In this video, we will talk about what are Bonds, their categories, their pros and cons and how to evaluate them.
What are Bonds?
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower.
Think of a bond as a loan arrangement between you, the investor and borrower (corporation or government) that includes the details of the loan and its payments.
Basically, You are lending your money to the corporation or government for a period of time. In return you are earning interest.
For example, if you buy a 10 year government 20,000$ bond paying interest of 3%. In exchange your government will promise to pay you back interest on that 20,000$ every six months. After the 5 years you will receive back your initial investment of 20,000$ as well. Your interest payment on that example will be 300$ every 6 months for a total of 6000$ profit once the bond matures.
Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds, which is you, are called debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner, and usually include the terms for variable or fixed interest payments made by the borrower.
Now you may wonder why you should buy a Bond, a fair question which I will try to address.
Investors buy bonds for 3 major reasons:
First they provide a means of preserving capital and earning a predictable return.
Bond investments provide steady streams of income from interest payments prior to maturity. On the example I provide earlier, you know for a fact that you will be receiving 300$ every 6 months. If the bond has a fixed rate that never changes, so you know for sure how much you will earn, dependless of what goes on in the market.
The second reason is that the interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.
Third , Bonds can help offset exposure to more volatile stock holdings. They are considered one of the safest investments in the market.
Despite being considered as a generally safe investment, bonds come with some disadvantages as well, keep in mind no investment is without risk.
The greatest of them all is credit risk.
The issuer may fail to timely make interest or principal payments and thus default on its bonds. When that happens the investor may lose all or substantial part of his investment.
Then you have the Interest rate risk.
Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. And this is exactly what happens right now in the market.
If we check the 30 year US bond we will see that the rising interest rates increased the bond rates as well, and devalued the stock to bellow 90$, so iff you want to sell you have to sell on a discount. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Inflation risk.
Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. Currently with the inflation to be above 8%, you realize that a 3% bond is not making any money for you, instead you are losing money.
Liquidity risk.
This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.
Call risk.
The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.
Now that you know both the good and the bad side of bonds let’s proceed and look at the different types of bonds.
There are 3 Basic types of bonds: US Treasuries, Municipal and Corporate.
Starting with US Treasuries. Bonds, bills, and notes issued by the U.S. government are generally called “Treasuries” and are the highest-quality securities available. They are issued by the U.S. Department of the Treasury through the Bureau of Public Debt. All treasury securities are liquid and traded on the secondary market. They are differentiated by their maturity dates, which range from 30 days to 30 years. One major advantage of Treasuries is that the interest earned is exempt from state and local taxes. Treasuries are backed by the U.S. government so there is little risk of default.
There are subcategories to the US treasury bonds, and we will briefly cover them:
- First, Treasury bills (T-bills) are short-term securities that mature in less than one year. They are sold at a discount from their face value and thus don’t pay interest prior to maturity.
- Second, Treasury notes (T-notes) earn a fixed rate of interest every six months and have maturities ranging from 1 to 10 years. To note here that The 10-year Treasury note is one of the most quoted when discussing the performance of the U.S. government bond market and is also used as a benchmark by the mortgage market.
- Third, Treasury bonds (T-bonds) have maturities ranging from 10 to 30 years. Like T-notes, they also have a coupon payment every six months.
- Fourth and last the Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds. The principal value of TIPS is adjusted by changes in the Consumer Price Index. They are typically offered in maturities ranging from 5 to 20 years.
The second type is Municipal Bonds.
Municipal bonds, also called (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. These bonds tend to be exempt from federal income tax and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt. It happened and it will happen again so proceed with caution in this one.
Keep in mind that in some states, investors will have to pay state income tax if they purchase shares of a municipal bond fund that invests in bonds issued by a state other than the one in which they pay taxes.
For example if you live in New York and you buy municipal bonds in the state of Texas, you may have to pay income tax on that, so these bonds will not be exempt from state tax.
There are two basic types of municipal bonds.
General obligation bonds, which are secured by the full faith and credit of the issuer and supported by the issuer’s taxing power.
And, Revenue bonds, that are repaid using revenue generated by the individual project the bond was issued to fund.
Corporate Bonds
Third and last type are the corporate bonds.
Corporations may issue bonds to fund a large capital investment or a business expansion. Corporate bonds tend to carry a higher level of risk than government bonds, but they generally are associated with higher potential yields. The value and risk associated with corporate bonds depend in large part on the financial outlook and reputation of the company issuing the bond.
Bonds issued by companies with low credit quality are high-yield bonds, also called junk bonds. I wouldn’t invest in anything that associates its name with Junk, but that is just me.
Investments in high-yield bonds offer different rewards and risks than investing in investment-grade securities, including higher volatility, greater credit risk, and the more speculative nature of the issuer. Variations on corporate bonds include convertible bonds, which can be converted into company stock under certain conditions.
So far we have talked about what bonds are, their advantages and disadvantages, and their types, now it’s time to analyze how to evaluate a bond.
When evaluating the potential performance of a bond, investors need to review certain variables. The most important aspects are:
- The bond’s price
- It’s interest rate and yield
- It’s date to maturity
- It’s redemption features
Bond Price
In the market, bond prices are quoted as a percent of the bond’s face value. The easiest way to understand bond prices is to add a zero to the price quoted in the market.
