A Lesson You’ll Bond With- Part 1

Monday, October 25th, 2010 by Charles Mayfield, CFP®

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“Bond Basics”

Bonds are an integral part to any diversified portfolio.  They add needed diversification to balance the volatility of stocks.  In addition, the income they provide is a complement to the capital gains (and losses) of stocks.  Studies have shown that a diversified portfolio should have between 25 and 40% in bonds.

This three part series is going to get into the basics of a Bond and how it works.  Furthermore, I’d like to cover the factors relating to Bond performance and why they are so important to overall portfolio diversification.  In terms of personal finance and diversification, Bonds are often referred to as ‘fixed income’ instruments.  Another way to think of bonds are as ‘debt instruments’ because the issuer is actually taking a loan from the buyer. 

I want to stress that we are covering the basics here.

Face Value or Par Value:  This amount represents two figures.  The first the initial price at which a bond is issued.  In other words, what it sells for at its initial offering.  It also represents the amount the bond holder will be repaid when the bond matures.  I’ll address these different types of bonds in a later post.  However, for now, just know that Corporate Bonds have a Par Value of $1,000, Municipal Bonds are $5,000 and Federal Bonds are $10,000.

Maturity Date:  This one is pretty self explanatory.  All bonds have a stated maturity.  In other words, it’s when the issuer will repay the debt.  This is often referred to as the ‘term’ of the bond.  Maturity dates will vary with each bond and in some cases have no maturity date at all (Perpetual Bonds). Most bonds are issued with a term of up to 30 years.  When they are issued with a maturity of less than 12 months, they are generally considered money market instruments rather than bonds.  

Coupon:  This is the stated interest rate that the issuer promises to pay on the bond.  This term originated because early bonds were issued with coupons attached to them.  When the ‘coupon date’ (see below) came up, the bond holder would cut the coupon off and exchange it at a bank for the payment.

Coupon Date:  This term states the dates on which the issuer pays the bond holder.  Most bonds have a semi-annual coupon date.  So the holder of the bond receives two payments per year.

Bond Yield:  This represents what the bond is paying relative to the price at which you could sell it.  Since the interest rate on a bond is typically fixed, the bond holder’s yield will fluctuate as the price of the bond goes up or down.  Simply stated, to calculate the yield of a bond, divide the coupon amount by the price.  Here is a basic example of how yield can change:

You own a bond that pays you $100 per year and is worth $1,000.  The yield would be 10% ($100/$1,000).  Let’s assume for a moment that prevailing interest rates drop.  The price of your bond is now $1,100 (we’ll discuss why this happens in Part 2).  The yield is now 9.09% ($100/$1100).  You are being paid the same amount of money.  However, since your bond is worth more now, the yield is decreased.

Now that you know the basic language around a bond, let’s discuss the four main types.  A bond is generally classified by the primary assets underlying their issue.

Government Bonds / Treasury Bonds:  Often considered the safest form of bond, these bonds are back by the full faith and credit of the issuing government.

Agency or Mortgage Bonds:  These are typically secured by real property and issued or guaranteed by various government agencies.  Examples include Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).

Municipal Bonds:  Issued by state and local governments and agencies that are subject to certain tax preferences.  The payments from these bonds are typically exempt from federal taxes.

Corporate Bonds:  Corporations issue bonds as a means to raise money.  They are backed by the credit (ability to pay back the debt) of the issuing company.  The coupon rate for corporate bonds is typically higher than that of government issues due to the added risk that the company may not be able to repay the note.

High Yield Bonds: As its name implies, a high-yield bond pays a higher rate of interest than other corporate bonds.  These bonds are issued by corporations whose credit rating is less than “investment grade”.  Along with the higher interest rate, you get a higher probability that the issuer will default and not be able to pay the promised interest and principal.

Bonds are subject to market and interest rate risk if sold prior to maturity.  Bond values will decline as interest rates rise and are subject to availability and change in price.  Interest income may be subject to the alternative minimum tax.  Municipal bonds are federally tax-free but other state and local taxes may apply.  The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

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