The risks of owning bonds

Thursday, October 11, 2018 | MarketBeat Staff
The risks of owning bonds

In a diversified portfolio, investors should be invested in stocks, bonds, and cash. Stocks are the part of a portfolio that focuses on growth. Bonds are a different story. Bond investors are trading growth for security. This is why many investors will shift their portfolio away from stocks and towards bonds and cash as they get closer to an investment goal such as retirement. This is because a quality bond offers bondholders the security, and certainty of regular interest payments, and no loss of principal when the bond matures.

This article will give you a deeper understanding of what a bond is and the common terms related to bonds. We’ll also explain how a bond’s interest rate (or yield) is determined, what are the risks associated with bonds, and review the different kinds of bonds.

What is a bond?

A bond is a type of fixed-income security that can be thought of like a credit instrument by the issuing party. When corporations and governments desire to raise money to fund their operations, they can obtain a bank loan or they can issue bonds.

When a company offers a bond it receives money from the bondholder at the par value (or face value) of the bond. The bondholder is now the creditor to which the issuer of the bond owes not only regular interest payments (called coupon payments) but also a return of the face value of the bond when the bond reaches maturity. In some cases, the bondholder may have to pay an amount above or below the par value of the bond to obtain the bond. However, at maturity, they will receive the par value of the bond.

For example, if an investor purchases a $1,000 bond from Company X at a premium of $1,050, they will only receive $1,000 at maturity. Bond holders can typically receive more than face value for a bond when prevailing interest rates are lower than the coupon payments the bondholder can get from purchasing the bond.

Conversely, if an investor purchases a $1,000 bond from Company Y at a discount of $950, they will receive $1,000 at maturity. This makes the bonds more desirable to purchase. Bond issuers will typically have to accept less than the face value of a bond if the prevailing interest rates are higher than what the bondholder can get from holding on to the bond.

Common terms related to bonds

Whether it’s a corporate or government bond, bonds share a common language. Here are some of the common terms investors should be familiar with as they relate to bonds.

  • Face value (also called par value)– Simply put, this is the amount of money the bond will be worth at maturity. It is also the value that interest payments (or coupon payments) are based on. In our example above if an investor paid $1,050 for a $1,000 bond, they will receive $1,000, not the $1,050 they paid for the bond. Conversely, if the bondholder had paid $950 they will receive $1,000 at maturity, not the $950 they paid when they purchased.
  • Coupon rate– is the interest rate the issuer of the bond pays to the bond holder. The coupon rate is based on the face value of the bond and expressed as a percentage. If interest rates rise before the bond matures, the coupon rate remains the same as when the bond is purchased. In our example above if the bonds that Company X and Company Y issued were both offering a 5% coupon rate, each bond holder would receive $50 coupon payments regardless of the price they paid for the bond.
  • Coupon Dates – these dates let the bond holder know when the issuer will make their interest (or coupon) payments. These payments are usually made on an annual or semi-annual basis.
  • Maturity Date – this is the date when the bond is said to mature and the issuer pays the owner of the bond the face value of the bond.
  • Issue Price – this is the original market price the bond is sold for. If the bond sells above its face value, the “issue” is said to be selling at a premium. If the bond sells below its face value, the “issue” is said to be selling at a discount.

How is a bond’s interest rate determined?

The interest rate of a bond is set by two factors. The first is the credit rating of the bond issuer. This is similar to what consumers experience when they seek a bank loan. Companies with a poor credit rating will probably see their bonds trading at a discount as prospective buyers assess the potential default risk with the price they pay for holding the bond. Also, non-investment grade bonds will typically offer higher coupon rates than more stable corporate or government bonds. This is a cautionary tale to investors that try to chase a high yield. Bond investing is about security. A company or government bond with a yield that seems too good to be true may indicate an underlying problem.

The other factor that determines the interest rate on a bond is the length of maturity. In general, the longer a bond issuer is asking you to hold the bond before maturity will dictate a higher interest rate as a reward. This, however, reflects normal market conditions with a yield curve that shows long-term rates being higher than short-term rates. In a case where the yield curve is flattening or inverting, investors may see higher interest rates on short-term bonds.   

