Ever borrow money from someone? Sure you have. Forgot your lunch money? Wanna buy a soda? Need cab fare? People borrow money every day, for all kinds of reasons.
Large organizations sometimes need to borrow money, too, just like people do. But unlike you and me, large entities such as corporations and governments can have an awfully difficult time getting as much money as they need. They have to agree not only to pay back the amount they borrowed but also to return a little extra, in the form of interest, for the privilege of borrowing the money. One way to collect the money they need is to issue bonds.
Bonds are a form of indebtedness sold to the public in set increments, normally in the neighborhood of $1,000. In return for lending the debtor the money, the lender gets a piece of paper that stipulates how much was lent, what the agreed-upon interest rate is, how often interest will be paid, and how long the term of the loan will be.
The first time an ancient monarch borrowed a large sum of money from a rich neighbor, agreed to repay the money with interest, and wrote everything up on a piece of papyrus, the bond was born. Deficit-laden governments across the world use bonds as a way to finance their operations. Cash-strapped companies sell debt to get the money they need to expand. Even individuals routinely take out interest-bearing loans, whether in the form of credit card balances, car loans, or mortgages.
Types of bonds
Bonds are known as "fixed-income" securities because the amount of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money.
There are four basic kinds of bonds, all defined by who's selling the debt. The U.S. government and its agencies sell one type, corporations another, and state and local governments yet another. A fourth type comes from foreign governments, but these can be difficult for the individual investor to buy and sell, outside the confines of a mutual fund.
Let's take a closer look at the issuers of some of these bonds.
- The federal government. U.S. government bonds are called Treasuries because the Treasury Department sells them. Treasuries come in a variety of different "maturities," or lengths of time until maturity, ranging from three months to 30 years. Various types of Treasuries include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed securities. These all vary based on maturity and the amount of interest paid. The Treasury Department also sells savings bonds and some other types of debt. Treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.
- Other government agencies. Some government agencies and quasi-government agencies, such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae), sell bonds backed by the full faith and credit of the U.S. for specific purposes, such as funding homeownership.
- Corporations. Companies sell debt through the public securities markets just as they sell stock. A company has a lot of flexibility on how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors, or else no one will buy them. Corporate bonds normally carry higher interest rates than government bonds do, because there's a risk that the company could go bankrupt and default on the bond, unlike the government, which can just print more money if it needs to. High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. Some corporate bonds are called convertible bonds because they can be converted into stock if certain provisions are met.
- State and local governments. Because state and local governments can go bankrupt, they have to offer competitive interest rates, just as corporations do. Unlike corporations, though, the only way that a state can get more income is to raise taxes on its citizens -- always an unpopular move. As a way around the problem, the federal government allows state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also waive their income taxes on the bonds, so that even though their bonds pay less interest, for borrowers in high tax brackets, the bonds can have a higher after-tax yield than other forms of fixed-income investments offer. Thus, tax-free municipal bonds, also known as "munis," were born.
Par value, coupon rate, maturity date
You should know three things about any bond before you buy it: the par value, the coupon rate, and the maturity date. Knowing about these three items -- and a few other odds and ends, depending on what kind of bond you're buying -- allows you to analyze the bond and compare it with other potential investments.
- Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount lent out, called the principal. Par value for corporate bonds is normally $1,000, although for government bonds, it can be much higher.
- The coupon rate is the amount of interest the bondholder will receive, expressed as a percentage of the par value. Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semiannually, or annually.
- The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes, a company will decide to "call" its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be called and how soon they can be called. Federal government bonds are never called, but state and local government bonds can be.
How to calculate bond yields
The most important piece of information for comparing a bond with other potential investments is the yield. You can calculate the yield on a bond by dividing the amount of interest it will pay over a year by the current price of the bond. If a bond that's worth $1,000 pays $75 a year in interest, then its current yield is $75 divided by $1,000, or 7.5%.
$75 annual interest / $1,000 current value = 0.075 = 7.5% current yield
Why bond yields can differ from coupon rates
Why not just look at the coupon rate to determine the bond's yield? Because bond prices fluctuate as interest rates change. So a bond can trade above or below the par value, based on current interest rates. If you hold the bond to maturity, you are guaranteed to get your principal back. However, if you sell the bond before it matures, you will have to sell it at the going rate, which may be above or below par value.
Say in the late 1970s, you bought a $1,000 bond with a coupon rate of 10% and a maturity date of Dec. 31, 2009, from a company called Yoyo Enterprises. This bond would pay you $100 per year until Dec. 31, 2009, at which time you'll also get back the $1,000 in principal.
Now say you still owned that bond in 2008, by which time interest rates had fallen to 5%. If issued today, that same bond would pay only $50 a year, not $100. Since interest rates had dropped since the coupon rate was set on the bond, you could sell your Yoyo Enterprises bond for more than the $1,000 par value. That's because an investor in 2008 would be expecting only a 5% yield and would pay a premium rate for a bond that paid 10%.
If you hold a bond to maturity, you won't lose your principal if the borrower doesn't default or is restructured. If you buy and sell bonds before they mature, you can make or lose money on the bonds themselves completely separate from the interest rates. How much more you are going to get depends on the exact maturity date of the bond, the current interest rates, and the transaction costs involved.
