Bonds are a core element of any financial plan to invest and grow wealth.
If you are just beginning to consider investing in bonds,
use this section as a resource to educate yourself on all the bond basics.
WHAT ARE BONDS?
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you lend money to the issuer of the bond. That issuer could be a corporation, government, agency or other entity. In return, the issuer agrees to pay you a specified rate of interest over the life of the bond and to repay the face value of the bond when it reaches maturity There are a wide range of bonds available to investors, such as corporate bonds, mortgage bonds and sovereign bonds.
WHY INVEST IN BONDS?
Whatever the purpose - saving for a new home, ensuring your retirement income or other financial goals - investing in bonds can help you achieve your objectives and play an important role in a diversified portfolio. Typically, bonds pay interest semi-annually, providing a predictable stream of income. Many people invest in bonds for the interest income and to preserve their capital investment. Understanding the role bonds play in a diversified investment portfolio is especially important for retirement planning.
HOW TO INVEST IN BONDS?
There are several ways to invest in bonds, including purchasing individual bonds directly, or investing in bond funds or unit investment trusts. There is a wide variety of individual bonds to choose from in creating a portfolio that reflects your investment needs and expectations. If you are interested in purchasing a new bond issue in the primary market (when it is first issued), your advisor will provide you with the prospectus and offering document. You can also buy and sell bonds in the secondary market, after they have already been issued in the primary market.
TYPES OF BONDS:
Secured bonds are backed by collateral. Types of collateral used to secure a bond can include cash, other types of securities, or physical assets such as real estate or equipment. If the bond issuer defaults, the secured debt holders have first claim to this collateral.
Unsecured bonds are not backed by any specific collateral. In the event of a default, bond holders take their place as priority creditors of the issuer, as described above. Unsecured debt will generally offer a higher interest rate than those offered by secured debt due to a higher level of risk. Within the category of unsecured bonds, some may be senior bonds and have priority in making claims over those who hold subordinated bonds. A subordinated bond will typically offer a higher interest rate due to the higher level of risk.
KEY FACTORS TO CONSIDER WHEN INVESTING IN BONDS
While bonds have been around for centuries, the most recent surge in activity has come from investors who are searching for the age-old combination of safety and income. Many individual investors have some experience with equity markets, but there are volatility risks. At the same time, very high-quality fixed-income markets like Government Bonds are near all-time lows in yields. The obvious, but important, question investors are trying to answer when looking at corporate credit is the extent to which a company will be both willing and able to pay coupon and principal. Most corporate bonds are structured to have a principal payment at maturity that is equal to the original investment amount (e.g., there is no amortization as only interest payments are made between the initial sale of debt and the maturity of the bond). Most companies depend upon the market to "roll over" or refinance their debt, which can be difficult when that rollover is supposed to occur during a period of either market or individual company stress. You need to review certain variables when evaluating the potential performance of a bond. The most important aspects in evaluating bond performance are the price of the bond, the interest rate and yield, the maturity and the redemption features. Analysing these key components allows you to determine whether a bond is an appropriate investment. The yield that you will receive on the bond impacts the pricing. Bonds trade at a premium, at a discount or at par. If a bond is trading at a premium to its face value, then the prevailing interest rates are lower than the yield the bond is paying. Hence, the bond trades at a higher amount than its face value, since you are entitled to the higher interest rate. A bond is trading at a discount if the price is lower than its face value. This indicates the bond is paying a lower interest rate than the prevailing interest rate in the market. Since you can obtain a higher interest rate easily by investing in other fixed income securities, there is less demand for a bond with a lower interest rate. A bond with a price at par is trading at its face value. The par value is the value at which the issuer will redeem the bond at maturity.
The price of a bond is based on variables like interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par (100% of the face value). Bonds traded in the secondary market, however, fluctuate in price in response to changing factors such as interest rates, credit quality, general economic conditions and supply and demand. 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.
The maturity of a bond is the future date at which your principal will be repaid. Generally, bond terms range from one year to 30 years. Short-term bonds are generally considered comparatively stable and safer because the principal will be repaid sooner and therefore usually offer lower returns.
Conversely, longer-term bonds typically provide greater overall returns to compensate investors for greater pricing fluctuations
and other market risks. Short-term bonds have maturities of one to five years. Medium-term bonds have maturities of five to 12 years.
Long-term bonds have maturities greater than 12 years. The maturity of a bond is important when considering interest rate risk.
Interest rate risk is the amount a bond's price will rise or fall with a decrease or increase in interest rates.
If a bond has a longer maturity, it also has a greater interest rate risk.
Term ranges are often categorized as follows:
Short-term: maturities of up to 5 years
Medium-term: maturities of 5-12 years
Long-term: maturities greater than 12 years
Bonds pay interest that can be fixed, floating or payable at maturity. Fixed rate bonds carry an interest rate that is established when the bonds are issued (expressed as a percentage of the face amount) with periodic interest payments, typically semi-annual. Some issuers, however, prefer to issue floating rate bonds, the rate of which is reset periodically in line with the then prevailing interest rates on Treasury bills, the London Interbank Offered Rate (LIBOR), or other benchmark interest-rates. The third type of bond does not make periodic interest payments. Instead, the investor receives one payment at maturity of the face amount. Known as zero coupon bonds, they are sold at a substantial discount from their face amount. Valuation calculations may vary depending on the features of the bond. For zero-coupon bonds, since all accrued interest and principal are payable only at the bond's maturity, the prices of this type of bond tend to fluctuate more than those of coupon bearing bonds. They are sold at discounts to their face values.
