what is a bond and how do bond investments work?
TRANSCRIPT
What Is a Bond and How Do Bond
Investments Work?
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What Is a Bond?• A bond, in its basic form, a plain vanilla
bond is a type of loan.• An investor takes his or her money and
temporarily lends it to the bond issuer.• In exchange, the investor receives
interest income at a predetermined rate(the coupon rate) and at predeterminedtimes (the coupon date).
• The bond has an expiration date (thematurity date) at which point the statedpar value of the bond must be returned.
• In most cases, with a notable exceptionbeing certain U.S. Government savingsbonds such as the Series EE savingsbonds, a bond ceases to exist at maturity.
Example Of Bond
• Imagine The Coca-Cola Company wanted to borrow $10 billion from investorsto acquire a large tea company in Asia.
• It believes the market will allow it to set the coupon rate at 2.5% for itsdesired maturity date, which is 10 years in the future.
• It issues each bond at a par value of $1,000 and promises to pay pro-ratainterest semi-annually.
• Through an investment bank, it approaches investors who invest in thebonds.
• In this case, Coke needs to sell 10,000,000 bonds at $1,000 each to raise itsdesired $10,000,000,000 before paying the fees it would incur.
Different Types of Bonds
1. Sovereign Government Bonds2. Municipal Bonds3. Corporate Bonds
Sovereign Government Bonds
• These are bonds issued by sovereign governments. In the UnitedStates, this would be things such as U.S. Treasury bills, bonds, andnotes, which are backed by the full faith and credit of the country,including the power to tax in order to meet its constitutionally requiredobligations.
• Additionally, sovereign governments often issue special types of bondsaside from their primary obligations.
• Agency bonds, which are issued by government agencies, often to fulfilla specific mandate and despite enjoying the implicit assumption ofbacking from the government itself, often provide higher yields.
• Likewise, savings bonds, which we've already discussed, can beparticularly interesting under the right circumstances; e.g., the Series Isavings bonds when inflation is a risk.
Municipal Bonds• These are bonds issued by state and local governments.• In the United States, municipal bonds are often tax-free to achieve two
things.• Firstly, it allows the municipality to enjoy a lower interest rate than it would
otherwise have to pay (to compare a municipal bond with a taxable bond,you must calculate the taxable equivalent yield, which is explained in thearticle linked earlier in this paragraph), easing the burden to free up moremoney for other important causes.
• Secondly, it encourages investors to invest in civic projects that improve thecivilization such as funding roads, bridges, schools, hospitals, and more.
• There are many different ways to weed out potentially dangerous municipalbonds.
• You also want to make sure you never put municipal bonds in your RothIRA.
Corporate Bonds
• These are bonds issued by corporations, partnerships, limitedliability companies, and other commercial enterprises.
• Corporate bonds often offer higher yields than other types ofbonds but the tax code is not favorable to them.
• A successful investor might end up paying 40% to 50% of his or hertotal interest income to Federal, state, and local governments inthe form of taxes, making them far less attractive unless some sortof loophole or exemption can be utilized.
• For example, under the right circumstances, corporate bondsmight be an attractive choice for acquisition within a SEP-IRA,especially when they can be acquired for much less than theirintrinsic value due to mass liquidation in a market panic, such asthe one that occurred in 2009.
Main Risks of Investing in Bonds
1. Credit Risk2. Inflation Risk3. Liquidity Risk4. Reinvestment Risk
Credit Risk
• Credit risk refers to the probability of not receiving your promisedprincipal or interest at the contractually guaranteed time due to theissuer's inability or unwillingness to distribute it to you.
• Credit risk is frequently managed by sorting bonds into two broadgroups - investment grade bonds and junk bonds.
• The absolute highest investment grade bond is a Triple AAA ratedbond.
• Under almost all situations, the higher the bond's rating, the lowerthe chance of default, therefore the lower the interest rate theowner will receive as other investors are willing to pay a higher pricefor the bigger safety net as measured by financial ratios such as thenumber of times fixed obligations are covered by net earnings andcash flow or the interest coverage ratio.
Inflation Risk
• There is always a chance that the government will enactpolicies, intentionally or unintentionally, that lead towidespread inflation.
• Unless you own a variable rate bond or the bond itself hassome sort of built-in protection, a high rate of inflation candestroy your purchasing power as you may find yourself livingin a world where prices for basic goods and services are farhigher than you anticipated by the time you get your principalreturned to you.
Liquidity Risk
• Bonds can be far less liquid than most major blue chip stocks.• This means that, once acquired, you may have a difficult time selling them at top
dollar.• his is one of the reasons it is almost always best to restrict the purchase of
individual bonds for your portfolio to bonds you intend to hold until maturity.• To provide a real-life illustration, I recently worked to help someone sell off some
bonds for a major department store in the United States, which are scheduled tomature in 2027.
• The bonds were priced at $117.50 at the time. We made a call to the bond desk -you can't trade most bonds online - and they put out a bid request for us. The bestanyone was willing to offer was $110.50.
• This person decided to hold the bonds rather than part with them but it's notunusual to encounter such a discrepancy between the quoted bond value at anygiven moment and what you can actually get for it; a difference known as a bondspread, which can hurt investors if they aren't careful.
Reinvestment Risk
• When you invest in a bond, you know that it's probably going tobe sending you interest income regularly (some bonds, knownas zero-coupon bonds, do not distribute interest income in theform of checks or direct deposit but, instead, are issued at aspecifically-calculated discount to par and mature at their facevalue with the interest effectively being imputed during theholding period and paid out all at once when maturity arrives).
• There is a danger in this, though, in that you cannot predictahead of time the precise rate at which you will be able toreinvest the money.
• If interest rates have dropped considerably, you'll have to putyour fresh interest income to work in bonds yielding lowerreturns than you had been enjoying.
