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As an investor you can either acquire an ownership interest in a company, by purchasing shares of common or preferred stock, or you can loan money to a company by purchasing a bond issued by the company. Bonds can also be issued by the federal and state governments, agencies of the government, cities, counties and others. The fundamental investment concept, in purchasing a bond, is that when the bond matures, the investor will receive back the principal face amount of the bond (par value), while in the interum being paid a stated rate of interest (the coupon rate), by the issuer, for the use of the investors money. However, as with any type of contract other provisions can be added by, in this case, the issuer, such as the issuer being given the right to pay off the bond earlier than maturity under certain identified circumstances.What is Bond Maturity and Generally What is a Bond’s Term?
A bond’s term, or years to maturity, is usually set when it is issued. Bond maturities can range from one day to 100 years, but the majority of bond maturities range from one to 30 years. Bonds are often referred to as being short, medium or long term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium- or intermediate-term bonds are generally those that mature in four to ten years, and long-term bonds are those with maturities greater than the years.Can Bonds be Called or Redeemed Before Maturity?
The simple answer is yes. Not all bonds reach maturity, even if you, as an investor, want them to. Callable bonds are common. They allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond’s prospectus (or offering statement or circular) and the indenture — both are documents that explain a bond’s terms and conditions. While firms are not formally required to document all call provision terms on the customer’s confirmation statement, many do so. (When you buy municipal securities, firms are required to provide more call information on the customer confirmation than you will see for other types of debt securities.)
You usually receive some call protection for a period of the bond’s life (for example, the first three years after the bond is issued). This means that the bond cannot be called before a specified date. After that, the bond’s issuer can redeem that bond on the predetermined call date, or a bond may be continuously callable, meaning the issuer may redeem the bond at the specified price at any time during the call period. Before you buy a bond, always check to see if the bond has a call provision, and consider how that might impact your investment decision.What is a Bond Coupon?
A bond’s coupon is the annual interest rate paid on the issuer’s borrowed money, generally paid out semiannually. The coupon is always tied to a bond’s face or par value, and is quoted as a percentage of par. For instance, a bond with a par value of $1,000 and an annual interest rate of 4.5 percent has a coupon rate of 4.5 percent ($45). Looking at it another way, if you invest $5,000 in a six-year bond paying 5 percent per year, semiannually. Assuming you hold the bond to maturity, you will receive 12 interest payments of $125 each, or a total of $1,500. This coupon payment is simple interest.What is Accrued Interest?
Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market, you most likely will catch the bond between coupon payment dates. If you’re selling, you’re entitled to the price of the bond, plus the accrued interest that the bond has earned up to the sale date. The buyer compensates you for this portion of the coupon interest, which is generally handled by adding the amount to the contract price of the bond.Are All Bonds Generally the Same?
The answer is no. There are varying types of bonds limited only by their terms. Here is an example on two such types of bond.Zero-Coupon Bonds
Bonds that don’t make regular interest payments are called zero-coupon bonds — zeros for short. As the name suggests, these are bonds that pay no coupon or interest payment. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures. For example, you might pay $3,500 to purchase a 20-year zero-coupon bond with a face value of $10,000.
Federal agencies, municipalities, financial institutions and corporations issue zeros. One of the most popular zeros goes by the name of STRIPS (Separate Trading of Registered Interest and Principal Securities). A financial institution, government securities broker or government securities dealer can convert an eligible treasury security into a STRIP bond. As the name implies, the interest is stripped from the bond. A nice feature of STRIPS is that they are non-callable, meaning they can’t be called to be redeemed should interest rates fall. This feature offers protection from the risk that you will have to settle for a lower rate of return if your bond is called, you receive cash, and you need to reinvest it, also known as reinvestment risk.
Note that on these types of bonds, the difference between the discounted amount that the investor pays for the zero-coupon bond and the face amount received is imputed interest. This is interest that the IRS considers to have been paid to the investor, even if the investor has not actually received it. While interest on zeros is paid out all at once, the IRS requires that the investor pay tax on this “phantom” income each year, just as the investor would pay tax on interest received from a coupon bond. Some investors avoid paying the imputed tax by buying municipal zero-coupon bonds, if they live in the state where the bond was issued) or purchasing the few corporate zero-coupon bonds that have tax-exempt status.Floating-Rate Bonds
While the majority of bonds are fixed-rate bonds, a category of bonds called floating-rate bonds (floaters) have a coupon rate that is adjusted periodically, or “floats,” using an external value or measure, such as a bond index or foreign exchange rate.
