Bond Characterestic

8/2/2019 Bond Characterestic

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Characteristics

Bonds have a number of characteristics of which you need to be aware. All of these factors playa role in determining the value of a bond and the extent to which it fits in your portfolio.

Face Value/Par ValueThe face value (also known as thepar valueor principal) is the amount of money a holder willget back once a bond matures. A newly issued bond usually sells at the par value. Corporatebonds normally have a par value of $1,000, but this amount can be much greater for governmentbonds.

What confuses many people is that the par value is not the price of the bond. A bond's pricefluctuates throughout its life in response to a number of variables (more on this later). When abond trades at a price above the face value, it is said to be selling at apremium. When a bondsells below face value, it is said to be selling at adiscount.

Coupon (The Interest Rate)The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon"because sometimes there are physical coupons on the bond that you tear off and redeem forinterest. However, this was more common in the past. Nowadays, records are more likely to bekept electronically.

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As previously mentioned, most bonds pay interest every six months, but it's possible for them topay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a

bond pays a coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year. Arate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Anotherpossibility is an adjustable interest payment, known as a floating-rate bond. In this case theinterest rate is tied to market rates through an index, such as the rate on Treasury bills.

You might think investors will pay more for a high coupon than for a low coupon. All thingsbeing equal, a lower coupon means that the price of the bond will fluctuate more.

MaturityThe maturity date is the date in the future on which the investor's principal will be repaid.Maturities can range from as little as one day to as long as 30 years (though terms of 100 years

have been issued).

A bond that matures in one year is much more predictable and thus less risky than a bond thatmatures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interestrate. Also, all things being equal, a longer term bond will fluctuate more than a shorter termbond.
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Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assuranceof getting paid back. For example, the U.S. government is far more secure than any corporation.

Its default risk(the chance of the debt not being paid back) is extremely small - so small thatU.S. government securities are known as risk-free assets. The reason behind this is that agovernment will always be able to bring in future revenue through taxation. A company, on theother hand, must continue to make profits, which is far from guaranteed. This added risk meanscorporate bonds must offer a higher yield in order to entice investors - this is the risk/returntradeoffin action.

FXCM -Online Currency Trading Free $50,000 Practice AccountThe bond rating system helps investors determine a company's credit risk. Think of a bond ratingas the report card for a company's credit rating. Blue-chip firms, which are safer investments,have a high rating, while risky companies have a low rating. The chart below illustrates thedifferent bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and

Poor's and Fitch Ratings.

Bond RatingGrade Risk

Moody's S&P/ Fitch

Aaa AAA Investment Highest Quality

Aa AA Investment High Quality

A A Investment Strong

Baa BBB Investment Medium Grade

Ba, B BB, B Junk Speculative

Caa/Ca/C CCC/CC/C JunkHighly

SpeculativeC D Junk In Default

Notice that if the company falls below a certain credit rating, its grade changes from investmentquality to junk status. Junk bonds are aptly named: they are the debt of companies in some sortof financial difficulty. Because they are so risky, they have to offer much higher yields than anyother debt. This brings up an important point: not all bonds are inherently safer than stocks.Certain types of bonds can be just as risky, if not riskier, than stocks.

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2nd

information

Corporate Bonds - These bonds are issued by corporations and are used to raise capital for the issuing

companies. They range from investment grade to junk grade depending on the issuing companies.As a

general rule they are riskier than treasuries and munis, but one must always consider who has issuedthe specific bond and what its ratings are. For example, bonds issued by companies such as GE or IBM

are considered very safe considering the long-established nature of these corporations, while those

issued by less well known companies are mostly junk bonds. As companies issuing junk bonds become

more credit-worthy, their bonds gain quality and rise in price while their yields correspondingly decline.

The reverse is also true for high quality bonds gone bad, which may attain higher yields as their prices

drop. The interest on corporate bonds is subject to federal, state, and local taxes.

Bond Characteristics

As we mentioned before, bonds can be classified in several ways. In the last section we looked atthe main bond types with regards to their issuers. However bonds have different features orcharacteristics depending on the specific issuing organizations or institutions. Here is a list ofsome of the better known features:

Secured Bonds - Also known as asset-backed bonds, they are issued using specific properties orassets as collateral. The best known example of this type of bond is a mortgage bond where thebond is backed by a pool of mortgages (e.g., bonds issued by Freddie Mac or Fannie Mae).These bonds have a high degree of safety since the bondholders have the right to sell the pledgedproperty in case of default.

Unsecured Bonds - Also known as debenture bonds, they are backed solely by the generalcredit-worthiness of the issuer. Regular corporate bonds are an example of unsecured bonds.

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Information

Bonds of all kinds operate on the same basic principle: You as the investor loan money to thebond's issuer, and the issuer pays you interest on the loan, typically twice a year. All bonds havethree characteristics that never change:

1. Face value:The principal portion of the loan, usually either $1,000 or $5,000. It's the amount you get back from the

issuer on the day the bond matures. A bond's price, which is in constant flux, can be more or less than

the face value.


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2. Maturity:

The day the bond comes due. A 30-year bond, for example, comes due 30 years from the day it is issued.

Most bonds mature within 30 years, but maturities can be as short as a year or even shorter. Short-term

bonds are usually called notes.

3. Coupon:Because bonds used to come with attached coupons that investors had to clip and redeem for their

interest payments (now it's all done electronically), the size of the interest payment is still called the

coupon. A bond with an 8% coupon pays 8% of the face value of the bond a year, in two installments.

Assuming a face value of $1,000, that's two $40 payments.

