A Lesson You’ll Bond With- Part 2Monday, November 1st, 2010 by Charles Mayfield, CFP®
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In Part One of “A Lesson You’ll Bond With” we discussed the basic components of a bond and the various issuing sources for them. This week we will focus on the nature of bonds, how they react and why they react the way that they do. When evaluating your retirement plan, it is so vital to fully understand the role bonds play in your overall portfolio, and should play in any investor’s portfolio.
Let’s focus on two distinct areas: Coupon Rates, Pricing.
Coupon Rate: The coupon rate is the annual interest rate that the bond issuer (borrower) promises to pay the bond holder (investor). This interest rate is typically fixed for the life of the loan. Coupon rates will vary depending on several factors.
- Credit worthiness: Debt issued by the US Government is typically thought of as the ‘safest’ investment out there. The government will always pay its obligations, even if it has to print the money to do it. The safer the investment, the lower the interest rate (coupon) that is promised on that debt. Across the spectrum of bond issuers, government debt will almost always pay the lowest rates in the market, as it has the lowest perceived risk of default.
- Maturity: The longer the debt is issued for, the higher the coupon will usually be. In other words, a 10-year note may be paying a 4% coupon. Debt issued by the same agency on a 5-year note will pay a lower coupon, say 2%. There is a cost to the lender associated with tying money up for a longer period of time.
- Tax Incentives: Bonds issued by state and local governments, or any agency that receives exempt status from Federal taxes, will usually pay a slightly lower coupon. If the interest the bond holder receives is tax free (at the Federal level), the effective interest rate can be slightly lower.
Pricing (the Market Price): Bonds come to market at Par Value (Corporate Bonds- $1,000; Municipal Bonds- $5,000 & Federal Bonds- $10,000). The market price of a bond is the present value of all future principal and interest payments. The Yield (or the return that you get on a bond) and price of a bond are inversely related. From the moment the Bond hits the trading floor, its price can begin to fluctuate, though the coupon rate—your annual interest payment—will remain the same. When a bond’s price in the market drops, the yield goes up—an investor has the potential to get “more for their money.” Consider the equation: Yield = Coupon rate/Bond Price.
- If you buy a bond at 1,000 with a 10% coupon ($100), your Yield is 10% – $100/$1000
- If the bond price dropped to $900 before you bought it, your Yield would be over 11%, as you would still get $100 annually, but on a bond that you purchased for only $900 – $100/$900 = 11.11%
- If the bond price rose to $1100 before you bought it, your Yield would drop to almost 9%, as you would still getting $100 annually, but on a bond that is now selling above it’s Par Value, you spent $1100 now to get the same $1000 at maturity – $100/$1100 = 9.09%
Bond prices will fluctuate based on two primary factors:
- Prevailing Interest Rates: Since we know interest rates are inversely related to bond prices, a newly issued debt will affect existing bonds if the interest rate is higher or lower. A new 10-year bond issued at 8% interest will cause the price of another 10 year bond paying 7% to fall. Conversely, if the new issue only pays 6%, the price for the existing bond that pays 8% will rise.
- Credit Worthiness (although in a different way): Rating agencies will assign a rating to most bonds; this rating is an interpretation of the bond’s risk. Put another way, the rating is an attempt to categorize the risk involved and give a general idea of the likelihood that the issuer will be able to make the interest payments and pay back the proceeds at maturity. This rating can change at various points in the bonds life depending on the financial stability of the issuing company or municipality. All other factors being equal, a bond with a higher rating will most certainly fetch a higher price than a similar bond that has a lower rating. The idea here being that an investor is willing to pay a ‘premium’ for the higher likelihood he or she will get their money back.
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.