Unlike stocks, which are equity instruments, bonds are debt
instruments. in effect, you’re loaning the bond issuer money, which they repay
with interest.
When bonds are first issued, the investor/lender typically
gives the company $1,000, upon which the company promises to pay a certain
interest rate every year, called the coupon rate, and then repay the $1,000
loan when the bond matures, at the maturity date. for example, general electric
(ge) could issue a 30-year bond with a 5% coupon. The investor/lender gives ge
$1,000; every year the lender receives $50 from ge, and at the end of 30 years
the investor/lender gets their $1,000 back.
Bonds differ from stocks in that they have a stated earnings
rate and will provide a regular cash flow, in the form of the coupon payments
to the bondholders. This cash flow contributes to the value and price of the
bond, and affects the true yield (or earnings rate) bondholders receive; there
are no such promises associated with common stock ownership.
After a bond has been issued directly by the company, the
bond then trades on the exchanges. as supply and demand forces take effect, the
price of the bond changes from its initial $1,000 face value. on the date the
ge bond was issued, a 5% return was acceptable given the risk of ge, but if
interest rates go up and that 5% return becomes unacceptable, the price of the
ge bond will drop below $1,000, so that the effective yield will be higher than
the 5% coupon rate.
Conversely, if interest rates in general go down, then that
5% ge coupon rate starts looking attractive, and investors will bid the price
of the bond back up above $1,000. When a bond trades above its face value, it
is said to be trading at a premium; when a bond trades below its face value it
is said to be trading at a discount. if you ever trade bonds, understanding the
difference between your coupon payments and the true yield is critical.
There are three common types of bonds available for general
sale, each of which offer different levels of security and projected earnings:
TREASURIES: u.s. treasury bonds carry the full faith and
credit of the u.s. federal government, eliminating much of the risk associated
with investments. as you can imagine, in return for this minimized risk, your
earnings rate will be less than more “exotic” investment choices.
Treasuries, particularly the 3-month treasury bill, are
sometimes quoted as the “risk-free rate of return,” the minimum rate of return
an informed investor will accept for enjoying the minimum risk. in the real
world there is no true risk-free investment, although treasuries do come close.
below is a snapshot of the government Bond page from Bloomberg.com:
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[Investing 101 - Wall Street Survivor # Page 14]
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You should also understand the meaning of a yield curve, as
displayed on the bloomberg.com screenshot opposite. a yield curve is the
relationship between the interest rate offered and the time to maturity of an
investment. While all investments have a yield curve, many traders and
economists closely follow the yield curve of treasuries of different maturities
to help make other financial decisions and projections.
CORPORATE BONDS: These bonds can be quite secure or sometimes
risky; their inherent value is greatly determined by the creditworthiness of
the corporation offering them, and corporate stability can change over time.
for example, until 2009, most bonds offered by u.s. automakers implied good
levels of security. The bankruptcies of gm and chrysler, combined with serious
financial problems at ford Motor company, generated much higher risk factors
for their corporate bonds. typically, however, corporate bonds are more secure
than corporate stocks.
MUNICIPAL BONDS: states, cities, or other local governments
often issue bonds to raise money to fund services or infrastructure projects
(road and bridge repair, sewers, purchasing open land, etc.). The primary
advantages to investors are security and tax benefits; most municipal bonds
offer interest earnings that are exempt from federal taxes. in addition, if you
are a resident of the state in which you own one or more municipal bonds issued
by local governments, your earnings may also be exempt from state or local
taxes. never assume a high security factor, however — some local governments
may be in dire financial condition and your risk factor may outweigh any tax
benefits you enjoy.
TIP!
Bonds are not nearly as liquid as stocks and ETFs, and
therefore there is not nearly as much information about them publicly and
freely available. If you are going to buy bonds, always buy them from a
reputable source and always check to make sure you are getting a fair price.
[Investing 101 - Wall Street Survivor # Page 13 - 15]
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