Debt securities, also known as fixed income securities, are financial instruments that have defined terms between a borrower (the issuer) and a lender (the investor). Bonds, issued by a corporation, government, federal agency or other organization to raise capital, are a common type of debt security in which the borrower agrees to pay interest in exchange for the capital raised.
The vast majority of bonds have a maturity date that’s set when the bond is issued. On a bond’s maturity date, the borrower fulfills its debt obligation by paying bond holders the final interest payment and the bond’s face value, called par value.
Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium- or intermediate-term bonds are generally those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. Not all bonds reach maturity. Callable bonds, which allow the issuer to retire a bond before it matures, are common.
A bond’s coupon—or annual interest—is generally paid out semiannually. The coupon is set at issuance and tied to a bond's face or par value. It’s quoted as a percentage of par. For instance, a bond with a par value of $1,000 and an annual interest rate of 4.5 percent has a coupon rate of 4.5 percent ($45). An investor in a bond with a $45 annual coupon that pays interest semiannually can expect to receive a $22.50 interest payment twice per year.
Bonds and bond funds can be an important component of a diversified investment portfolio. They can be helpful for anyone concerned about capital preservation and income generation and can help partially offset the risks that come with equity investing.
Bonds are issued by many different entities, from the U.S. government, cities and corporations to international bodies. Some bonds, such as mortgage-backed securities (MBSs), can be issued by financial institutions. Thousands of bonds are issued each year and, even though bonds may share the same issuer, it’s a pretty good bet that each bond is unique. Most bonds are fixed income securities, meaning they provide fixed interest payments until the bond matures and the bond’s principal is returned to the investor.
Here are some of the most common types of bonds.
Companies issue corporate bonds to raise money for capital expenditures, operations and acquisitions. Corporates are issued by all types of businesses and are segmented into major industry groups.
When you buy a corporate bond, you receive the equivalent of an IOU from the issuer. While you don’t receive any ownership rights in the company, you’re more likely than common stockholders to receive some of your investment back if the company declares bankruptcy.
You have a wide range of choices when it comes to corporate bonds, their structures, coupons, maturity, credit quality and more. Most corporate bonds are issued with maturities ranging from one to 30 years and trade in the over-the-counter (OTC) market. Corporate bonds can fall under a number of classifications, including secured corporates, unsecured corporates, guaranteed and insured bonds and convertibles. A bond’s classification depends on its relationship to a corporation's capital structure.
Agency securities are bonds issued by U.S. federal government agencies (other than the U.S. Treasury) or by U.S. government-sponsored enterprises (GSEs). Most agency bonds pay a semiannual fixed coupon and are sold in a variety of increments, generally requiring a minimum initial investment of $10,000.
With the exception of bonds issued by Ginnie Mae, agency securities are not fully guaranteed by the U.S. government. The issuing agency will affect the strength of any guarantee provided on the agency bond. Evaluating an agency's credit rating before you invest should be standard procedure.
Municipal bonds, or muni bonds, are issued by states, cities, counties, towns villages, interstate authorities, intrastate authorities and U.S. territories, possessions and commonwealths to support their obligations and those of their agencies. They are generally backed by taxes or revenues received by the issuer.
Asset-backed securities (ABSs) offer returns based on the repayment of debt owed by a pool of underlying assets. There’s quite a range of assets that might constitute a given ABS, from a pool of home equity or car loans, to credit card receivables, or even movie revenues. Just about any stream of revenue could become securitized as an ABS.
Mortgage-backed securities (MBSs) are a type of ABS. These are bonds secured by home and other real estate loans. They’re created when a number of these loans, usually with similar characteristics, are pooled together by an entity that then issues securities. These securities represent claims on the principal and interest payments made by borrows on the loans in the pool.
Most MBSs are issued by Ginnie Mae, a U.S. government agency, or Fannie Mae and Freddie Mac, both U.S. GSEs. Often these are traded as to-be-announced (TBA) contracts to buy or sell an MBS on a specific date. With such trades, the underlying mortgages are not known to the parties at the time the trades are made.
MBSs exhibit a variety of structures. One of the more complex types is a collateralized mortgage obligation (CMO), which is an MBS composed of residential mortgages and that tends to be sensitive to interest rate changes and economic conditions. Investors who purchase a CMO receive payments (money from principal and interest) at a set schedule after the mortgage borrowers make the monthly payments on their mortgages.