Floaters offer protection against interest rate risk, because the fluctuating interest coupon tends to help the bond maintain its current market value as interest rates change. However, their coupon rate is usually lower than that of fixed-rate bonds. Because a floating bond’s rate increases as interest rates go up, they tend to find favor with investors during periods when economic forces are causing interest rates to rise. Most floater coupon rates are generally reset more than once a year at predetermined intervals (for example, quarterly or semiannually). Floaters are slightly different from so-called variable rate or adjustable rate bonds, which tend to reset their coupon rate less frequently. (Note: Floating and adjustable-rate bonds may have restrictions on the maximum and minimum coupon reset rates.)How are Bonds Priced?
Bonds are generally issued in multiples of $1,000, also known as a bond’s face or par value. But a bond’s price is subject to market forces and often fluctuates above or below par. If you sell a bond before it matures, you may not receive the full principal amount of the bond and will not receive any remaining interest payments. This is because a bond’s price is not based on the par value of the bond. Instead, the bond’s price is established in the secondary market and fluctuates. As a result, the price may be more or less than the amount of principal and the remaining interest the issuer would be required to pay you if you held the bond to maturity.
The price of a bond can be above or below its par value for many reasons, including interest rate adjustments, whether a bond credit rating has changed, supply and demand, a change in the creditworthiness of a bond’s issuer, whether the bond has been called or is likely to be (or not to be) called, a change in the prevailing market interest rates, and a host of other factors. If a bond trades above par, it is said to trade at a premium. If a bond trades below par, it is said to trade at a discount. For example, if the bond you desire to purchase has a fixed interest rate of 8 percent, and similar-quality new bonds available for sale have a fixed interest rate of 5 percent, you will likely pay more than the par amount of the bond that you intend to purchase, because you will receive more interest income than the current interest rate (5 percent) being attached to similar bonds.What is Bond Yield?
Yield is a general term that relates to the return on the capital you invest in the bond. With bonds, there are a number of types of yield. The different terms are important to understand because they are used to compare one bond with another to find out which is the better investment.
There are several definitions that are important to understand: coupon yield, current yield, yield-to-maturity, yield-to-call and yield-to-worst.
Let’s start with the basic yield concepts.
If you buy a new bond at par and hold it to maturity, your current yield when the bond matures will be the same as the coupon yield.
Note: The price and yields of a bond are inversely related. As the price of a bond goes up, its yield goes down, and vice versa. Also you should be familiar with the following yield terminology:
Yield-to-Maturity (YTM) is the rate of return you receive if you hold the bond to maturity and reinvest all the interest payments at the yield-to-maturity rate. It is calculated by taking into account the total amount of interest you will receive over time, your purchase price (the amount of capital you invested), the face amount (or amount you will be paid when the issuer redeems the bond), the time between interest payments and the time remaining until the bond matures.
Yield-to-Call (YTC) is figured the same way as YTM, except instead of plugging in the number of months until a bond matures, you use a call date and the bond’s call price. This calculation takes into account the impact on a bond’s yield if it is called prior to maturity and should be performed using the first date on which the issuer could call the bond.
Yield-to-Worst (YTW) is whichever of a bond’s YTM and YTC is lower. If you want to know the most conservative potential return a bond can give you — and you should know it for every callable security — then perform this comparison.
To get a more accurate picture of what a bond will cost you or what you received for it, you should also confirm that your broker has calculated the yield, adjusting the purchase price up (when you purchase) or down (when you sell) by the amount of the mark-up or commission (when you purchase) or mark-down or commission (when you sell) and other fees or charges that you are charged by your broker for its services. This is called yield reflecting broker compensation.What are the Risks of Investing in Bonds?
There are many risks associated with purchasing a bond. They are too numerous to discuss in detail. The following is a list of some of the risks that an investor should always consider:
Risk is definitely something that, as an investor, you need to fully understand and take into consideration in making your investment decisions. Moreover, once you own a bond, certain of these risks are fluid and change with time so that you need to consistently monitor your investments and take appropriate remedial action to protect yourself. If you deal with an investment professional, he or she should be able to provide you with all the information that you need.Contact Us
With extensive courtroom, arbitration and mediation experience and an in-depth understanding of securities law, our firm provides all our clients with the personal service they deserve. Handling cases worth $25,000 or more, we represent clients throughout Florida and across the United States, as well as for foreign individuals that invested in U.S. banks or brokerage firms. Contact us to arrange your free initial consultation.