk of non-payment of interest and principal payments due on the obligation as required. When an investor buys a bond, he expects the issuer to make interest and principal payments – just like any other creditor.
When an investor considers corporate bonds, he should consider the likelihood of a company defaulting on debt. Safety usually means that a company has greater operating income and cash flow compared to its debt. If the opposite is true and the debt outweighs the available cash, the investor may want to walk away.
Prepayment Risk
Prepayment risk is the risk of paying off a particular bond issue earlier than expected, usually through a call provision. This could be bad news for investors because the company only has an incentive to pay off the obligation early when interest rates drop significantly. Instead of continuing to hold high-interest investments, investors are left to reinvest money in a low-interest rate environment.
Bond Valuations
Most bonds come with a rating that determines their credit quality. That is, the strength of the bond and its ability to pay the principal of the debt and interest. Reviews are published and used by investors and professionals to judge their feasibility.
Agencies
The most popular bond rating agencies are Standard & Poor's, Moody's Investors Service, and Fitch Ratings. They assess the company's ability to pay its obligations. Ratings range from AAA to AAAA for high-quality cases that are very likely to be reimbursed to D for issues that currently exist in the event of a default. 2
Bonds rated from BBB to Baa or higher are called investment grade. This means that they are unlikely to default and tend to keep their investments stable. Bonds rated BB to Ba or below are called junk bonds – and defaults are likely to be more speculative and prone to price volatility.
Corporate bonds will not be classified, in which case it is up to the investor alone to judge the company's ability to repay. Since rating systems vary by agency and change from time to time, research the classification definition of bond issuance you're considering.
Bond yields
Bond yields are all measures of yield. Yield to maturity is the most commonly used measurement, but it is important to understand many other yield measurements used in certain situations.
Yield to maturity (YTM)
As mentioned above, yield to maturity (YTM) is the most common yield measure. It measures the return on a bond if held until maturity and all coupons are reinvested at YTM price. Since it is unlikely to reinvest coupons at the same price, the actual return for the investor will vary slightly. Manually calculating YTM is a lengthy procedure, so it's best to use the Excel RATE or YIELDMAT functions (starting with Excel 2007). A simple function is also available in the financial calculator.
Current yield
The current yield can be used to compare the interest income provided by a bond with the dividend income provided by a stock. This is calculated by dividing the annual bond voucher by the current price of the bond. Keep in mind that this return only includes the income portion of the return, ignoring potential capital gains or losses. As such, this return is extremely beneficial for investors interested only in current income.
Nominal yield
The nominal yield of a bond is simply the percentage of interest that must be paid on a bond periodically. It is calculated by dividing the annual coupon payment by the nominal or nominal value of the bond. It is important to note that the nominal yield does not accurately estimate the yield unless the price of the current bond is the same as its face value. Therefore, only the nominal yield is used to calculate other yield metrics.
Return to Contact (YTC)
A callable bond always carries some probability of being called before the maturity date. Investors will make a slightly higher return if the required bonds are repaid at a premium. An investor in such a bond may want to know what return will be made if the bond is called on a certain call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate the yield to connect using the YIELD or IRR functions in Excel, or using a financial calculator.
Realized Return
The realized yield of a bond should be calculated if the investor plans to hold the bond for a certain period of time only, rather than maturity. In this case, the investor will sell the bond, and the expected future price of the bond must be estimated for his calculation. Since future prices are difficult to predict, this yield measurement is only an estimate of return. This yield calculation is best done with the YIELD or IRR functions in Excel, or with a financial calculator.
The Bottom Line
Although the bond market seems complex, it is already driven by the same risk/return swaps as the stock market. Once an investor has mastered these few basic terms and measurements to reveal familiar market dynamics, they can become a competent bond investor. Once you learn the language, the rest is easy.