Fixed income investments (also known as bonds) seem straightforward on the surface: The investor earns a fixed rate of return from the bond issuer (a public or corporate entity) for a specified term. However, there is more to this vital asset class than meets the eye. So let us take a closer look, starting with the basics.
What are Bonds?
The U.S. bond market is the world’s largest repository of investment capital. Valued at over $38 trillion, this market is nearly twice the size of the U.S. stock market. But what, exactly, is a bond?
Simply stated, a bond is a loan made by an investor to a company or governmental entity. Bonds are used to finance a wide range of public and private activities, ranging from new product development and corporate acquisitions to municipal infrastructure and governmental operations.
Bonds typically pay a fixed interest rate for a set term; that is why they are often called "fixed income investments." At the end of this term, the investor’s "loan" is repaid in full. A small percentage of bonds are issued at a floating — rather than fixed — interest rate, tied to some external index.
Most bonds are issued in denominations of $1,000 and generate interest payments twice each year. The interest rate is often called the "coupon" of the bond, referring to a time long past when most bonds carried coupons that were detached and redeemed by the investor. Some bonds are issued for very short maturities (such as U.S. T-Bills), ranging from a few days to one year. Others are issued for an intermediate term like two to ten years, while long-term bonds can have terms up to 30 years.
What are the Main Types of Bonds and How do They Differ?
There are three main types of bond issues:
- Corporate Bonds - are issued by private companies. As these companies are perceived as less creditworthy than the U.S. government, Corporate bonds pay a higher interest rate than Treasury bonds of the same term. Of course, not all Corporate bonds are equally creditworthy. Bonds issued by higher-rated companies pay a lower interest rate to investors, as there is a correlation between perceived risk and return.
- Treasury Bonds and T-Bills - are issued by the United States government. As sovereign debt of the world’s richest and most powerful nation, they are viewed in all financial circles as the world’s most creditworthy investment (despite a downgrading by Standard & Poors during the 2011 Congressional budget standoff).
- Municipal Bonds - are issued by state and local governmental entities. There are two kinds of Municipal Bonds:
- Revenue Bonds – which are repaid by direct revenue from the project or infrastructure financed by the bonds, such as a toll road or sports stadium.
- General Obligation (GO) Bonds – which are a general obligation of the bond issuer, and are repaid by taxes and other municipal revenues not tied to a specific project or infrastructure.
Most Municipal bonds are exempt from federal and state taxation, so their coupon rate is typically lower than both Corporate and Treasury bonds, presuming the Municipal bond issuer has a solid credit rating. Despite the lower interest rate these bonds deliver, they generally provide a higher total yield, on an after-tax basis, to bond investors.
How are Bonds Rated?
There are three main bond rating agencies: Standard & Poors (S&P), Moody’s, and Fitch. Corporate and municipal bonds carry ratings from these agencies that reflect — but do not guarantee — their creditworthiness. AAA is the highest rating provided by S&P; Aaa is the highest provided by Moody’s. Anything rated BB or lower by S&P, or Ba and lower by Moody’s, is considered below investment grade, and are sometimes known as "junk bonds." The lower the credit rating, the higher the risk — and interest rate — will typically be.
How Interest Rate Movements Affect Bond Values
Interest rates and bond values have an inverse relationship; rising interest rates will reduce the value of existing bonds while falling rates will increase their value. To understand this influence, consider the following example:
Investor A buys a $10,000, 10-year Treasury bond today that pays an interest rate (coupon) of 5%. This means she will receive a $250 payment twice each year for 10 years. The following month, interest rates fall, and a newly issued 10- year Treasury bond pays just 4%. Investor B purchases this bond, also for $10,000, and will receive a $200 payment twice each year for 10 years. Thus, investor A will receive $5,000 in total interest payments over the life of the bond, while Investor B will receive only $4,000. Because interest rates came down following her bond purchase, Investor A owns the more valuable bond today. The opposite effect occurs when interest rates rise.
This concept of bond "value" is significant only when an investor wishes to sell a bond. If the bond is worth more today than when the bond was purchased, the investor will realize a profit; if worth less, a loss. However, if an investor holds a bond until maturity, he or she will be repaid 100% of invested principal, provided the bond issuer remains solvent.
What are the Primary Risks in Bond Investing?
There are four main risks facing bond investors. They are:
- Credit Risk – The chief form of credit risk is that a bond issuer becomes insolvent and cannot repay bondholders. The secondary form of credit risk is that the issuer suffers a credit downgrade from one or more of the rating agencies, even while remaining solvent. This will result in lower values for all the issuer’s outstanding bonds.
- Market Risk – The risk that interest rates will be higher when the bond is sold than when it was purchased, resulting in a loss of principal.
- Call Risk – Some bonds are "callable" which means they can be redeemed by the bond issuer prior to the bond’s maturity date. Bonds are called when it is cheaper to repurchase old bonds and refinance with new bonds issued at a lower interest rate. The risk to investors is that bonds called before maturity can leave a gap in expected income, and in a call-inclined market, investors may have trouble finding similar value for their investment dollar. Fortunately, most bonds can only be called five or ten years after the issuance date, so income protection can be assured until the call date.
- Currency Risk – This risk applies only to investments in the bonds of foreign governments or corporations. Because currencies of the bond issuer’s nation can rise or fall in relation to other currencies, there is risk that the currency of the bond issuer will be worth less as interest and/or principal payments are made.
Can Diversifying my Bond Portfolio Lower Risk?
Many experts suggest a balanced portfolio of fixed income instruments diversified by: duration (time to maturity), income, credit quality, and issuer. By not putting all your fixed income "eggs" into any single basket, you can optimize portfolio returns while significantly mitigating risk.