Bonds

Sep 20, 2011 | By: Mr_Blue | Tags: bonds, personal finance

Here’s an introduction to bonds.

A bond is a loan or a debt between bond issuer (borrower) and bond holder/owner (lender). Like a loan or debt, a bond must be paid back with interest or at some rate of return. A bond holder, obviously, has no ownership interest in bond issuer - unlike a stock holder/owner.

There many types of bonds. Here are the more typical ones:

  1. Treasury securities - Treasury Bills - mature one year or less; Treasury Notes - mature one to ten years; Treasury Bonds - mature 20 to 30 years; and Treasury Inflation Protected Securities (TIPS).
  2. Federal government agency bonds - such as Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae) - there bonds are typically backed by the ‘full faith and credit’ of U.S. government.
  3. Government Sponsored Entities bonds - such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae) and the Federal Home Loan Banks provide credit for the housing sector and Federal Agricultural Mortgage Corporation (Farmer Mac).
  4. State and municipal bonds - these can be in form of “revenue bonds” or “general obligation bonds”
  5. Corporate bonds - issued by corporations such as General Electric.

A bond is at face value (or par value) - usually $1,000 or $5,000. The bond issuer promises to pay bond holder the face value or principal at some specified future date known as the maturity date. To compensate the bond holder for paying principal at maturity date, issuer agrees to pay interest to bond holder at some coupon rate.

For example, let’s say you buy four - 10 year bonds at face value of $1,000 and pay 6% coupon rate. As a bond holder, you would receive $240 per year for 10 years and then receive $4,000 on the maturity date. Now, this example assumes a fixed coupon rate but many bonds have a floating rate - a coupon rate tied to some index rate such as London Interbank Offer Rate (LIBOR).

Now, the above example as assumes you buy bond in primary market or initial offering. But most bond investors buy bonds in the secondary market or bond market. This is where bond prices become relevant because bond prices do fluctuate over time. Bond pricing can be tricky for someone new to bonds. Let’s start with pricing convention - bond are priced as a percentage of par value. For example, you might see a quote in Bloomberg for 101-19 (dash or colon represents 32nds of a dollar for 10 year Treasury Note, this means the bond price is 101-19/32% of $1,000 or $1,015.94. In this example the bond price was above par value (101-19) this is known as a premium. Bonds trading below par value (say 99-27) are trading at a discount.

There are a number of factors that effect the price of bonds including issuer’s credit rating, inflation expectations, supply/demand of debt issues, and economic outlook. These factors and a few others such as reinvestment risk are reflected in market yield or bond yield. Generally, bond investors demand higher market yield or bond yield to compensate for higher risk. And this is where it sometimes gets tricky but it’s very important to understand: Bond price and market/bond yield have an inverse relationship - when market/bond yield goes up, bond price decreases; and when market/bond yield goes down, bond price increases.

So much for an introduction. Any questions?

Like all investments, before investing make sure we understand what we are getting ourselves into. For information on investing in bonds - check out - InvestinginBonds.com. Good luck.

 

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