Individual Bonds—Section 7

While stocks represent ownership, bonds represent debt. When you buy a bond, you are loaning money to a corporation or government entity. The corporation or government in turn promises to pay back the amount borrowed at some specified date in the future and to pay you a fixed rate of interest until that date.

The dollar amount that the bond was originally issued for is known as the bond’s face value. This is the amount that you will receive, when the bond is redeemed at maturity. The original interest rate payable on the bond is known as the coupon rate and is stated as a fixed percentage of the bond’s face value. The bond’s face value and coupon rate do not change. The bond’s current value, however, does change; often on a daily basis.

Bonds are actively traded by both individuals and institutions. Through the constant interaction of bond buyers and sellers, a consensus is reached as to what the return should be for a particular class of bonds. This return is often referred to as the prevailing interest rate and takes into consideration the bond’s quality, length of time until maturity, inflation expectations and Federal Reserve policy.

A bond’s yield is adjusted to reflect prevailing interest rates by raising or lowering the price of the bond. For example, the price of a $1,000 bond with a coupon of 5% would have to be reduced to $833 if prevailing rates were to increase to 6%.

          $ 50 Interest = 5% Yield              $ 50 Interest = 6% Yield
          $1000 Bond Price                        $833 Bond Price

If you held your bond until maturity, you would receive the $1,000 face value of the bond. If, however, you wanted to sell your bond prior to maturity, you would have to reduce its price so that its yield was increased to reflect the return currently available in the market.

The same thing would happen in reverse if prevailing rates declined to 4%; only this time the price of your bond would increase to $1,250.

$ 50 Interest = 5% Yield                          $ 50 Interest = 4% Yield
          $1000 Bond Price                                   $1250 Bond Price

Bond yields are also determined by the credit worthiness of the issuer. The less likely the issuer is to default on the bond, the lower the yield. Conversely, if there is a possibility of the issuer defaulting, investors will demand a higher interest rate in order to be compensated for the additional risk.

U.S. Government and U.S. Government Agency bonds are considered to have the highest degree of credit worthiness because the chances of the U.S. Government defaulting on its obligations are almost non-existent. The bonds of certain foreign governments such as England, Canada, and Australia are also considered very safe. Investing in foreign government bonds, however, is more complicated due to fluctuating exchange rates, political risk and accounting differences.

State, county and municipal governments and their agencies also issue bonds. The interest paid on these bonds is usually not subject to federal income taxes and is therefore somewhat lower than comparable taxable bonds. Municipal bonds are not a suitable retirement plan investment because all investment earnings are taxed as ordinary income when withdrawn from the plan.

Below U.S. government bonds, in terms of credit worthiness are investment grade corporate bonds. Here the risk of default is small, but it does exist. As a result, these bonds offer higher returns than U.S. Government bonds.

Speculative bonds, also known as junk bonds or high yield bonds, have the highest level of risk and potentially provide the greatest return. Here there is a real possibility of default.

Several services rate corporate debt. Listed below are the rating categories issued by Standard and Poor’s

Bond price fluctuations are usually mild when compared to stocks. There have, however, been times when bond prices have been extremely volatile. During the late 1970s and early 1980s, interest rates doubled and bonds lost half of their value.

A way to control bond price volatility is by purchasing bonds with different maturity dates and creating a laddered bond portfolio. For example, you could buy bonds with 5, 10 and 15 year maturities. Every 5 years one-third of your bonds would mature and the proceeds could be reinvested in new 15 year bonds. In the meantime, your 10 year bonds have become 5 year bonds and your 15 year bonds have become 10 year bonds so you are back to the same position where you started. This process can be repeated indefinitely. The advantage is that you may receive a higher blended return and a large portion of your portfolio is always reasonably close to maturity.

A practical problem with individual bonds is that they are typically sold in blocks beginning at $10,000. Sometimes you can buy smaller amounts but this usually requires that you sacrifice some return. This may make it difficult to achieve an adequate level of diversification. An easy solution to this problem is to invest in bond based mutual funds.

Quiz - Section 7

1.Bonds represent:

A) Ownership

B) Debt

2.When interest rates go up the price of bonds:

A) Go down

B) Go up

C) Move sideways

3.When interest rates go down the price of bonds:

A) Go up

B) Go down

C) Move sideways

4.The higher the credit worthiness of the bond issuer the _______________ the bond’s yield.

A) Lower

B) Higher

5.All things being equal, a long maturity bond has a __________ level of risk than a short maturity bond.

A) Lower

B) Higher

C) The same

6.The possibility of an issuer defaulting on a speculative grade bond is ____ than an investment grade bond.

A) Higher

B) Lower

7.The fluctuation of bond prices is usually _____ then stock prices.

A) More

B) Less

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