Investing in Bonds

Investing in bonds offers more protection than stocks. In the event a company defaults on its bonds or goes bankrupt, bond investors get repaid ahead of shareholders. This lower risk is a big reason that the investment rates of return on bonds are significantly lower than they are on stocks.

Bonds are also called fixed income securities because they pay interest that is fixed at a coupon rate. (Although there are bonds whose coupon rates are variable, most bonds have a fixed rate.) As a result, the amount of interest income is fixed over the term of the bond. For bond investors, who are generally more conservative than stock investors, these predictable cash flows allow them to sleep at night.

For example, say you have a $1,000 bond that has a 5-year term and coupon rate of 7%. This bond would generate $70 a year in interest for each of the next five years. Since it is conventional for bonds to pay interest every six months, this means you receive $35 in interest twice a year. From an investing point of view, this is preferable: you pocket the income sooner, and have a chance to reinvest it. This reinvested income is an important part of a bond's total return.

Companies often prefer to sell bonds instead of stock since they are allowed to deduct the interest expense on bonds from their taxable income. When they sell bonds, companies hire an investment bank. Investment banks compete aggressively to earn lucrative underwriting fees.

However, investment banks also collaborate often as a syndicate to sell a bond issue, splitting the underwriting fees. The syndicate's lead manager gets the largest share of fees, the largest share of the bond issue, and the most prestige. Co-managers receive a smaller share of fees, commensurate with a smaller share of the bond issue. Many underwriting deals involve more than one lead manager, and as many as a dozen co-managers.

The underwriting syndicate prices a bond issue by looking at interest rates of bonds with similar characteristics. Usually, this means looking at the yields of bond issues by companies with a similar credit rating as the bond issuer. If the issuer has a lower credit rating, the syndicate will likely have to add a spread to compensate investors for the extra perceived risk.

For example, if ABC Co. has an investment-grade rating, it can likely sell its bonds at the same yield as the recently issued bonds of XYZ Co., which also has an investment-grade rating. However, if ABC has a lower rating, the syndicate will likely have to add some basis points to increase the yield to a level that entices risk-averse investors. The size of the bond issue, as well as the general level of buying interest by market participants, will also influence the bond issue's pricing.

How does an understanding of the bond underwriting process help you? Remember, the coupon rate of the bond is likely to have been fixed previously. As a result, a change in market interest rates results in the bond's issue price moving away from its par value. Instead, it may sell at either a discount or premium to par value.

For example, assume an issue of 5-year bonds that is priced to have a yield-to-maturity of 10% is sold at par value. This implies that the market interest rate for bonds with similar characteristics is also 10%. If interest rates for bonds with similar characteristics fell to 9.5%, however, investors would be willing to pay a premium for a chance to receive a 10% coupon. In fact, they would be willing to pay up to $1,014 for each $1,000 bond, since that bond price results in a yield-to-maturity of 9.5%.

If interest rates for similar bonds rose to 10.5%, investors would require a discount for the bonds. This is because the market rate of 10.5% results in a bond with a 10% coupon being less attractive. In order to entice investors, the syndicate would have to lower the issue price to at least $974.
These changes in bond price illuminate a basic relationship of bonds: prices and bond yields move in opposite directions. When bond prices rises, yields fall. When bond prices fall, yields rise. What causes bond prices to rise or fall? Higher inflation, or the prospect of higher inflation, is the main culprit. When inflation is likely, investors demand a higher yield to compensate them for an anticipated loss in the value of their bonds.

The risk of bond prices falling from a higher expected inflation is called inflation risk. The Federal Reserve is likely to increase interest rates if it thinks inflation is likely to harm the economy. If the Fed hikes the fed funds target rate and discount rate, investors' expectations prove accurate. The risk of market interest rates rising is called interest rate risk. Higher inflation is the usual reason for higher rates, but a change in supply-demand conditions can also affect interest rates.

A bond's return is measured by its yield. The major ways of measuring yield are:

Yield-to-maturity. A bond's yield-to-maturity is the return you earn on a bond if you buy today and hold to maturity. It is the interest rate that sets the price you pay for the bond equal to the sum of its future coupon interest payments and value at maturity. Yield-to-maturity assumes that the bond's coupon interest is reinvested at the same interest rate as the yield-to-maturity.

In fact, investors routinely sell bonds before they mature. In this case, a bond's yield is best measured by its total return. Total return shows a bond's rate of return over the time you hold the bond, and includes all capital gains and coupon interest income. Total return requires you to make an explicit assumption about the reinvestment rate you receive on your coupons.

Yield-to-call. This is the yield you earn on a callable bond if you buy it today and hold it until its first call date. Companies choose to issue callable bonds because of their flexibility. If interest rates decline following the bond issue, it can call the bonds and refinance at a lower interest rate. Callable bond investors are compensated for this risk by receiving a premium for their bonds.

Current yield. This is a snapshot of a bond's value. It is the bond's coupon rate divided by its current price. Since bond prices often change many times a day, the current yield also changes constantly.

The yield curve shows yields-to-maturity for a specific type of bond over a range of maturity terms. For example, the yield curve for U.S. Treasury securities shows the yields for Treasury bills and bonds over a range of 3 months to 30 years.

