- Bond Pricing & Risk
- Buying a Bond Mutual Fund
For some reason, stocks are much more understood than bonds. Bonds are nothing more than loan to an entity, aka a debt investment, with the promise of the entity to pay interest in some form and repay the principal back after a pre-arranged duration. Perhaps it is because we have to crunch actual numbers to understand the value of bonds instead of just sticking our finger in the air and saying, “that looks about right!” Either way, we hope to show bonds are nothing to be scurred of. In fact, we are all probably aware of how bond pricing works if we have at one time taken on debt. With bonds, you are just on the other side of the table. And after our series, a reader should be able to make educated decisions about investing in bond mutual funds.
Bonds have 4 major characteristics: Issuer, Priority, Coupon Rate and Redemption Features.
Issuer is no more than the person, company or government who has debt and who is borrowing the money from you. Examples of issuers are Corportations, Municipalities, Governments and International. Within two of these categories, Government and International, we will drill a deeper into further sub-categories.
Corporations are nothing more than businesses which need your money. You can buy corporate bonds, either new issue or secondary through your broker.
Ok, so municipalities (munis are they are often referred as) are a type of government. But these are local governments (cities, counties, states) which take on debt to fund their projects (such as our favorite project, a toll road). One interesting thing about municipal bonds is they can be tax free (state income tax) for the state which they are issued in. So, if you live in California and buy California muni bonds you can skate tax free from the state.
Here in the US, when we say Government treasuries, we mean the issue of debt by the federal government. These are often referenced in 3 different ways. A US government bond has a maturity of 10 yrs or more. A US government note has a maturity of 1 to 10 yrs and a T-bill‘s maturity is less than 1 year.
International Bonds, Foreign or Corporate, are for entities outside of your home country and/or your home countries currency. These become increasingly more complicated because you have to deal with fluctuations of the currency market as well. These are probably best suited for the professionals and if investing in foreign debt via bonds is your thing, find a mutual fund. There are three major sub-categories of international bonds: 1) Eurobonds, 2) foreign bonds and 3) Global bonds. Why does Europe get their own class of international bonds? They don’t. The name Eurobonds has absolutely nothing to do with the European Union or Europe as a continent. Eurobonds are bonds which are issued in a currency different from the currency used by the country which the bond was issued from. So, we would say there are Euroyuan or Eurodollars (Bonds issued in yuan and dollars, respectively, in countries which do not use those currencies). For example, a bond issued from the US but in Brazilian real would be called a Euroreal. Foreign bonds are foreign entities (corporations, governaments) which use the currency of the country they are issuing the bond in. For example, Yankee bonds use US dollars, are issued in the US, but are for entities outside of the US. Global bonds are offered in both Eurobond and Foreign Bond markets.
Priority refers to the place you get to stand in line when shit hits the fan. Generally, there are two types of priority, Junior (aka subordinated) and Senior (aka unsubordinated). Senior debt is given first priority and must be repayed, in theory, before all other debt is repayed. We think of this as being in the front of the line. Junior debt is after all other types of debt are repayed. This is the back of the line. Obviously, the more risk one carries of the bond issuer going bankrupt or liquidating, junior debt will carry a higher yield than senior debt.
Coupon Rate is often referred to as the interest rate or yield. But there are various types of coupon rates. Straight refers to an unchanging rate which pays over the bonds time of issue. Floating rate (or floaters) pay an interest rate according to a ibenchmark (e.g. 6 month T-bill rate + 0.5%). Inverse Floaters pays according to set rate less a variable benchmark (e.g. 5% – 6 month T-bill rate). Zero Coupon do not pay a rate. These bonds promise a set amount at maturity date (e.g. a zero coupon will be worth $1000 in 10 years, so you give them $905 today and they pay $1000 in 10 years).
Redemption Features are additional benefits, either to the issuer or bond holder or both, which can help to protect from interest rate risk. Callable bonds give the issuer the right to prematurely pay back the debt. This option is often exercised when interest rates decline and the debt will be re-issued (sold) at lower interest rates. Convertible bonds give the bond holder the right to convert their bond to a predetermined amount of shares and on a predetermined schedule. This is a right, not an obligation. Puttable bonds offer interest rate protection for the bond holder. The bond holder has the right (again, a right, not obligation) to sell the bond back to the issuer at predetermined prices and a predetermined schedule. If interest rates rise, the bond holder can sell back the bond and get back in at higher interest rates.
And of course you can find just about any mix or match of these. The exception being, it will be tough to find government convertible bonds.