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KEY BOND INVESTMENT CONSIDERATIONS There are a number of key variables to look at when investing in bonds: the bond's maturity, redemption features, credit quality, interest rate, price, yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives. Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Typically, investors receive interest payments semiannually. For example, a $1,000 bond with an 8% interest rate will pay investors $80 a year, in payments of $40 every six months. When the bond matures, investors receive the full face amount of the bond--$1,000. |
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But some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index, such as the rate on Treasury bills. Some bonds have no periodic interest payments. Instead, the investor receives one payment--at maturity--that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the (original) interest rate. Known as zero-coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures. If the bond is taxable, the interest is taxed as it accrues, even though it is not paid to the investor before maturity or redemption. Maturity A bond's maturity refers to the specific future date on which the investor's principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years. Maturity ranges are often categorized as follows:
Redemption Features While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment. Call Provisions - For example, some bonds have redemption, or "call" provisions that allow or require the issuer to repay the investors' principal at a specified date before maturity. Bonds are commonly "called" when prevailing interest rates have dropped significantly since the time the bonds were issued. Before you buy a bond, always ask if there is a call provision and, if there is, be sure to obtain the "yield to call" as well as the "yield to maturity." Bonds with a redemption provision usually have a higher annual return to compensate for the risk that the bonds might be called early. Puts - Conversely, some bonds have "puts," which allow the investor the option of requiring the issuer to repurchase the bonds at specified times prior to maturity. Investors typically exercise this option when they need cash for some purpose or when interest rates have risen since the bonds were issued. They can then reinvest the proceeds at a higher interest rate. Principal payments and Average Life - In addition, mortgage-backed securities are typically priced and traded on the basis of their "average life" rather than their stated maturity. When mortgage rates decline, homeowners often prepay mortgages, which may result in an earlier-than-expected return of principal to an investor. This may reduce the average life of the investment. If mortgage rates rise, the reverse may be true--homeowners will be slow to prepay and investors may find their principal committed longer than expected. Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment you are seeking within your risk tolerance. Some individuals might choose short-term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long-term securities. Alternatively, investors seeking greater overall returns might be more interested in long-term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks as well as credit risk. Credit Quality Bond choices range from the highest credit
quality U.S. Treasury securities, which are backed by the full faith and
credit of the U.S. government, to bonds that are below investment-grade
and considered speculative. Since a bond may not be redeemed, or reach
maturity, for years - even decades - credit quality is another important
consideration when you're evaluating a fixed-income investment. When a
bond is issued, the issuer is responsible for providing details as to its
financial soundness and creditworthiness. This information is contained
in a document known as an offering document, prospectus or official
statement, which will be provided to you by your investment advisor. But
how can you know whether the company or government entity whose bond
you're buying will be able to make its regularly scheduled interest
payments in five, 10, 20 or 30 years from the day you invest? Rating
agencies assign ratings to many bonds when they are issued and monitor
developments during the bond's lifetime. Securities firms and banks also
maintain research staffs which monitor the ability and willingness of the
various companies, governments and other issuers to make their interest
and principal payments when due. Your investment advisor or the issuer of
the bond can supply you with current research on the issuer and on the
characteristics of the specific bond you are considering. |
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Credit RatingsIn the United States, major rating agencies include Moody's Investors Service, Standard & Poor's Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody's). Bonds rated in the BBB category or higher are considered investment-grade; securities with ratings in the BB category and below are considered "high yield," or below investment-grade. While experience has shown that a diversified portfolio of high-yield bonds will, over the long run, have only a modest risk of default, it is extremely important to understand that, for any single bond, the high interest rate that generally accompanies a lower rating is a signal or warning of higher risk. How can you find out if the credit factors affecting your bond investment have changed? Usually, rating agencies will signal they are considering a rating change by placing the security on CreditWatch (S&P), Under Review (Moody's) or on Rating Watch (Fitch Ratings). The rating agencies make their ratings available to the public through their ratings information desks. Many also provide online ratings information that can be accessed through the Internet. In addition, their published reports and ratings are available in many local libraries. Bond Insurance Credit quality can also be enhanced by bond insurance. Specialized insurance firms serving the fixed-income market guarantee the timely payment of principal and interest on bonds they have insured. In the United States, major bond insurers include MBIA, AMBAC, FGIC and FSA. (See glossary for list.) Most bond insurers have at least one triple-A rating from a nationally recognized rating agency attesting to their financial soundness, although some bond insurers bear lower credit ratings. In either event, insured bonds, in turn receive the same rating based on the insurer's capital and claims-paying resources. While the focus of their underwriting activities has historically been in municipal bonds, bond insurers also provide guarantees in the mortgage and asset-backed securities markets and are moving into other types of securities as well. Price The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount. Yield Yield is the return you actually earn on the bond--based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: Current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price. If you bought at $1,000 and the interest rate is 8% ($80), the current yield is 8% ($80/$1,000). If you bought at $900 and the interest rate is 8% ($80), the current yield is 8.89% ($80/$900). Yield to maturity and yield to call, which are
considered more meaningful, tell you the total return you will receive by
holding the bond until it matures or is called. It also enables you to
compare bonds with different maturities and coupons. Yield to maturity
equals all the interest you receive from the time you purchase the bond
until maturity (including interest on interest at the original purchasing
yield), plus any gain (if you purchased the bond below its par, or face,
value) or loss (if you purchased it above its par value). Yield to call
is calculated the same way as yield to maturity, but assumes that a bond
will be called and that the investor will receive face value back at the
call date. You should ask your investment advisor for the yield to
maturity or yield to call on any bond you are considering purchasing.
Buying a bond based only on current yield may not be sufficient, since it
may not represent the bond's real value to your portfolio. |
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