Bonds are normally part of a conservative diversified investment strategy. As such, it is important to have an understanding of bonds and how they function. Bonds (or “fixed income”) are utilized in portfolios to help reduce risk and add stability to the portfolio. In addition, bonds can create cash flow that can be used to fund withdrawals.
Bonds are issued by businesses and governments to help fund their operations. It is essentially similar to a loan or an I.O.U, which is a promise to pay back the principal (amount borrowed) plus interest to the holder. They are typically issued with a face value of $1000 per bond and will have a stated interest rate that is set when the bond is issued. The stated face value is also referred to as the “par value”. For most bonds, the interest payments will be made semi-annually, although some bonds do pay monthly or quarterly interest. For example, an ABC Corporate bond that has a stated interest (or coupon) rate of 4% and a maturity date of 10/1/2011 will pay $20.00 semi-annually until the bond’s maturity date. ($1000.00 x 4% /2). Assuming the bond was purchased for $1000, or par value, the yield to maturity for the investor will be 4%. The yield to maturity of a bond measures the net return of the cash flows if the bond is held to maturity.
Once issued, most bonds can be traded like other securities; however, the price at which it is purchased will determine the yield to maturity for the purchaser. If we take the example above and assume the bond is sold at a premium for $1020, the yield for the new owner will be less that the 4% coupon rate since at maturity the holder will only receive $1000, the stated face value. The actual yield to maturity that the holder receives will be 3.3% since the holder is receiving $20 less than his purchase price of the bond at maturity. If the bond is purchased at a discount for $980, the opposite would be true. The yield to maturity would be 4.72%, more than the 4% coupon since the holder is receiving $20 more than his cost in addition to the interest payments. As this example illustrates, the yield to maturity of a bond will move inversely to its price.
As interest rates fluctuate, the price of bonds will fluctuate accordingly creating what is commonly referred to as interest rate risk. Interest rate risk exists for all bonds. Since interest rates change constantly, the prices on bonds also change constantly. If an investor wants to sell a bond, the direction of interest rates from the time the bond was purchased may determine if the bond is sold at a gain or loss. If the bond is held to maturity, then the daily price fluctuations have no impact on the return the bond produces.
The number of years to maturity will also have an impact on the price fluctuation of a bond. Bonds with longer maturities will fluctuate in price more than those with shorter maturities. Therefore, longer maturity bonds will have more interest rate risk.
Credit risk is another risk associated with bonds. Credit risk measures the likelihood that the issuer will repay the face amount at maturity and make interest payments in a timely manner. The failure to meet either obligation will put the issuer in default. Rating agencies, such as Standard and Poor’s and Moody’s rate the credit worthiness of issuers. Each has its own rating scale based upon factors they deem reliable indicators of default risk. Based upon their assessment, they will assign a rating to the issuer. For example, Standard and Poor’s will use a rating system based upon letters to signify the issuer’s rating. “AAA” is used to designate those of the highest credit worthiness, followed by “AA”, “A”, ”BBB”, ”BB” and so on. Issuers with a rating of “BBB” or higher are considered “investment grade”. A rating of BB or lower is considered “speculative” and should be monitored closely.
The higher the rating of the issuer, the lower the relative yield will be on their bonds since it is considered a safer investment. If a bond issuer has a lower rating, investors will need to be potentially rewarded for buying a security with added risk; thus the yield to maturity will be higher. U.S. Treasury securities are not rated because they are considered to have no credit risk since the federal government has unlimited authority to tax and raise revenue to pay off their debt and interest. However, they are still subject to interest rate risk as explained earlier.
While this explanation is somewhat elementary, the bond market can be much more complex. As with stocks, it is important to have an understanding of what you’re buying and the underlying risk associated with the investment. For additional information about bonds and their use in a portfolio, please contact us.