This section describes the details of the Bond Market. A bond is a long-term ldebt with a stated amount of interest and end date. They have several features in common.
- vary by issuer type and form of asset backing
- bought and sold like stocks
- have value techniques iusing risk measures.
General Features of Bonds
Bonds are debts of their issuers for a fixed sum called principal. They have have end dates ranging from one day to thirty years. Owners receive a flow of payments or interest in return for use of their money. Generally, the longer the maturity, the higher the interest paid.
The going interest rate in the bond market is set by the perceived value of
- the issuer’s credit risk
- inflation concerns
- the risk-free rate
Although all interest rates change, short-term rates change more than long-term rates.
The indenture is the document which states the terms of the bond issue. To protect your interests, a trustee is named for each bond issue to make sure the issuer does what they are supposed to do. Most bonds are issued in a nameless book form held by your broker and cleared through a clearinghouse in New Jersey called the DTC.
All bonds have risk with varying degrees:
- Default risk– interest and principal will not be repaid
- Interest rate risk– price declines, principal moves inversely to changes in the market rate
- Inflation risk– changes in actual inflation affects purchase power
- Call risk– issuer may redeem bonds sooner than stated end date
- Reinvestment risk– investing proceeds at a lower interest rate
Even though it’s assumed the feds will make good on their debts, the price of Treasuries move around prior to maturity. This is due to changes in the market rate and expected inflation rates.
To aid buyers of debt, several firms have developed a credit rating system which notes the degree of risk for a large number of issued bonds. The highest rated ones have the least amount of risk and the best chance of not paying back while the riskiest issues are called junk bond or high yield and pay higher interest.
How to Buy Bonds
The bond market is about a third larger than the stock market. Bonds are purchased like stocks, either from a broker/dealer or through an exchange. After your bond is purchased, a confirm is sent to you by your broker.
Bonds earn interest everyday, but the firm makes the payments only twice a year. When you purchase a bond, you owe the previous owner accrued interest for the days the owner held the bond. When the bond is sold, you receive the accrued interest.
A few bonds trade without accrued interest, usually in default. These bonds are rated below investment grade and are only suitable for speculators, not our clients. The risk of buying them is enormous but if they resume paying interest, the return can be substantial.
Governments at all levels issue bonds to cover the shortfall from tax receipts and costs in times of budget shortfalls. Issuers include
- Federal governments
- Federal agencies
- State and local governments
- Other subdivisions such as school and water districts
Firms issue many types of bonds either secured or not secured:
- Mortgage bonds- secured by certain assets
- Equipment Trust Certs- issued by railroads and airlines secured by planes and rolling stock
- Debentures- unsecured promissory notes supported by the firm’s general creditworthiness
- Income bonds- riskiest because the firm only pays interest if it earns it
- Convertible bonds- pays interest but has added feature allowing holders to convert to common stock
Legally, preferred stock is an equity, but due to its fixed payout nature, it has the traits of a bond. They are mainly issued by utilities and banks and usually unsecured. Because of their lowly status, they pay a higher yield than bonds.
Bond Market Values
The price of any bond is mainly related to
- First, interest paid by the bond
- iThen, nterest rate iowners may receive on similar bonds
- Finally, end date
The current price of your bond equals the present value of the interest payments plus the present value of the sum received at the end. The discount rate used in figuring is the current interest being paid by newly issued bonds with the same length of maturity.
The meaning of yield s has three key aspects
- Current Yield- annual interest payment divided by the current price of the bond
- Yield to Maturity- considers current income when determining annual return if bond is held to maturity
- Yield to Call- similar to yield to maturity except assumption is bond will be called at call date
The price volatility of bonds with equal coupons and different terms may be compared on the basis of time. In addition, for a given risk class, the price of the bond with the longer term to maturity should be more volatile.
Computing yield to maturity may be used to comparing bonds with common features, but doesn’t work with bonds with different maturities and coupons. Also, an alternate technique, duration, compares bonds with varying maturities and coupons by determining each bonds sensitivity to interest rate changes.
Duration is defined as the time it takes for the bondholder to receive interest and principal back. It is a weighted average encompassing the total amount of the bond’s payments and their timing.
Bond Portfolio Management
Since bonds pay a fixed income and mature at a specified date, they are conducive to passive management. Interest is collected and principal paid back at a known amount. The market value of the portfolio fluctuates but the investor is assured of a specified return of principal if held to maturity.
The construction of a passively management portfolio takes into consideration reinvestment risk and matches the portfolio’s cash flow needs to your needs. Techniques involve staggering maturity dates and interest payment cycles.
In addition, a more active management uses the duration to manage the reinvestment risk and requires frequent trading of bonds. Also, a strategy designed to take advantage of an expected change in rates paid by one type of bond relative to a different type requires bond swapping.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Statement Analysis
- Foreign Securities
The material presented in this Bond Market section and other Investment Basics sections are adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. Also, see our Site Credits page for Bond Market reference sources.