By John M. Gannon
Bonds can prove extremely helpful to anyone concerned about capital preservation and income generation. Bonds also may help partially offset the risk that comes with equity investing and often are recommended as part of a diversified portfolio. They can be used to accomplish a variety of investment objectives. Bonds hold opportunity - but, like all investments, they also carry risk.
This article explains what a bond is and provides an introduction to three concepts important to bond investing: maturity, coupons and yield.
These concepts are important to grasp whether you are investing in individual bonds or bond funds. The primary difference between these two ways of investing in bonds also is important to understand: When you invest in an individual bond and hold it to "maturity," you won't lose your principal unless the bond issuer defaults. When you invest in a bond fund, however, the value of your investment fluctuates daily - your principal is at risk.
A bond is a loan that an investor makes to a corporation, government, federal agency or other organization. These loans in turn are used by the pubic and private sectors to do all sorts of things - build roads, improve schools, open new factories and buy the latest technology.
Since bond issuers know you aren't going to lend your hard-earned money without compensation, the issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest.
The bond issuer also agrees to repay you the original sum loaned at the bond's maturity date. This is the date on which the principal amount of a bond is to be paid in full. A bond's maturity usually is set when it is issued.
Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. Whatever the duration of a bond, the borrower fulfills its debt obligation when the bond reaches its maturity date, and the final interest payment and the original sum you loaned (the principal) are paid to you.
Not all bonds reach maturity, even if you want them to. Callable bonds are common: They allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond's prospectus (or offering statement or circular) and the indenture - both are documents that explain a bond's terms and conditions. While firms are not formally required to document all call provision terms on the customer's confirmation statement, many do so.
You usually receive some call protection for a period of the bond's life - for example, the first three years after the bond is issued. This means that the bond cannot be called before a specified date. After that, the bond's issuer can redeem that bond on the pre-determined call date, or a bond may be continuously callable, meaning the issuer may redeem the bond at the specified price at any time during the call period.
Before you buy a bond, always check to see if the bond has a call provision, and consider how that might impact your portfolio investment.
A bond's coupon is the annual interest rate paid on the issuer's borrowed money, generally paid out semi-annually on individual bonds. The coupon is always tied to a bond's face or par value and is quoted as a percentage of par.
Say you invest $5,000 in a six-year bond paying a coupon rate of five percent per year, semi-annually. Assuming you hold the bond to maturity, you will receive 12 coupon payments of $125 each, or a total of $1,500.
Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market, you most likely will catch the bond between coupon payment dates. If you're selling, you're entitled to the price of the bond plus the accrued interest that the bond has earned up to the sale date. The buyer compensates you for this portion of the coupon interest, which generally is handled by adding the amount to the contract price of the bond.
Bonds that don't make regular interest payments are called zero-coupon bonds - zeros, for short. As the name suggests, these are bonds that pay no coupon or interest. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures. For example, you might pay $3,500 to purchase a 20-year zero-coupon bond with a face value of $10,000.
Yield is a general term that relates to the return on the capital you invest in a bond. You hear the word "yield" often with respect to bond investing. There are, in fact, a number of types of yield. The terms are important to understand because they are used to compare one bond with another to find out which is the better investment.
Coupon yield is the annual interest rate established when the bond is issued. It's the same as the coupon rate and is the amount of income you collect on a bond, expressed as a percentage of your original investment. If you buy a bond for $1,000 and receive $45 in annual interest payments, your coupon yield is 4.5 percent. This amount is figured as a percentage of the bond's par value and will not change during the lifespan of the bond.
Current yield is the bond's coupon yield divided by its market price. To calculate the current yield for a bond with a coupon yield of 4.5 percent trading at 103 ($1,030), divide 4.5 by 103 and multiply the total by 100. You get a current yield of 4.37 percent.
Say you check the bond's price later and it's trading at 101 ($1,010). The current yield has changed. Divide 4.5 by the new price, 101. Then multiply the total by 100. You get a new current yield of 4.46 percent.
Note: Price and yield are inversely related. As the price of a bond goes up, its yield goes down, and vice versa.
If you buy a new bond at par and hold it to maturity, your current yield when the bond matures will be the same as the coupon yield.
Yield-to-Maturity (YTM) is the rate of return you receive if you hold a bond to maturity and reinvest all the interest payments at the YTM rate. It is calculated by taking into account the total amount of interest you will receive over time, your purchase price (the amount of capital you invested), the face amount (or amount you will be paid when the issuer redeems the bond), the time between interest payments and the time remaining until the bond matures.
Yield-to-Call (YTC) is figured the same way as YTM, except instead of plugging in the number of months until a bond matures, you use a call date and the bond's call price. This calculation takes into account the impact on a bond's yield if it is called prior to maturity and should be performed using the first date on which the issuer could call the bond.
Yield-to-Worst (YTW) is the lower of a bond's YTM and YTC. If you want to know the most conservative potential return a bond can give you - and you should know it for every callable security - then perform this comparison.
For more detailed information about investing in bonds and bond funds, visit NASD's Smart Bond Investing Learning Center at www.nasd.com. In addition to educational information, this resource provides real-time bond quotations and tools such as an accrued interest rate calculator.