For example, if a bond is quoted at 99 in the market, the price is $990 for every $1,000 of face value and the bond is said to be trading at a discount.
If the bond is trading at 102, it costs $1,020 for every $1,000 of face value and the bond is said to be trading at a premium.
If the bond is trading at 100, it costs $1,000 for every $1,000 of face value and is said to be trading at par.
Another common term is “par value,” which is simply another way of saying face value. Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rate, credit or other factors.
To put it simply, when interest rates are rising, something that happened now in our economy, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price. Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market.
Interest Rate and Yield
A bond pays a certain rate of interest, usually twice a year until it matures.
Bonds’ interest rates, also known as the coupon rate, can be fixed, floating or only payable at maturity. The most common interest rate is a fixed rate until maturity, and it’s based on the bond’s face value. Some issuers sell floating rate bonds that reset the interest based on a benchmark such as Treasury bills.
As their name implies, zero-coupon bonds don’t pay any interest at all. Rather, they are sold at steep discounts to their face values. This discount reflects the aggregate sum of all the interest the bond would’ve paid until maturity.
Closely related to a bond’s interest rate is its yield. The yield is the effective return earned by the bond, based on the price paid for the bond and the interest it generates. Yield on bonds is generally quoted as basis points (bps).
Two types of yield calculations exist.
The current yield is the annual return on the total amount paid for the bond, and it is calculated by dividing the interest rate by the purchase price. The current yield does not account for the amount you will receive if you hold a bond to maturity.
The yield-to-maturity (YTM) is the total amount you will receive by holding the bond until the end of its lifespan. The yield to maturity allows for the comparison of different bonds with varying maturities and interest rates. For bonds that have redemption provisions, there is the yield to call, which calculates the yield until the issuer can call the bond—that is, demand that investors surrender it, in return for a payoff.
Maturity
The maturity of a bond is the future date at which your principal will be repaid. Bonds generally have maturities of anywhere from one to 30 years. Short-term bonds have maturities of one to five years. Medium-term bonds have maturities of five to 12 years. Long-term bonds have maturities greater than 12 years.
The maturity of a bond is important when considering interest rate risk. Interest rate risk is the amount a bond’s price will rise or fall with a decrease or increase in interest rates. If a bond has a longer maturity, it also has a greater interest rate risk.
Redemption
Last, redemption. Some bonds allow the issuer to redeem the bond prior to the date of maturity.
This allows the issuer to refinance its debt if interest rates fall.
A call provision allows the issuer to redeem the bond at a specific price at a date before maturity.A put provision allows you to sell it back to the issuer at a specified price prior to maturity.
A call provision often pays a higher interest rate. If you hold such a bond, you are taking on additional risk that the bond will be redeemed and you will be forced to invest your money elsewhere, probably at a lower interest rate (a decline in interest rates is usually what triggers a call provision). To compensate you for taking on this chance, the bond pays more interest.
Analyzing these key components allows you to determine whether a bond is an appropriate investment.In addition to that and in order to help with the evaluation, Fitch, Moody’s and Standard & Poors provide a scoring system, which goes from triple A to D
A bond with a higher rating is considered safer, but its return on investment is lower for that exact reason. A bond with a lower rating has a greater return on investment as compensation for taking on additional risk.
As we mentioned earlier, there are junk bonds, which are bonds with a rating system of BBB-. A junk bond may not be investment-grade, but it does have the potential to carry a greater return on investment. Bond ratings aren’t static, so it’s a good idea to research a bond’s history and keep tabs on its ongoing performance.
If you recall the 2008 housing crisis a lot of AAA proved to be junk bonds, so once more bonds have their risks.
Prior to ending the video let’s look at a bond and point out where each of the terms we learned in this video can be found, and in general how to read it.
Let’s check the United States 30 Year Government Bond. This is a Treasury Inflation-Protected Security Bond. As you can see from the chart the rates of the bond have been in a decline since it was issued. That happens because the interest rates over the years declined, back in that time you had mortgage rates at 10% and by the end of the 90’s they were below7% . And as you know last year they were around 2-3% and thus the US30 Bond was at an all time low of 0.71% rate.
With the Federal reserve increasing interest rates, the us30 Year Government bond has spiked up and currently is over 3.6%. Most likely by the time you watch the video this will be much higher.
What that means: Well if you buy today a 30 year Government Bond today you can expect a 3.606% annual return. The price of the bond is at 88.42, and since it is below 100 we know that it is trading on a discount. A nice discount of more than 11%.
Basically you can buy a 100,000 US30Y Bond for 88,420$. You will get your 3.606% annual rate which is 3606$ for the next 30 years, plus a 100K at when the bond matures.
If you think the US30Y is selling on a discount, check the Australian 30 Year Bond which is selling at 60.16$ and at almost 40% discount.
The reason treasury bonds trading lower is because Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa.
If you are interested in investing in bonds you will need to create an account with a broker that offers bonds. Unfortunately not all brokers do.
Some of the ones that do are Charles Schwab, Ally investment, Fidelity and TD Ameritrade. It is in my plans to create an account with one of these brokers, and once I do I will Create a walkthrough tutorial on it as well.
Also watch How To Evaluate A Stock – 5 Important Parts and The 11 Stock Market Sectors Explained
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