4 basic things to know about bonds (2023)

You want to strengthen your portfoliorisk-returnprofile? Adding bonds can create a more balanced portfolio by adding diversification and peace of mindvolatility. But the bond market can seem unfamiliar to even the most seasoned investors.

Many investors only make temporary investments in bonds because they are confused by the apparent complexity of the bond market and terminology. In reality, bonds are very simple debt instruments. So how do you enter this part of the market? Get started investing in bonds by learning these basic bond market terms.

Basic characteristics of bonds

INtapeit is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds. in trade forcapital, the company pays coupon interest, which is the annual interest paid on a bond expressed as a percentage of face value. The company pays the interest at predetermined intervals (usually annually or semi-annually) and repays the principal on the due date, terminating the loan.

In contrast toshares, bonuses can vary significantly depending on the terms of yourwriting, a legal document that describes the characteristics of the bond. Because each bond issue is different, it is important to understand the exact terms before investing. There are six important features in particular to keep in mind when considering a bond.

Types of bonds

corporate bonds

Corporate bonds refer to debt securities that companies issue to pay their expenses and raise capital. The yield of these bonds depends on the solvency of the company that issues them. The riskiest bonds are known as "junk bonds", but they also offer the highest returns. Interest on corporate bonds is subject to both federal and local income taxes.

Government bonds

Government bonds or government debt are debt securities issued by national governments to cover their expenses. Because issuing governments are highly unlikely to default, these bonds typically have very high credit ratings and relatively low yields. In the United States, bonds issued by the federal government are calledtreasure, while those issued by the United Kingdom are calledfirst timers. Treasury bonds are exempt from state and local taxes, although they are still subject to federal income tax.

municipal bonds

municipal bonds, or munis, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Income from municipal bonds is not subject to most taxes, making them an attractive investment for investors in higher tax brackets.

key concepts

Maturity

This is the date on which the principal or face amount of the bond is paid out to investors and the bond companyobligationTherefore, it defines the useful life of the bond. a bonusmaturityIt is one of the most important considerations for an investor to weigh his goals and investment horizon. Maturity is often classified in three ways:

• Short-term: Bonds that fall into this category tend to mature within one to three years.
• Medium-term: The maturity dates for this type of bond are usually longer than ten years.
• Long-term - These bonds typically mature over longer periods.

sure/not sure

A bond can be guaranteed or unguaranteed. TOguaranteed bonuscommits specific assets to bondholders if the company is unable to pay the obligation. This asset is also called collateral for the loan. So if the issuer of the bond defaults, the asset is transferred to the investor. TOmortgage-backed securities(MBS) is a type of collateralized bond that is backed by borrowers' home titles.

Unsecured bonds, on the other hand, are not backed by any collateral. This means that interest and principal are only guaranteed by the issuing company. Also calledobligations, these bonds return only a small amount of your investment if the company goes bankrupt. As such, they are much riskier than covered bonds.

settlement preference

When a company goes bankrupt, it pays investors in a certain order as it goes into liquidation. Once a company has sold all of its assets, it begins paying its investors.senior goddessit is the debt that must be paid first, followed by the subordinated (subordinated) debt.Shareholdersget what's left.

Coupon

Hecouponrepresents the interest paid to bondholders, usually on an annual or semi-annual basis. The coupon is also called the coupon rate orrated performance. To calculate the coupon rate, divide the annual payments by the face value of the bond.

tax situation

While most corporate bonds are taxable investments, some government andmunicipal bondsis tax free, so income andCapital gainsthey are not taxable.Tax-free bonds typically have a lower interest rate than corresponding taxable bonds. An investor must calculate the tax equivalent return to compare the return with taxable instruments.

callability

Some bonds can be paid by an issuer before maturity. If a bond has a collection provision, it can be paid at earlier times at the option of the company, usually with a smaller premium perstk. A company can choose to redeem its bonds ifRentergive them the opportunity to borrow at a better interest rate. Convertible bonds also attract investors because they offer better coupon rates.

Obligation risks

Bonds are a great way to make money because they tend to be relatively safe investments. However, like any other investment, they carry certain risks. These are some of the most common risks of these investments.

Interest rate risk

Renterthey share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa. Interest rate risk occurs when rates change significantly from what the investor expected. If interest rates fall significantly, it willinvestoris faced with the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument that yields below market rates. The longer the time to maturity, the greater interest rate risk an investor has, because it is more difficult to predict future market developments.

