What You Might Not Know About Bonds

If you are new to investing perhaps you are not familiar with bonds. Before you get started, you need to understand some of the risks associated with bond investing. Most people assume that all interest-bearing securities are completely risk free, but this is not the case. Even if you know a lot about investing, you may not be aware of some of the risk characteristics associated with bonds.
The most important thing to take into account is the interest rate. The Federal Reserve (also known as the Fed) meets every 6-8 weeks to evaluate the health of the economy. At each meeting, the Fed renders a decision regarding interest rates.

If inflation is rising, the Fed will need to raise interest rates to tighten the money supply. If inflation is moderate or contained, the Fed will likely leave rates unchanged. However, if the economy is slowing down and there is very little inflation or maybe even deflation, then the Fed might decide to reduce interest rates to create a stimulus for economic growth.

The reason why you need to consider present and future interest rate levels is because as interest rates increase, bond prices go down, and vice versa. If you are able to hold your bond until maturity, then interest rate movements do not really matter, because you will redeem the principal upon redemption. But often, investors have to cash out their bonds well before the maturity date. If interest rates have moved up since you purchased the bond, and you sell it prior to maturity, then the bond will be worth less than your initial investment.

You should also be aware of the claim status of the bond you are buying. Claim status refers to your ability to liquidate your investment in the event the bond issuer goes bankrupt. If you are buying a government bond, such as a Treasury Bill, claim status is irrelevant, because the odds of the Federal Government going bankrupt are slim and none.

If you are buying a corporate bond, however, there is always a chance that the issuer could go out of business. In the event of liquidation, bondholders are given priority over stockholders. However, there are often different classes of bondholders. Senior note holders can often claim against certain kinds of physical collateral in the event of bankruptcy, such as equipment (computers, machines, etc.). Regular bondholders can not always claim against physically collateral, and are next in line after the senior note holders.

Next, you should always check the three main features of the bond you are buying; the coupon rate, the maturity date, and the call provisions. The coupon rate is the interest rate. Most bonds pay an interest rate semiannually or annually.

The maturity date is the date that the bond will be redeemed by the issuer; simply put, the maturity date is when the company must pay back to you the principal you loaned to them. The call provisions are the rights of the issuer to buy back your bond prior to maturity. Some bonds are non-callable, while others are callable, meaning that the company can buy your bond back before maturity, usually at a higher price than what you paid.

Finally, you should also understand that if economic conditions become more favorable after you a buy a bond, and interest rates start to go down again, the issuer will likely issue a lot more bonds to take advantage of the low interest rates, and will use the proceeds to try to buy back any callable bonds it issued previously. So, when interest rates go down, there is an increasing likelihood that your bond will be redeemed prior to maturity, if in fact the bond is callable.

You should invest in bonds. However, you should also take into account the risk factors we have covered. Your portfolio should contain a mix of corporate, federal, municipal, and even junk bonds (there is always a default risk associated with junk bonds, but they pay a huge interest rate). Talk to your broker about diversifying the kinds of bonds in your portfolio and you will reduce your overall risk and maximize your return.

Jim Pretin is the owner of www.forms4free.com

Yield Curve Spreads - Treasury Yield vs. Corporates

Corporate bonds trade at spreads above the corresponding treasury security of the same maturity range on the curve. Basis point spreads are how they trade. Since corporate bonds have more credit risk than treasury notes and bonds, they will sell at higher yields.

When interest rates are very low, or when the yield curve is flat or inverted, these spreads on corporates can thin. This is mostly true with the higher credit quality of corporate bonds rated A or better.

If a 10 year treasury is at 2.5%, a corporate bond may be at 2.85% of a high quality. Lower grade bonds or junk bonds will have higher spreads as their credit quality is less.

Attractive spreads over treasuries is what professional or seasoned traders look for. As interest rate environments change, these levels will adjust. This market is changing every minute.

Recommended Reading:

Corporate Bonds: Structure and Analysis

Managing a Corporate Bond Portfolio

Trading and Selling Corporates

Corporate debt is traded mostly in the over the counter (OTC) market. There are also bond trades and selling on the NYSE (New York Stock Exchange).