If you connect the dots that represent yields-to-maturity over the range of bond terms, you will see that shape of a yield curve usually slopes upward. This is called a normal yield curve. The opposite of a normal yield curve is an inverted yield curve. An inverted yield curve only occurs once in awhile. It shows that yields on longer-term bonds are lower than on short-term bonds, and is generally a signal that interest rates are reaching their peak. This occurs as investors, anticipating lower interest rates, favor bonds with longer maturities. This preference drives down their prices relative to the prices of bonds with shorter maturities. A flat yield curve shows, roughly, a straight line. This suggests that yields-to-maturity change little, regardless of maturity.

The yield curve changes shapes daily, often dramatically over the course of an economic cycle. A bond's yield curve flattens when interest rates are at, or near, their highs. It also flattens if there is an imbalance in the supply of, and demand for, the bond. Conversely, a bond's yield curve steepens when interest rates are headed higher, or for similar imbalances in the supply-demand relationship of the bond.

There are four major bond categories, including:

Government bonds. Treasury bonds and their kin, inflation-protected Treasury securities, make up the government bond market in the U.S. The interest that you earn on these securities is exempt from state income tax. Treasury securities are considered the safest of bonds worldwide, since the risk of the U.S. government defaulting on its debt is essentially zero. However, the supply of Treasury securities is dwindling as the government pays down debt and reduces the sizes of new issues. The bond market has relied on the Treasury bond market as a benchmark for pricing other bonds. As a result of this drying-up in the supply of Treasurys, agency bonds appear likely to serve as a benchmark in the future.

The national treasuries of most countries sell government bonds. These usually have nicknames, the way U.S. government bonds are called Treasurys. For example, government bonds in the U.K. are called gilts. Government bonds in Japan are called JGBs. Government bonds in Germany are called bunds.

You can also invest in U.S. savings bonds. These are government securities sold in denominations of as little as $25. There are three types of savings bonds: Series EE, Series HH, and Series I bonds. For more information, see the U.S. Treasury's TreasuryDirect program.

Corporate bonds. Companies of all sizes and industries sell corporate bonds. A company's credit rating determines how cheaply it can sell its bonds to investors. Credit rating agencies assign an investment-grade rating to bonds of companies with the most financial resources and that are least likely to default on their debt. Investment-grade bonds pay smaller spreads over a benchmark bond than do below-investment grade bonds. These bonds are sometimes called "junk" bonds, because of their greater risk of default.

Some corporations also sell convertible and exchangeable bonds. Convertible bonds allow investors to convert the value of their bonds into shares of the company, if and when the price is good to do so. Exchangeable bonds allow investors to swap their bonds for shares of another company's stock.

Agency bonds. Government-sponsored enterprises such as Fannie Mae and Freddie Mac sell agency bonds. Fannie Mae and Freddie Mac are private corporations that focus on buying and selling residential mortgage securities. While the U.S. government does not explicitly guarantee the bonds of Fannie Mae and Freddie Mac, their size and importance in the economy makes the chance of their default extremely unlikely. As a result, their bonds are considered only slightly more risky than Treasury securities. The government does guarantee bonds sold by Ginnie Mae, Sallie Mae, and some other federal housing agencies.

Agency bonds are often structured in a complicated way. Residential mortgages and credit card receivables often serve as the collateral for these bonds. A risk is that the borrowers of these mortgages and credit cards will pay off their loans if interest rates begin to fall. This is called prepayment risk. Prepayment risk means that an investor in these bonds is repaid sooner than expected, and is forced to reinvest this amount at an interest rate that is usually lower.

Municipal bonds. Municipal bonds, or "munis," are issued by state and local governments. A revenue muni bond repays investors from the revenues directly earned from the project the bond is financing. These include bonds for transportation and other infrastructure-related projects. A general-obligation muni bond is a muni bond that will repay investors from the general tax coffers of the issuing authority. Interest on muni bonds is exempt from federal income tax. Residents of states who buy muni bonds issued by that state may be able to exempt interest income from state income taxes as well. This is called a double-exempt muni bond.

The larger your tax bracket, the greater the tax advantage of investing in muni bonds. For example, if you're in the 25% income tax bracket, a 5.5% yield on a muni bond is equivalent to a taxable yield of 7.33%. This is called the taxable-equivalent yield. If you buy a muni bond that falls into the double-exempt category, the yield advantage is even higher. For example, if you pay a state income tax rate of 10%, your combined tax burden is 35%. This makes a double-exempt bond even more attractive. That 5.5% yield has a new, higher taxable-equivalent yield of 8.46%.

Zero-coupon bonds, or "zeros," are issued at a steep discount to their par value. Instead of receiving coupon interest, investors earn imputed interest. For example, if you buy a 10-year zero-coupon bond that is discounted at an annual interest rate of 8%, you would pay $463. A year later, the bond's price would rise to $500. This $37 appreciation in the first year represents imputed interest. The IRS also requires that you report this as taxable income. Since you owe taxes on money you don't actually receive until the bond's maturity, some financial planners advise that you buy zero-coupon bonds for tax-advantaged accounts. These include retirement accounts such as IRAs and 401(k) plans.