Bonds 101

Basically, a bond is a loan. When a company or a government offers a bond to the public, they are asking you to give them money—today. In exchange they are giving you a financial instrument that will pay back the same amount when the bond reaches its maturity date. Along the way the bond will make clearly defined periodic interest payments to the bond holder. This is called the “coupon.” Back in the day, when it was time to collect the quarterly interest payment, the bondholder literally took out a pair of scissors and cut the coupon off the side of the bond. He would then take his coupon to the appropriate financial institution and exchange it for cash.

Maturity is generally categorized as short, medium, or long term. Depending on the type of bond and who is doing the defining short could mean less than three years to less than six years. Medium could mean anything from three to twelve years. Long term could start as low as five years or as high as twelve years. There are even “Perpetuals” that never return the principal. What kind of interest rate would you ask for if I told you I was just going to give you an interest payment every three months, but I was never going to give you your money back? Hmm….

When you buy a bond, you must first consider how much money you wish to place at risk. In this example, let’s assume you want to buy a $10,000 bond with a ten year maturity date. That means ten years from the date of issue, you get $10,000 back (maybe). At this point you need to consider how likely it is that the bond issuer can fulfill his promise. U.S. Treasury Bonds are backed by the “full faith and credit” of the United States of America. As long as our Government owns the printing presses, you will get your money back. How much that $10,000 can buy ten years from now is another question. The last rating I can find for the City of Detroit is CC, deeply in the “junk bond” category. I expect it has dropped further since the city slid into bankruptcy.

There are five rating agencies that can rate your bonds. This power is authorized by the Federal Government. It was grievously misused by the rating agencies in the subprime meltdown of 2008. Hopefully, we have learned our lesson from that fiasco.

With that warning in mind, here is the letter ratings used by Standard and Poors, probably the best know of the rating agencies.

‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.

‘AA’—Very strong capacity to meet financial commitments.

‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

‘BBB-‘—Considered lowest investment grade by market participants.

‘BB+’—Considered highest speculative grade by market participants.

‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

‘B’—More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

‘CCC’—Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

‘CC’—Currently highly vulnerable.

‘C’—Currently highly vulnerable obligations and other defined circumstances.

‘D’—Payment default on financial commitments.

Note: Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

The market price of the bond is driven by maturity date, coupon rate, rating, and the prevailing interest rate. Consider, the current rate on ten year treasuries is 2.68%. In 2013 the “junk bond” index returned 7.4%. During the darkest hours of 2008 the junk bond index went over 21%! At the same time the 10 year Treasury paid 2.3%.

Once a bond has been issued, it can be bought and sold just like stocks. Here is the important rule for pricing bonds that is usually answered wrong on financial literacy quizzes.

When the prevailing interest rate goes up, the value of a bond goes down.

When the prevailing interest rate goes down, the value of the bond goes up.

Think about it. If you can get a return of 5%, are you going to pay full face value for a bond that only pays 3% or are you going to ask for some kind of discount? Maturity date also sneaks back into this calculation. There is less risk if my money is going to be returned in six months than if I won’t get it back for six years. I would expect a larger discount on a ten year bond with six years left to maturity than a ten year bond with six months left until maturity.

When the dust settles, what you are really buying is yield. Current yield is the annual interest payment divided by the current market price of your bond. There are more complicated methods of calculating yield, termed yield to maturity or redemption yield that considers maturity and the actual timing of coupon payments.

Bonds are considered a “senior” security. That means, as a creditor, the bond holder gets paid before anyone else. In good times bondholders are to be paid before shareholders get their dividends. In bad times the bondholder should be given absolute priority in bankruptcy proceedings. As the song says, “It ain’t necessarily so.” During the GM bankruptcy the executives and the unions that wrecked that once great American icon received their golden parachutes, pensions, and healthcare. The bondholders got nothing. That isn’t supposed to happen, but it did.

Be careful. Not all bonds are considered “senior.” There are also subordinated bonds that are considered “junior” securities. That means they get paid off after the senior bondholders are made whole. Needless to say these bonds carry a lower rating and provide a higher yield than the safer, senior bonds.

Bonds are also sold with various options that can affect their market price. Some bonds are “callable” meaning that either the bond issuer or the bond holder has the legal right to call the bond at specific times or under specific conditions. If a bond issuer thinks he will be able to get a better interest rate sometime in the future he might issue a bond today that allows him to repay the principal before the stated maturity date. The market will take that into consideration when pricing the bond. Sometimes bonds are issued that allow the bondholder to convert the bond into shares of stock at some predetermined price at sometime in the future rather than getting his principal back when the bond matures. If you are a billionaire investor discussing the future of a basically sound company that has fallen on hard times, you might find such an option quite appealing.

Generally speaking individual bonds (other than Treasuries) are somewhat illiquid. If the owner of a Fredrick County Water and Sewer Bond needed to sell before the bond’s date of maturity, it might be difficult to locate a buyer unless the bond was sold at a discount. For this reason individual investors are better served by investing their money in low cost bond funds. These funds are highly liquid. They can be sold at posted, well understood share closing price on the day of the transaction. The money will then be available for the investor to spend in no more than a few days depending on the rules of the fund.

The problem with bond funds is interest rate risk. Unlike individual bonds, you are never out of the game with a bond fund. There is no maturity date to a bond fund. When one bond matures the fund managers use the money to buy more bonds. While these funds are frequently categorized by bond type, quality and length of investment term, their price (like individual bonds) moves inversely with changes in interest rates.