...But the Yield on a Bond is Ever-Changing

Another common feature among bonds is that yield is the measure of their value. Think of yieldsas you would interest rates on a loan. If you're a borrower, you want the lowest possible interestrate. Your lender wants to charge you the highest possible rate.

When you buy a bond, you're the lender, and you want a high interest rate -- or yield.

Generally, the higher a bond's yield, the more credit- or interest-rate risk it carries. Just asborrowers pay more if their credit is bad -- or to borrow for a longer term -- you can get a higheryield from a riskier issuer, or if you are willing to lend your money long term.

Like their prices, bonds' yields are also in constant flux. When a bond's price rises, its yielddrops, and vice versa. Here's why: The yield, in essence, is the annual coupon payment dividedby the price. If the price -- the denominator -- gets bigger, the yield gets smaller. If the price getssmaller, the yield gets bigger.

The actual formula for the yield is more complicated mathematically, but the upshot is the same:As bond prices drop, the investor who buys that bond for less ends up with a better deal,reflected in a higher yield.

Conversely, if a bond's price rises, the investor who buys it at the higher price is getting a worsedeal than the investor who bought it when the price was lower. That worse deal is expressed as alower yield. All of which is why bond investors like to see dropping interest rates. Droppingyields mean rising bond prices.


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Yield, Price And Other Confusion

Understanding the price fluctuation of bonds is probably the most confusing part of this lesson.

In fact, many new investors are surprised to learn that a bond's price changes on a daily basis,just like that of any other publicly-traded security. Up to this point, we've talked about bonds asif every investor holds them to maturity. It's true that if you do this you're guaranteed to get yourprincipal back; however, a bond does not have to be held to maturity. At any time, a bond can besold in the open market, where the price can fluctuate - sometimes dramatically. We'll get to howprice changes in a bit. First, we need to introduce the concept of yield.

Measuring Return With YieldYield is a figure that shows the return you get on a bond. The simplest version of yield iscalculated using the following formula: yield = coupon amount/price. When you buy a bond atpar, yield is equal to the interest rate. When the price changes, so does the yield.

Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 parvalue, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800,then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200,the yield shrinks to 8.33% ($100/$1,200).

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Yield To Maturity

Of course, these matters are always more complicated in real life. When bond investors refer toyield, they are usually referring toyield to maturity (YTM). YTM is a more advanced yieldcalculation that shows the total return you will receive if you hold the bond to maturity. It equalsall the interest payments you will receive (and assumes that you will reinvest the interestpayment at the same rate as the current yield on the bond) plus any gain (if you purchased at adiscount) or loss (if you purchased at a premium).

Knowing how to calculate YTM isn't important right now. In fact, the calculation is rathersophisticated and beyond the scope of this tutorial. The key point here is that YTM is moreaccurate and enables you to compare bonds with different maturities and coupons.

Putting It All Together: The Link Between Price And YieldThe relationship of yield to price can be summarized as follows: when price goes up, yield goesdown and vice versa. Technically, you'd say the bond's price and its yield are inversely related.

Here's a commonly asked question: How can high yields and high prices both be good when theycan't happen at the same time? The answer depends on your point of view. If you are a bondbuyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives thebond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your
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interest rate, so you hope the price of the bond goes up. This way you can cash out by sellingyour bond in the future.

Price In The MarketSo far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of thesecharacteristics of a bond play a role in its price. However, the factor that influences a bond morethan any other is the level of prevailing interest rates in the economy. When interest rates rise,the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringingthem into line with newer bonds being issued with higher coupons. When interest rates fall, theprices of bonds in the market rise, thereby lowering the yield of the older bonds and bringingthem into line with newer bonds being issued with lower coupons.

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How To Read A Bond Table

Column 1: Issuer - This is the company, state (or province) or country that is issuing the bond.

Column 2: Coupon - The coupon refers to the fixed interest rate that the issuer pays to thelender.
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Column 3: Maturity Date - This is the date on which the borrower will repay the investors theirprincipal. Typically, only the last two digits of the year are quoted: 25 means 2025, 04 is 2004,etc.

Column 4: Bid Price - This is the price someone is willing to pay for the bond. It is quoted in

relation to 100, no matter what the par value is. Think of the bid price as a percentage: a bondwith a bid of 93 is trading at 93% of its par value.

Column 5: Yield - The yield indicates annual return until the bond matures. Usually, this is theyield to maturity, not current yield. If thebond is callableit will have a "c--" where the "--" is theyear the bond can be called. For example, c10 means the bond can be called as early as 2010.

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How Do I Buy Bonds?

Most bond transactions can be completed through afull serviceordiscount brokerage. You canalso open an account with a bond broker, but be warned that most bond brokers require aminimum initial deposit of $5,000. If you cannot afford this amount, we suggest looking at amutual fund that specializes in bonds (or abond fund).

Some financial institutions will provide their clients with the service of transacting governmentsecurities. However, if your bank doesn't provide this service and you do not have a brokerageaccount, you can purchase government bonds through a government agency (this is true in mostcountries). In the U.S. you can buy bonds directly from the government through TreasuryDirectathttp://www.treasurydirect.gov. The Bureau of the Public Debt started TreasuryDirect so that

individuals could buy bonds directly from the Treasury, thereby bypassing a broker. Alltransactions and interest payments are done electronically.

If you do decide to purchase a bond through your broker, he or she may tell you that the trade iscommission free. Don't be fooled. What typically happens is that the broker will mark up theprice slightly; this markup is really the same as a commission. To make sure that you are notbeing taken advantage of, simply look up the latest quote for the bond and determine whether themarkup is acceptable.

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