U.S. Treasury securities ("Treasurys") are issued by the federal government and, because they’re backed by the "full faith and credit" of the U.S. government, are considered to be among the safest investments you can make. This means that, come what may (e.g., recession, inflation, war), the U.S. government is expected to repay its bondholders. They’re also among the most liquid—or actively traded—investments in the world.
Savings bonds are also issued by the federal government and backed by the "full faith and credit" guarantee. Unlike many other types of bonds, only the person(s) in whose name a savings bond is registered can receive payment for it.
The two most common types of savings bonds are Series I and Series EE bonds. Both are accrual securities, meaning the interest you earn accrues monthly at a variable rate and is compounded semiannually. Interest income is paid out at redemption.
The STRIPS program lets investors hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities. STRIPS can only be bought and sold through a financial institution or brokerage firm, and they’re held in what’s known as the commercial book-entry system.
You can purchase bonds issued by foreign governments and companies as another way to diversify your portfolio. Since information is often less reliable and more difficult to obtain for these bonds, you risk making decisions on incomplete or inaccurate information.
Like U.S. Treasurys, many international and emerging market bonds pay interest semiannually, although European bonds traditionally pay interest annually. Unlike U.S. Treasurys, however, there can be increased risks for U.S. investors who buy international and emerging market bonds, and buying and selling these bonds generally involves higher costs and requires the help of your firm or investment professional.
A bond fund is a mutual fund or exchange-traded fund that invests in bonds. These funds can contain all of one type of bond (municipal bonds, for instance) or a combination of bond types. Each bond fund is managed to achieve a stated investment objective.
Bonds can be bought when they’re issued (on the primary market) and held until maturity, or they can be traded through a broker-dealer (on the secondary market). A bond’s face or par value and interest remain fixed for the life of the bond. But if you buy or sell a bond after it’s been issued, its price is subject to market forces and often fluctuates above or below par. Because there is such a variety in bond rates and terms, some bonds trade more frequently (and liquidly) than others.
The way you buy and sell bonds on the primary market often depends on the type of bond you select.
Once new-issue bonds have been priced and sold, they begin trading on the secondary market, where buying and selling is handled by a brokerage firm or investment professional. For Treasury bonds, if you bought directly from the U.S. government at auction and want to sell before maturity, you’ll need to transfer your Treasury bond to a brokerage firm or commercial bank and ask them to sell it for you.
Bond funds can be bought and sold through an investment professional, your brokerage firm’s website or app, or the fund directly. Keep in mind that if you work with an investment professional, the choice of bond funds is limited to those the brokerage firm allows its professionals to sell.
If you sell a bond before it matures, you may not receive the full principal amount of the bond and won’t receive any remaining interest payments. The price you receive will depend on where the bond is currently trading on the secondary market. This may be more or less than the amount of principal and the remaining interest the issuer would be required to pay you if you held the bond to maturity.
The price of a bond can be above or below its par value for many reasons, including whether the credit rating for the issuer or the bond itself has changed, a change in supply and demand and a host of other factors, but is often driven by changing interest rates.
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 accrued interest—the interest that adds up each day between coupon payments—up until the sale date. The buyer compensates you for this portion of the coupon interest, which is generally handled by adding the amount to the contract price of the bond.
Bond quotes are typically expressed as a percentage of their par value with the percentage converted to a point scale. A $1,000 bond trading at par is said to be trading at 100. A bond quoted at 105 is trading at a premium at 105 percent of par, or $1,050. A bond quoted at 95 is trading at a discount at 95 percent of par, or $950.
Remember, bond prices and interest rates move in opposite directions. If you own a bond that pays a coupon of 8 percent but new issuances are only paying 5 percent (so interest rates fell), the secondary price of your 8 percent bond will rise because people will be willing to pay a premium for that higher coupon payment.
When it comes to how interest rates affect bond prices, there are three cardinal rules:
One of the key determinants of a bond’s coupon rate (the interest you receive) is the federal funds rate, which is the prevailing interest rate that banks with excess reserves at a Federal Reserve district bank charge other banks that need overnight loans. The Federal Reserve sets a target for the federal funds rate and maintains that target interest rate by buying and selling U.S. Treasury securities. Another rate that heavily influences a bond's coupon is the Fed’s Discount Rate, which is the rate at which member banks may borrow short-term funds from a Federal Reserve Bank. The Fed directly controls this rate.