ARE ALL INTEREST PAYMENTS FIXED RATE?
It is also important for an investor to determine whether a bond's coupon is fixed or floating rate. Fixed coupons offer a set percentage of the face value in interest payments. Floating rate bonds, on the other hand, have their coupon rate set by movements in the market's benchmark rates, such as LIBOR. Most floating rate bonds are issued with 2- to 5-year maturities, and usually by governments, banks, and other financial institutions. A bond's prospectus should fully educate buyers on the floating rate, including when the rate is calculated.
A bond's yield is closely related to the interest rate. The yield is the return earned based on the price paid for the bond and the interest received. Yield on bonds is generally quoted as basis points (bps). There are two types of yield calculations used. The current yield is the annual return on the total amount paid for the bond. It is calculated by dividing the interest rate by the purchase prices. The current yield does not account for the amount you will receive if you hold bond to maturity. The yield to maturity is the total amount you will receive by holding the bond until it matures. The yield to maturity allows for the comparison of different bonds with varying maturities and interest rates.
THE LINK BETWEEN PRICE AND YIELD
From the time a bond is originally issued until the day it matures, or is called, its price in the marketplace will fluctuate. General market conditions, including prevailing interest rates, the bond's terms and credit rating and other factors affect that price. Because of these fluctuations, the value of a bond will likely be higher or lower than its original face value if you sell it before it matures. Generally, bond prices and interest rates tend to move in opposite directions. When interest rates rise, prices of outstanding fixed coupon bonds fall and vice versa. Prices of fixed coupon bonds move up and down inversely with interest rates to bring the yield of those bonds into line with the coupon rates of new bonds being issued.
WHAT ARE THE RISKS?
All investments carry some degree of risk - in general, the higher the risk, the higher the return. Conversely, lower levels of risk offer lower returns. That may mean you sacrifice the potential for higher returns in favour of a safer investment. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors - as well as others discussed with your financial professional - determine the value of a particular bond and whether it might be an appropriate investment for you. There are numerous risks involved with bonds as well as several management tools to assess, analyse, and ultimately help investors manage the risks they take on as they invest in bonds. Some specific types of risk of primary concern to investors in corporate bonds are: inflation risk, interest rate risk, liquidity risk, and credit risk.
Some bonds allow the issuer to redeem the bond prior to the date of maturity. This allows the issuer to refinance its debt if interest rates fall. A call provision allows the issuer to redeem the bond at a specific price at a date before maturity. Before investing, it's absolutely vital that investors perform a risk-disposition self-assessment. The goal is to determine how much risk they can or are willing to take on when investing in bonds.
The highest ratings are. Bonds rated in the BBB category or higher are considered investment grade; bonds with lower ratings are considered high yield, or speculative. Lower ratings suggest a bond that may have a greater risk of default. It is important to understand that the high interest rate that generally accompanies a bond with a lower credit rating is being provided in exchange for the investor taking on the risk associated with a higher likelihood of default. The rating agencies make their ratings available to the public through their ratings information desks and their respective websites. Rating agencies continuously monitor issuers and may change their ratings of such issuer's bonds based on changing credit factors. Usually, rating agencies will signal they are considering a rating change by placing the bond "under review". Not all credit rating agency evaluations result in the same credit rating, so it is important to review multiple credit ratings and related updates to properly evaluate the underlying credit risks. Bear in mind that ratings are opinions, and you should understand the context and rationale for each opinion. Investors should not rely solely on credit ratings as a measure of credit risk but, instead, use a variety of resources to assist in evaluation and decision making. Additional sources of information can be found online and include recent independent news reports, research reports and issuers' financial statements. Your financial professional can also serve as a valuable source of information and guidance.
Some corporate bonds, known as convertible bonds, contain an option to convert the bond into common stock instead of receiving a cash payment. Convertible bonds contain provisions on how, when the option to convert can be exercised and at what price. Convertibles offer a lower coupon rate because they have the stable return of a bond while offering the potential upside of a stock.
Bond funds let you diversify risks across a broad range of issues and opt for additional conveniences, such as having interest payments either reinvested or distributed periodically. Some funds are designed to follow a particular market or a specified index of bonds. These are often referred to as "index funds". Other funds are actively managed according to a stated objective, with bonds purchased and sold at the discretion of a fund manager. Unlike individual bond investments, a bond fund does not have a specified maturity date, because bonds are added to and eliminated from the portfolio in response to market conditions and investor demand, or to track an index. With open-end mutual funds, an investor is able to buy or sell a share in the fund at any time at the fund's net asset value. Because the market value of a bond fluctuates, a fund's net asset value will change to reflect the aggregate value of the bonds in the portfolio. As a result, the value of investment bond fund may be higher or lower than the original purchase price, depending upon how the underlying portfolio of bonds has performed. Closed-end mutual funds, on the other hand, are made up of a specific number of shares that are listed and traded on a stock exchange. The price of closed-end funds will fluctuate not only with the price of the underlying portfolio, but also the supply and demand of the shares of the fund, and so may be priced at, above, or below the net asset value of the fund's holdings.