NASDAQ quotes convertible corporate bonds since they are similar to stocks and equities, but they do not quote non convertible corporates.

Round lot trades of bonds is 5 $1000 par bonds = $5000

Yellow Sheets - Bond dealers get printed offering quotes for corporate bonds in the yellow sheets, which are printed daily. There are electronic pricing services as well.

Bloomberg and TRACE. TRACE offers real time reporting of corporate bond trades.

Commercial Paper is sold OTC through dealers and can also be bought through the issuing corporation.

Corporate bonds settle trade day plus 3 business days T+3 for buying and selling.

Regular was trading is trade date plus 3 business days.

"When Issued"

When a corporation announces it will sell new securities. The exchanges will allow trading in the bonds before they exist. If the issue never comes out or sells, then the trades are canceled.

Bond Trading Yield

Junk Bond - Junk Notes

Corporate bonds that are rated below investment grade are considered junk or speculative. Standard and Poors and Moodys are 2 rating agencies that will rate the credit quality of corporate notes and bonds.

A bond that has a rating of below Baa/BBB are considered speculative. The reality is over 95% of these securities pay off fine, but because of their junk rating (pretty strong word), they will offer a higher yield or rate of return. So, the majority of investors buying these bonds will earn more money than investors who only buy AAA or high rated corporate bonds and notes.

There are domestic and foreign issues of speculative bonds. Some of these securities are also callable and/or convertible. A callable junk bond will have a set call date that the issuer can redeem the bonds back early at. There will be a set call price on these securities as well. Normally a junk bond is called when interest rates have declined to a certain level. Thus, the investor will get their money back when interest rates are low. Callable bonds will have a higher yield than non callbale bonds if the quality is the same and the maturity is as well.

Convertible junk bonds are securities where the investor can convert into common stock of the issuing corporation.

Convertible Bonds
Subordinated Debentures

Bond Yield Spreads

Spreads on corporate bonds are normally priced above the treasury note or bond of the same maturity. These spreads on yield are quoted in basis points.

1 percentage point in yield or interest rates equals 100 basis points. If the 5 year treasury note is at 4% and AA corporate bonds are priced at 50 basis points over the treasury - the yield on the bond would be 4.50%.

Spreads on corporate debt securities are different based on the rating of the bond. AAA rated fixed income debt would trade at a lower or thinner spread than a BBB rated bond - over the same treasury maturity.

Since private equity debt like corporates are of lesser credit quality than US Government securities, they will always have spreads over them. During times of lower interest rates and yields - these spreads can tighten.

Yield To Maturity

Income Bonds

Securities that only pay interest when the issuing company earns enough income are known as adjustment or income bonds.

They tend to trade like 0 coupon bonds because their interest is no longer timely or predicatable. For companies in restructuring, income bonds allow the corporation to not completelt default on the investments, but allow them time to make up the interest to the investors.

These are speculative bonds or junk bonds during this period. Investors generally hold income bonds in hopes that the interest will soon begin. Speculators that buy them at deep discounts can realize a potential profit on the debt later on should interest rates fall or the bond begins to perform well - rate of return wise.

Income or adjustment bonds should be fully understood before investing in them or placing them a portfolio. Higher risk bond funds may have a substantial amount of adjustment bonds in their managed portfolio.

http://www.aitraining.com/fglossary.htm - Over 50 complete discussion definitions of key investment products.

Subordinated Bonds

Corporate bonds that are backed by the full faith and credit of the company, but have a lower priority than debentures are subordinated debentures.

These debt securities will pay a higher rate, but are lower in the creditor ladder should the company need to liquidate.

The bonds pay a stated rate of interest and a yield to maturity. Some may be callable and many are rated below investment grade - but not all. A rating below investment grade is known as a junk bond.

Subordinated debt could be issued by large or small corporations. If the company pays on the bonds timely, investors can realize a very attractive and above market rate of return.

http://www.aitraining.com/subordinated.htm