Yield to maturity
Because you can buy a bond above or below par value, bond investors often use another kind of yield called "yield to maturity." The yield to maturity not only includes the interest payments you will receive all the way to maturity, but it also assumes that you reinvest that interest payment at the same rate as the current yield on the bond, and it takes into account any difference between the current par value of the bond and the trading price of the bond at that time.
If you buy a bond at par value, then the yield to maturity will be very close to the current yield, which is exactly the same as the coupon rate. Yield to maturity is especially important when looking at zero-coupon bonds, a special type of bond that pays no interest until the maturity date, when you receive all of your principal back plus interest for the entire period the money was borrowed. Because zeros have no present yield, any yield you see associated with them is always a yield to maturity.
In general, people buy bonds because they are relatively safe investments. However, except for bonds from the federal government, bonds do carry the potential risk of default, no matter how remote that risk might be. Whether it's a high-yield corporate bond or a one sold by the Commonwealth of Virginia, there's always a chance that the entity that borrowed the money won't be able to make the interest payment.
That's where bond ratings come in. Bond ratings were developed as a way to indicate a bond issuer's financial stability. But they're not always easy to understand. Third-party bond-rating services, such as Standard & Poor's and Moody's, issue ratings involving a mixture of letters and numbers to indicate an issuer's financial soundness. To complicate things even more, the agencies use entirely different rating systems from each other. So it's important that you check what the ratings mean before you make any assumptions. When you figure that out, you can be assured that the higher the rating, the higher the quality of the bond. Treasury bonds will be rated the highest, junk bonds the lowest.
Some bonds trade frequently for a low commission, while others can involve large transaction costs and don't have an easy time finding a buyer or a seller. The degree of ease with which a bond can change hands is referred to as its liquidity. Highly liquid bonds include U.S. Treasuries; billions of dollars' worth of them trade every day. Illiquid bonds would include those from a company considered to be teetering close to bankruptcy. Because such bonds are no longer a safe investment, only those speculating that there will be a corporate turnaround are willing to buy them, and as a result, they trade a lot less frequently. Liquidity has a direct effect on the commission you pay to trade a bond, which, unlike a stock, rarely trades on a fixed commission schedule.
The most common way to buy bonds, much like stocks, is to use a brokerage account, whether a full-service (or full-price) broker or a discount broker. Bond commissions vary widely between brokerages, so shop around before making your decision. Through a brokerage, you can buy anything from a 30-year Treasury to a three-month junk bond from a corporation near bankruptcy. Depending on your brokerage, you can participate in the direct offering of the bonds or pick them up in the secondary market.
To make buying U.S. government bonds easier, the Bureau of the Public Debt started the Treasury Direct program, which lets people purchase bonds directly from the Treasury and avoid going through a brokerage. Investors can establish a single Treasury Direct account that will hold all of their Treasury notes, bills, and bonds. Interest and principal payments are made by direct deposit to a bank or brokerage that the account holder designates, and the holder receives periodic account statements. The investor can freely transfer bonds to and from the account, and as long as the investor has enough money, he or she can buy any type of Treasury security. The bureau also lets account holders reinvest money after a bond matures and sell bonds for a flat fee. To learn more, visit Treasury Direct.
Preferred stock. Many beginning investors mistakenly believe that preferred shares are the same as common shares, just with higher dividends. Although called "stock," preferred stock is actually a hybrid between a stock and a bond. It is called "preferred" stock because preferred shareholders get their proceeds first. If a company goes bankrupt, for example, preferred shareholders have superior claims over common-stock shareholders on a company's assets.
Preferred stock always carries a dividend, although the company can elect not to pay it if lacking the financial resources. However, another benefit of the preferred share is that the dividends are often cumulative. Before the company can pay a dividend to the common-stock shareholders, it must completely catch up on any missed dividends to the preferred shareholders.
As hybrid securities, preferred stocks do not appreciate as much as common stocks do if the company that issued them improves financially -- except in rare circumstances or if a conversion feature exists. Convertible preferred shares can be "converted" into a set amount of common stock when certain conditions are met. A company may also choose to retire its preferred shares -- it buys them back to stop paying the dividend. This action often includes the payment of a premium on the current share value.
Real estate investment trusts (REITs). REITs are a specialized form of equity that allows investors to own a portion of a group of real estate properties, although many investors think of them as an alternative to bonds. REITs have become increasingly popular over the past decade. Granted special tax status by the Internal Revenue Service, REITs pay out at least 95% of their earnings in the form of dividends to shareholders and thus frequently offer healthy dividend yields approaching the same magnitude as those of bonds. Even better, as REITs acquire more property and increase the value of the properties they own, the value of the equity increases as well and provides a nice total return. For more information on REITs, check the website of the National Association of REITs.
We've covered a lot of ground here. After reviewing the cornucopia of bonds available, we looked at the three things every investor should examine before buying one -- par value, coupon rate, and maturity date. You are now equipped to calculate a bond yield, which will allow you to compare a bond to other potential investments. And although bonds are considered safe investments, there are remote risks that you can assess by checking out the bond's rating.