What are Bonds? – Bonds for Investment
Bonds are securities that represent debt, and can usually be categorized as being issued by local governments (i.e., municipal bonds issued by cities or states), national governments (US Treasury or Sovereign Bonds), or corporations (corporate bonds issued by companies like General Motors). When one decides to buy bonds, they are essentially buying an I.O.U. that will guarantee the return of principal (face value) and interest (coupon to be paid at an agreed upon schedule). It is interesting to note that economists estimate that roughly 80% of the world’s securities investment wealth is invested in bonds, while only 20% is in stocks. It would seem that a majority of people are concerned about preserving what they have rather than taking risks to gain more.
Bonds are rated by rating agencies that assess the risks associated with the issuer’s level of indebtedness relative to its ability to repay. Moody’s, Standard and Poor’s, and Fitch are the three primary agencies, although there are others. “Investment grade”, which usually implies a safety rating suitable for pension and other institutional money with relatively low chance of default, is between AAA and BBB-. Anything below that is considered riskier, and is called a “junk bond” in Wall Street parlance.
Most people get their first exposure to bonds as children, when they are given gifts in the form of savings bonds, which are zero coupon bonds with an extended maturity. That means that they are sold at a discount to its face value, or par amount, and are redeemable at full face value at maturity. For example, a $50 savings bond payable in 20 years can sell at a 50% discount ($25), and is redeemable at a full $50 at maturity. The interest yield would be a calculation based on the amount of discount versus the amount of time left before maturity.
Municipal Bonds in the U.S. are also referred to as Tax Exempt Bonds, since the yields are not subject to taxation by Federal or State governments. In high tax areas, like New York City, NY issued Municipal Bonds are high in demand, since they are triple tax free, which also includes exemption from local taxes.
Corporate bonds are an important tool for corporations to raise capital without selling equity in their companies. In the 80′s, junk bond financed Leveraged Buy Outs allowed for the creation of Turner Broadcasting and other famous companies.
Yields on bonds are inverse to their market price. For example, XYZ issues a bond with a 5% coupon at par ($1000) with a maturity of 10 years. If the demand for the XYZ bonds goes up, then the price of the bonds will rise above par, so instead of $1000 per bond, it may sell at a premium for $1005 or even higher. As a result, the 5% coupon yield to one who will buy bonds is less due to the higher price of the bond at purchase. Conversely, if the bond’s price falls below par, say to $995 or lower, than the 5% coupon is actually paying a higher yield since the base purchase price is lower.
Historically, bonds are less volatile than stocks and the annual calculated return on a bond via its coupon and/or market appreciation is preferred by many investors and accountants who want to plot out their annual fixed income revenue stream from investments. Of late, however, news events have made bonds somewhat more volatile. The recent S&P downgrade of US debt, the pending default of Greece and other European nations, and the regulatory and liquidity problems faced by international banks have added an increased speculative angle to the bond markets.