Beginner Lessons Lesson 8: Let's Talk Bonds

Lesson 8: Let’s Talk Bonds

 

Bond actors
This is not the type of “bond” I will be discussing. Image courtesy of moviepilot.com

The bond market. You may think you haven’t heard about it.  You are probably wrong. In addition to occasionally hearing about “rallies” in the bond market most Americans has heard of the $3 trillion deficit the U.S. government currently faces.  What makes up this deficit? Treasury bonds. These bonds and other securities the U.S. Treasury issues help fund the activities of the U.S. Government and have an integral role in the bond market. The bond market is comprised of many different types of bonds which can greatly vary in features. Let’s explore some basic functionality.

Key Points

  • A bond is a debt security that obligates the borrower to pay a specified amount to the investor on a given date and usually includes coupon payments.
  • A bond offers investors returns through appreciation and interest (coupon) payments.
  • A bond has many distinguishing features including par value, maturity, coupon rate, issuer, credit rating.
  • There is an inverse relationship between bond yield and bond price.

What is a Bond?

A bond is a type of debt security issued by a borrower which obligates the borrower to pay a specified amount on a given date and usually includes periodic interest payment to the investor. Another way of looking at a bonds is they are the “loans” that companies and governments take on.  To compare bonds to stocks (equities) when you hold a company’s stock you are a part owner in that company; when you hold a bond you are a debt holder of that company.  This will change the way you should look at the company. It will not matter if the company exceeds market expectations as a bondholder because your payment will stay the same. You also do not want the company to make very risky investments that could endanger them paying your interest payments and bond at maturity.  The point to take away is that bond holders and stock holders will look at a business through different eyes.  So why would I want to invest in a bond?

Two main reasons:

  1. Bonds are traded everyday on the NASDAQ and other exchanges with investors buying and selling different bonds. As a result of new information and changes in interest rates, bond prices change. If you buy a company’s bond and the bond price increases (appreciating), you can sell that bond and you have made a profit. On the flip-side you could buy a bond and then it could drop in value (depreciate). In this case you would have a loss on the investment should you sell it.
  2. As a bond holder you are entitled to a periodic interest rate payment. Companies usually distribute these payments to bondholders semiannually these payments are called coupon payments (or interest payments). Thus by holding the bond you receive payments. Unlike stock dividends  a bonds interest rate payments are legal obligation in the bond contract. (Not all bonds offer coupon payments and we will discuss which types of bonds are instead sold at a discount).

 

Features of A Bond

  • Par Value: The par value (or face value or principal) represents the dollar amount that the issuer must pay to you, the investor, at maturity. Bonds are commonly sold at a par value of $1,000. Take note that a bond’s par value and its price do not have to be equal and are usually not equal.
  • Maturity Date: The maturity date is the date that the issuer must repay the par value of the bond. Maturities vary from 1 to 5 to 10 to etc. years. So I could say a bond has a maturity of five years meaning that in five years the par value will be due to me.
  • Coupon Rate: The coupon rate is the percentage of the par value that you will receive in a given year. Let’s use some quick numbers to get a feel for this. Say I have a $1,000 bond with a maturity of 10 years and a 5% coupon rate. How much money in interest payments am I due in each year? I am due $50 in one year (or two $25 semiannual payments).  Note that the coupon rate is known and does not change over the course of the bond.

 

Coupon Payment = Coupon Rate * Par Value

$50 = %5 x $1,000

 

  • Issuer: The issuer of the bond is simply the entity offering the bond to investors. The two main bond issuing entities are large corporations and governments.
  • Credit Rating: As we have discussed investors have to be compensated more return for taking on more risk. We have a problem with bonds. How does an investor compare the riskiness of one company to another? This is the role of credit rating agencies.  Standard and Poor’s, Moody’s, and Fitch are the three largest credit-rating agencies. Their job is to gather information about a corporation or government and assess a rating to it that reflects how likely that entity is to default (not pay) on their debt. Lower rated bonds are sometimes called high-yield or junk bonds while higher rated bonds are termed investment-grade bonds.
Bond Chart
Image courtesy of learnbonds.com

 

  • Price: The price of the bond is the current selling price of a bond. A bond’s price is primarily driven by one factor: market interest rates. I will discuss why this is but the intuition behind it is pretty simple. A bond has many features (the par value, the coupon rate, the maturity, issuer, etc.) that are effectively “locked-in”. Thus the only thing that can change its price is how good or bad the bond looks relative to other investments in the market.  If the price of a bond is above its par value that bond is trading at a premium. If the price of a bond is below its par value that bond is said to be trading at a discount.
  • First Claimant: A bond holder is a first claimant on a bond meaning that should an issuer declare bankruptcy, the bondholders have first claim on any of the assets of the business. This in effect lowers the perceived risk of holding bonds vs. stocks as stocks are only residual claimants.

The One Relationship About Bonds to Remember

If everyone held bonds till they matured there would be no need for a market.  A bond’s price would not change and every investor would know what return he or she would earn when the bond was first purchased.  This is not the case however because not all bonds are held to maturity.  Let’s introduce the idea of bond yield. Yield is a proxy for measuring the return on a bond and there are many types of yield calculations. Let’s us current yield because it is simple enough to suit our purposes. Let’s also assume that our bond as a par value of $1,000,a coupon rate of 10% making the annual coupon $100, and a current price of $1,000.

Current Yield = Annual Coupon/ Current Bond Price

10% = $100/$1,000

You may notice something. In this case the current yield was equal to our coupon rate. That is because this bond is trading at par or its price is equal to its par value. However this is generally not the case.  Let’s change our price and see what happens to the yield.

Case 1 (Discount): Bond price goes from $1,000 to $900

11.1% = $100/$900

Case 2 (Premium): Bond price goes from $1,000 to $1,100

9.09% = $100/$1,100

Based on our simple example we can see that there is an inverse relationship between bond prices and bond yields.  To say it in another way when a bond’s price increases, its yield decreases and vice versa.  Whether this is good or bad for you depends on whether you are buying or selling the bond.  If you are buying the bond you want a higher return (you are buying something at a discount) whereas if you are selling the bond you hope the bond is trading at a premium (you hope to sell the bond at a premium price)

There’s still a bit more to discuss about bonds but now you have a basic understanding of how bonds work.

Definitions

  1. Bond: A debt security that obligates the borrower to pay a specified amount to the investor on a given date and usually includes coupon payments.
  2. Par Value (Face Value or Principal): The dollar amount to be repaid on the maturity date of a bond.
  3. Maturity date: The date on which the par value is to be repaid to the bond holder.
  4. Coupon rate: The percentage of the principal that is to be paid to the bondholder on a yearly basis.
  5. Coupon payment: The interest payment that a bond holder receives (usually semiannually) that is calculated by multiplying the coupon rate by the par value.
  6. Credit rating: A letter rating given to a bond issuer that indicates the relative risk of the issuer defaulting on its debt
  7. Credit-rating agency: An agency tasked with assessing the stability of bond issuers and assigning a rating the relative risk of a bond issue.
  8. Current yield: Current yield is a measurement of the return on a bond calculated by dividing the annual coupon payment by the bond’s price.
  9. Premium: A bond that is trading at a price that is greater than its par value.
  10. Discount: A bond that is trading at a price that is lower than its par value.

Further Reading

 

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