Say the Fed raises the discount rate by .5 percent. The next time the U.S. Treasury holds an auction for new Treasury bonds, it will quite likely price its securities to reflect the higher interest rate. Those new bonds pay more interest. What happens to the Treasury bonds you bought a couple of months ago at the lower interest rate? They're not as attractive. If you want to sell them, you'll need to discount their price to a level that equals the coupon of all the new bonds just issued at the higher rate.
It works the other way, too. Say you bought a $1,000 bond with a 6 percent coupon a few years ago and decided to sell it three years later to pay for a trip to visit your ailing grandfather, except now, interest rates are at 4 percent. This bond is now quite attractive compared to other bonds out there, and you'd be able to sell it at a premium.
In the majority of bond transactions, a brokerage firm acts as principal, selling you a bond it already owns. When a brokerage firm sells you a bond in a principal capacity, it may increase or mark up the price you pay over the price the firm paid to acquire the bond.
Similarly, if you sell a bond, the firm may offer you a price that includes a markdown from the price at which it believes it can sell the bond. The markup or markdown is the brokerage firm's compensation.
If the firm acts as agent, meaning it acts on your behalf to buy or sell a bond, you may be charged a commission, which will appear on your trading confirmation.
The tax rules that apply to bonds are complicated. Whether or not you will need to pay taxes on a bond's interest income (coupons) or a bond fund's dividends often depends on the entity that issued the bond. You might want to check with your tax advisor about the tax consequences before you invest.
Like other investments, when you invest in bonds and bond funds, you face the risk that you might lose money. Here are some common risk factors to be aware of with respect to bonds and bond funds.
This is the risk that changes in interest rates—in the U.S. or other world markets—may reduce, or increase, the market value of a bond you hold. Interest rate risk increases the longer you hold a bond.
This is the risk that a better opportunity will come around that you may be unable to act upon. The longer the term of your bond, the greater the chance that a more attractive investment opportunity will become available, or that any number of other factors may occur that negatively impact your investment. This also is referred to as holding period risk.
This risk is associated with the sensitivity of a bond’s price to a 1 percent change in interest rates. Duration, which is stated in years, signals how much the price of your bond investment is likely to fluctuate when there’s an up or down movement in interest rates. The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.
This is the risk that a bond may be redeemed by an issuer when interest rates are falling (similar to when a homeowner seeks to refinance a mortgage). This is a risk for bonds that include a call provision or are “callable.” Investors can avoid call risk by purchasing non-callable bonds. Call risk also leads to reinvestment risk (see below).
Some bonds (often including those issued by industrial and utility companies) contain sinking fund provisions, which require a bond issuer to retire a certain number of bonds periodically. This can be accomplished in a variety of ways, including through purchases in the secondary market or forced purchases directly from bondholders at a predetermined price. That latter method is referred to as refunding risk. Refunding risk also leads to reinvestment risk (see below).
This is the risk that no available investments will be able to provide a similar return to a bond that has been called or mandatorily refunded.
This is the risk that a bond issuer will fail to make interest payments or to pay back your principal when your bond matures. Other than U.S. Treasury securities, which are generally deemed to be free of default risk, most bonds face some degree of credit risk, which is often indicated by a bond’s credit rating.
This is the risk that the yield on a bond will not keep pace with purchasing power. For instance, if you buy a five-year bond in which you can realize a coupon rate of 5 percent but the rate of inflation is 8 percent, the purchasing power of your bond interest has declined. All bonds but those that adjust for inflation, such as TIPS, expose you to some degree of inflation risk.
This is the risk that you won’t be easily able to find a buyer for a bond you need to sell. A sign of liquidity, or lack of it, is the general level of trading activity. A bond that’s traded frequently is considerably more liquid than one which only shows trading activity intermittently.
This is the risk that than an event, such as a merger, acquisition, leveraged buyout, major corporate restructuring or other event might result in changes in a company's financial health and prospects, which might trigger a change in a bond's rating. Event risk is extremely hard to anticipate and might have a dramatic and negative impact on bonds.
A country's unique set of risks is known collectively as sovereign risk. A nation's unique political, cultural, environmental and economic characteristics are all facets of sovereign risk. Default risk is real in emerging markets, where the sovereign risk (such as political instability) could result in the country defaulting on its debt.
This is the risk that a change in the exchange rate between the currency in which your bond is issued—euros, say—and the U.S. dollar can increase or decrease your investment return. The impact of currency risk can be dramatic. It can turn a gain in local currency into a loss in U.S. dollars, or it can change a loss in local currency into a gain in U.S. dollars.
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