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In comparing different bonds for potential investment, there
are three main factors to consider.
1) The characteristics of the issuers
· How secure is the bond? Can you be sure the issuer
will pay you back?
· Is the issuer a governmental entity that might allow you to qualify
for tax-free income?
2) The type and amount of interest they pay
· How much will you be paid? How many payments
are there in a year (is it monthly, quarterly, or less often)?
· Is the coupon rate
always the same or can it change (fixed
or floating)?
3) The terms of repayment
· Is the principal
only payable at the end of the time period (straight
bonds)?
· Can the issuer, under certain conditions, repay the principle
early and end the loan obligation (callable
bonds)?
· Can the borrower, under certain conditions, force the issuer to
repay the principle before the end of the time period (puttable
bonds)?
1) Characteristics of issuers:
When an individual applies for a credit card, a home loan,
or any other type of debt the bank or other financial institution
always checks the person's credit rating. Some companies like TRW
(now Experian) specialize in assessing the ability of millions of
individuals to pay back all of these IOU's. Depending on personal
credit ratings, financial institutions might charge different individuals
different interest rates for the same type of loan. In fact, we
all know that if one's credit rating is too low, they won't be able
to get any type of loan or even a credit card.
The importance of creditworthiness of a fixed-income issuer is just as important. Now that the shoe's on the other foot, you want to be reasonably sure that the bond issuer you loan money to is going to pay you back. At the very least, you would expect a higher return from a more risky investment. In general, the better the quality of the credit, the lower the interest rate offered to investors.
Just as with individual credit ratings, third party companies, such as Moody's and Standard and Poor's, determine the creditworthiness of bond issuing organizations. The rating scales developed by these companies start by defining United States Treasury Securities as the top quality level (despite all the jokes about the US' fiscal responsibility, they have never defaulted on a loan obligation). US Treasury Securities are considered risk-free and generally offer the lowest interest rates to investors. At the other end of the scale are the bond issues of cash-strapped and financially troubled corporations. These issues, often referred to as junk bonds, offer attractive interest rates and correspondingly higher levels of risk.
The full Moody's and Standard and Poor's rating scales can be found here.
2) The type and amount of interest they pay
Fixed Income investments are offered with varying terms to maturity,
ranging from very short term to thirty years (even some 100-year
bonds have been issued). The normal situation has longer maturities
yielding more than shorter maturities (see Understanding the Yield
Curve). Investors are thereby compensated for the increased risk
and uncertainty that goes with longer periods of time. Maturity
ranges can be broken up into four categories: 1. Money Market: maturities
up to one year 2. Short-term notes: maturities up to two years 3.
Medium-term notes: maturities two to ten years 4. Long-term bonds:
maturities greater than ten years.
A brief description of the various major Bond classes follows:
1. US Treasury Securities:
Us Treasuries are backed by the full faith and credit of The US
Government; consequently, they are, by definition, risk-free securities.
The market for Treasury securities is the most liquid securities
market in the world. Interest paid on US Treasury Bonds is exempt
from state and municipal taxation.
2. Municipal Obligations:
Municipal Bonds ("Munis") include issues from states, counties,
cities and other municipal tax districts. In addition, they include
obligations of state and local agencies, local commissions, community
colleges and universities and other local authorities. The wide
variety of issuers has generated a wide variety of issues. Federal
Law provides that income earned from Munis be exempt from Federal
Income Tax (though this favorable treatment does not extend to capital
gains earned on Munis and may be subject to the Alternative Minimum
Tax). Many states exempt their obligations from state taxation as
well.
3. Corporate Bonds:
Corporations of various levels of creditworthiness use the bond
market to raise capital to finance investment in technology, research,
business expansion and other general business purposes. Holders
of corporate debt have a senior claim on the underlying assets of
the corporation to owners of company stock.
4. Mortgage-Backed Securities:
A mortgage-backed security is an instrument whose cash flow depends
upon the cash flow from an underlying group, or pool, of specific
mortgages. Financial institutions pool similar loans together and
sell interests in the cash flows derived form the underlying pools.
Many of these securities are guaranteed by government agencies.
Only those backed by the Government National Mortgage Association
(GNMA) are backed by the full faith and credit of the US Government.
5. Asset-Backed Securities:
Asset-Backed Securities are an extension of the idea that loans,
such as mortgages, can be pooled together and then sold as securities.
These securities represent receivables on other types of debt including
automobiles, credit cards, equipment leases and other loan types.
6. Preferred Stock:
Preferred Stock is a hybrid security, having both equity and fixed
income components. The dividend on a preferred is fixed, and the
owners have a prior claim on company assets to holders of common
stock. The firm, however, unlike with a bond, is not legally required
to pay this dividend. Owners of preferred stock are not generally
given voting rights. Public utilities have been the main issuers
of preferred stock.
7. Convertible Issues:
Convertible Bonds are Bonds that can be exchanged for specified
amount of the common stock of the issuing firm. The terms of conversion
are provided in the bond's indenture.
Important terms include the stock price at which the bonds can be
exchanged (Conversion Price)
and the ratio of how many shares can be converted per Bond (Conversion
Ratio). Convertible Issues carry somewhat lower rates of interest
than their non-convertible counterparts.
8. International Bonds:
The term "International Bond" generally
refers to the home country of the issuing party (though it can refer
to the location of the primary trading market), be it a foreign
sovereign entity or a foreign corporation. Regardless of the domicile
of the issuing party, the price and yield of these bonds is primarily
affected by the currency of issuance. A French corporate Bond, for
instance, that is issued in US Dollars will be primarily affected
by general movements of US interest rates.
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Bond Funds