Speaking of Bonds
Do you hear the bond market update on CNBC and just shrug your shoulders? That bond stuff seems just a little too removed from our beloved stock market. Bond traders speak a different language right? Well, yes they do as a matter of fact. This is the place to interpret that arcane bond speak. Maybe you just clicked on this link for curiosity, or ended up here by accident - oh well, you might as well stay and test your bond knowledge.
Stocks and bonds are more related than you might have realized. It's said that the stock market follows the bond market. When bond prices go up, stocks often follow. That's because bond prices are acutely tied to interest rate risks. Stocks respond to the bond market's interpretation of interest rates. We know what makes stock prices go up - simple supply and demand. The same principle applies to bonds, but the dynamics of bond pricing are a little more complicated. Let's start from the basics and work up.
Coupon Rate
Let's first assume that you buy a bond for a long-term income stream - as most people do, as opposed to speculating by trading bonds. A bond investor will receive a reliable, steady interest payment stream. The rate of interest is called the coupon rate. An 8% coupon bond on a $1000 par value will pay out $80 per year, usually in two payments of $40 each. The coupon rate is dependent on three things - time to maturity, credit risk, and prevailing interest rates in the overall economy.
Par Value
The par value (also called principal or face value) is the amount on which the interest payments are computed. Par value is usually equal to the price of the bond when it was initially issued. Par value is also the amount that will be repaid at maturity.
Maturity
Maturity is measured from the time that a bond is a new issue, to the date when it expires, at which time the principal is repaid in full. Maturities can range from 1 day (short-term) to 10 years (intermediate term) to 50 years (long term).
Credit Ratings
Most bonds are not a risk-free investment. The only bonds that can claim to be default free are treasuries, which are backed by the full faith and credit of the U.S. Government. The rate of return paid on a bond is directly tied to the risk of default. That's why treasuries pay such low rates. Municipal bonds, while subject to default risk, pay even lower interest - they enjoy a special federal tax-free status that makes them attractive to investors.
Standard & Poor's and Moody's Investors Services are the leading rating agencies for assigning a credit risk. Investment grade ratings range from AAA down to BBB, BB are called high yield, and below that are the notorious "Junk Bonds".
Bond Types
The type of bond you purchase will determine the credit risk and coupon rate. The main categories of bonds are Treasuries, Corporate, Agency Backed, and Municipals. A full description of each is included in our Credit Market Basics section. Each type of bond can be traded in the secondary markets.
Secondary Market
After a bond is initially issued, they become traded on organized exchanges, which include either the New York stock exchange or the OTC market (an electronic exchange). Keep in mind that investors who buy bonds are not obligated to hold them to maturity. A secondary market provides liquidity to bondholders, making them a more attractive investment. In the bond markets, price fluctuates daily.
Price
Price is determined by the interaction of credit ratings, prevailing interest rates, maturity, supply and demand, and a number of other factors. Most simply, price is variable and changes daily.
Do not confuse price with par value. Par value does not fluctuate - it's the price on which interest is computed. Price is applicable to bonds traded in the secondary market - after the initial issuance. When the price moves above the par value, it becomes priced at a premium. A bond trading below par value is at a discount.
Changes in credit ratings can affect bond prices. The most important factor in bond pricing is interest rates. When interest rates in the general market increase, the price of already existing bonds will decrease. If prevailing interest rates decrease, the price of already existing bonds will increase. The reason for this is the relationship of price to yield.
Yield
In bond terminology, yield is equivalent to saying return on investment. When bond prices increase, yields decrease. If bond prices decrease, yields increase. Here are some examples to illustrate the relationship:
Say you buy a $1000 par value bond, paying 8%, and pay $1000 for it - the yield is 8%, equivalent to the coupon rate. If however, the bond is trading at a premium price of $1050 and the coupon rate is 8%, the current yield is $80/$1050 = 7.6%.
Now, let's say a bond is trading at a discount. You pay $950 for a $1000 par value bond and the coupon rate is 8%. The current yield is $80/$950 = 8.4%.
The above examples compute current yield. Be aware that bonds with redemption provisions (see advanced terminology below) will have a yield to call.
Keep in mind that interest rates drive the price/yield relationship. When prevailing rates rise, the price of existing bonds will fall, which in turn raises the yield of those existing bonds. When prevailing interest rates fall, the price of existing bonds will rise, which in turn decreases the yield on those existing bonds.
Advanced Bond Terminology:
Call Provisions
Certain bonds have call provisions, also known as redemptions. The "call" allows the issuer the option to repay the principal before the maturity date. The reason an issuer would call a bond is if prevailing interest rates have dropped since the time when the bonds are issued. In other words, the issuer does not want to have an interest expense that is more costly than that which can be found elsewhere in the market. A call provision will stipulate the date beyond which the call can be effected. For instance, a bond issued in 2000, might not be callable until 2005.
Bonds of this type typically have a higher yield than a bond of equivalent maturity, coupon rate and risk, because the risk is higher for the bondholder that the bond could be called before maturity. By owning a callable bond, the holder has an increased future interest rate exposure, in return for a higher yield.
Put Provisions
A bond with a put provision will allow the bondholder (investor) the option the option of requiring the issuer to repurchase the bond - effectively returning the principal before the date of maturity. Why do that? The most common reason would be that prevailing interest rates have become higher than that paid by the bond. An investor would not want to hold a bond paying them 4% if they can get 6% elsewhere.
A bond with a put provision will typically have a lower yield than a bond of equivalent maturity, coupon rate and risk, because the risk is higher for the issuer of the bond that they may have to repay the principal before maturity. By owning a bond with a put provision, an investor can decrease future interest rate exposure, in return for a lower yield.
Convertible Bonds
A hybrid of both the equity and bond markets, a convertible bond pays a fixed rate, just like a normal bond. The difference however, is that the bond can be converted to stock at a preset price target. Convertible bonds are also callable by the issuer. The issuing company has the option to convert the bond to shares at any time during the first five years.
Convertible bonds typically have a higher yield, because of the call provisions. Also, convertible bond prices are more volatile because the conversion potential is influenced by stock market fluctuations.
Duration
The weighted maturity of a bond's cash flows, discounted to the present is also called duration. The computation of duration is important in the determination of price as it relates to interest rate changes.
Deriving a duration number for a bond or fund is a complex calculation, which is usually provided by an advisor. There are a couple of important generalities to keep in mind about duration. First, a lower duration will generally mean less price risk for the bond. A higher duration will cause the bond price to be more volatile with changes in interest rates. A crude formula for determining the effect of duration is this: For every 1% move in interest rates, expect a percentage move in the price of the bond equal to the duration. Example: Duration of bond = 7, interest changes from 5% to 6%, price of bond decreases 7%.
Swapping
Bond swapping involves the sale of one bond with the simultaneous purchase of another bond, often with similar maturity, price, coupon and risk qualities.
The purpose of swapping is to take advantage of market conditions that may favor one investment over another, taking into consideration the tax implications of individual investors. Swapping is a complicated topic, it is best to consult an investment and tax advisor for this strategy.
Zero-Coupon Bonds
These are another hybrid bond, which does not pay interest annually. Zeros are purchased at a discount and at maturity, all compound interest and the original principal are paid to the bondholder in one lump-sum. Zeros have a downside from a tax perspective, because although the interest payments are not received, they are accrued. Bondholders are required to pay taxes annually on the accrued interest.