Credit risk/default

credit orDefault riskThere is a risk that due interest and repayments on the obligation will not be made as required. When an investor buys a bond, he expects the issuer to fulfill the interest andheadmasterpayments, like any other creditor.

When an investor looks at corporate bonds, they must weigh the possibility of the company defaulting on the debt. Security generally means that the company has higher operating income andcash flowin relation to your debt. If the opposite is the case and the debt exceeds the cash available, the investor may want to steer clear.

Risk of prepayment

PrepaymentRisk is the risk that a given bond issue will be paid off sooner than expected, typically through acall functionThis can be bad news for investors because the company only has an incentive to pay the liability early when interest rates have fallen significantly. Instead of continuing to invest in high interest rates, investors must reinvest funds in a lower interest rate environment.

bond ratings

Most bonuses come with oneclassificationthat describes your credit quality. That is, how strong the bond is and its ability to pay its principal and interest. The ratings are published and used by investors and professionals to judge your worth.

Agencies

The most commonly mentioned bond rating agencies are, Moody's Investors Service, yFitch ratings. They assess a company's ability to pay its obligations. Ratings range from AAA to Aaa for high-quality issues most likely to be redeemed to D for issues that are currently in default.

Bonds with a rating of BBB to Baaor above are called investment grade. This means they are unlikely to default and tend to remain stable investments. The BBto Baor rated bonds below are referred to asJunk bonds— default is more likely and they are more speculative and subject to price volatility.

Companies will not rate their bonds, and in that case it is solely up to the investor to assess a company's ability to pay. Because rating systems are different for each agency and change from time to time, research the definition of rating for the bond issue you are considering.

bond interest

bond interestthey are all return targets. Yield to maturity is the most commonly used measure, but it is important to understand several other measures of yield that are used in certain situations.

Yield to Maturity (YTM)

As mentioned above,Yield to maturity(YTM) is the most cited performance measure. It measures what the return is on a bond if it is held to maturity and all coupons are reinvested at the YTM rate. Because coupons are unlikely to be reinvested at the same rate, an investor's actual return will vary slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excel's RATE or YIELDMAT functions (as of Excel 2007). A simple function is also available in a financial calculator.

current performance

Hecurrent performancecan be used to compare the interest income from a bond withdivisionincome provided by an action. This is calculated by dividing the bond's annual coupon by the current price of the bond. Please note that this return only incorporates the income portion of the return, ignoring any capital gains or losses. As such, this yield is most useful for investors who are only interested in current income.

Nominal dividend

The nominal yield on a bond is simply the percentage of interest that will be paid periodically on the bond. It is calculated by dividing the annual coupon payment by the par ornominal valueIt is important to note that the nominal yield does not accurately estimate the return unless the current price of the bond is the same as its nominal value. Therefore, nominal performance is only used to calculate other performance measures.

Yield to Call (YTC)

A callable bond always has a certain probability of being called before the maturity date. Investors will notice a slightly higher pricemanufactureif the required bonds are canceled at a premium. An investor in such a bond might want to know what the return will be if the bond is called on a particular call date to determine whether the prepayment risk is worth it. The easiest is to calculateyield to callusing Excel's YIELD or IRR functions, or with a financial calculator.

achievement realized

Heachievement realizedof a bond must be calculated if an investor plans to hold a bond only for a certain period of time, rather than until maturity. In this case, the investor will sell the bond, and this expected future price of the bond must be estimated for the calculation. Because future prices are difficult to predict, this performance measure is only an estimate of performance. This return calculation is best done using Excel's return or IRR functions, or by using a financial calculator.

How do bonds pay interest?

There are two ways bondholders receive payment for their investment. Coupon payments are periodic interest payments over the life of a bond before the bond can be redeemed at face value at maturity.

Some bonuses are structured differently.zero coupon bondsthey are non-coupon bonds; the only payment is the redemption of the face value at maturity. Zeros are generally sold at a discount from face value, so the difference between purchase price and face value can be calculated as interest.

convertible bondsThey are a type of hybrid security that combines the characteristics of bonds and stocks. These are ordinary interest-bearing bonds, but they can also be converted into shares in the issuing company. This adds an additional profit opportunity if the issuing company shows large gains in its share price.

Bottom line

Although the bond market seems complex, it is actually driven by the same risk/return trade-offs as the stock market. Once an investor masters these few basic terms and measures to uncover familiar market dynamics, they can become a competent bond investor. Once you have mastered the language, the rest is easy.