The risks of owning bonds

The ability to purchase bonds above or below their face value is part of the opportunity cost of owning a bond. When an investor owns a bond, they are choosing to not use that money for other investments. As a bond issuer, you have to either offer a significantly higher rate of interest or allow the buyer the opportunity to purchase the bond at a discount to its face value.

Another potential risk to bond owners is the potential for default. If an investor is buying U.S. Treasury bonds the risk of default is virtually zero since, in the worst case scenario, the government can print money to ensure that the bondholder receives their payment. However, if the company is buying a corporate bond, they will want to assess the company’s ability to make the regular coupon (or interest) payments as well as the full face value at maturity. One fundamental analysis tool that can be used for this purpose is to look at a company’s cash flow statement and review their free cash flow. A company with a free cash flow number of near 0 or is negative may be an indication that the company may have difficulty paying its debt obligations.

Second tool investors use to determine the default risk for a bond issuer is to look at the bond rating. Bonds are grouped into two categories: investment grade and non-investment grade. As you might guess, investment-grade bonds have lower default risk. Non-investment grade bonds, also called junk bonds, generally have a higher default risk. At the same time, they will offer a higher yield. An easy way to determine if a bond is investment grade is to look at how the bond is graded by Standard & Poors. A bond with any of the following grades (AAA, AA, A, or BBB) is investment grade. Any bond with a grade of BB or below is considered non-investment grade.

Understanding the different types of bonds

Most investment grade bonds are sold on major exchanges. They can be divided into three categories.

  • Corporate bonds – as the name suggests, these bonds are issued by companies.
  • Municipal bonds – these bonds are government bonds issued by a state or municipality. One of the attractive features of a municipal bond is that residents of the municipality can receive tax-free coupon income. For most bonds, a bond holder has to pay taxes on the coupon payments.
  • S. Treasury Securities – these are broken up into Treasury bonds (which have maturity dates greater than 10 years), Treasury notes (which have maturity dates of 1-10 years) and Treasury bills (that have a maturity date of less than one year).

There are also several varieties of bonds within each category.

  • Zero-coupon bonds – these are attractive options for individuals who might be setting money aside for something like a college education. A bond holder does not receive regular coupon payments. However, they can purchase these bonds sell at a large discount and that market price converges to face value at maturity. So in this case, the discount of the bond will be equivalent to the anticipated yield of a similar coupon bond. For example, if an owner were to buy a 10-year, $10,000 bond that paid 5% interest. With a coupon bond, they would pay $10,000 and receive regular payments of $500 and $10,000 upon maturity. With a zero-coupon bond, they would pay a price for the bond that is equal to the compounded interest the bond would receive until maturity. So while an investor forfeits the regular coupon payments, they still receive $10,000 upon maturity.
  • Convertible bonds – these are bonds that give investors a call option for converting the bond into stock if the company's share price were to rise to a level that would make the conversion attractive.
  • Callable and Pullable bonds – these are corporate bonds that allow the issuer to “call back” the bonds from their bond holders if interest rates drop to a sufficient level. Pullable bonds give the bond holder the option to return the bond to the issuer if interest rates rise. However, these kinds of bonds are rare. Most corporate bonds are considered bullet bonds, meaning they have no call or pull options and payout at face value upon maturity.

The final word on bonds

As an investor, investing in bonds requires a different mindset than stock investing. Instead of buying shares (or pieces of ownership/equity) in a company, you are agreeing to lend the company or government money for a fixed period of time (called the maturity date). In return, the issuer of the bond agrees to pay you regular interest payments (called coupon payments) that are determined when you purchase the bond.

Bond investing also is a tactical shift away from growth that can come from equity and to the security provided by bonds. While bonds can represent a portion of every investor’s portfolio, they will generally take up a larger percentage of a portfolio as an investor nears retirement and it’s time to lock in the gains that they have achieved over the years.

The primary risk of owning a bond is that the issuer may default and not be able to make their scheduled coupon payments and/or pay the face value of the bond at maturity. To help lessen the risk, bond investors can buy U.S. Treasury instruments which come with virtually no risk of default or look for high-quality (i.e. bonds with a grade of BBB or higher) bonds.

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