Investing in Bonds and Bond Funds
There are two ways that individuals can invest in fixed-income securities: bond funds or individual bonds. The vast majority of securities are held by large institutions such as banks, pension plans, and insurance companies. Roughly 10% of all bonds are held directly by individuals.
Bonds versus Bond Funds
In this article, we're first going to discuss the advantages of holding bonds versus investing in funds. Later on, we'll cover several topics investors should understand before purchasing a bond, or shares in a fund. That discussion will include terms, features found in offerings, the types of securities issued, as well as a quick lesson on valuing bonds.
Individual bonds offer investors a dependable source of income, and diversification, relative to a portfolio that consists solely of stocks. They offer investors a predictable stream of payments, and the eventual repayment of principal. As such, they are viewed as a means of creating a dependable source of income, and a way to preserve net worth.
Bond funds are a portfolio of fixed income securities, selected and maintained by the fund's management team. As is the situation with other types of funds, a portfolio of securities greatly reduces the risk associated with default or bankruptcy.
This is an extremely important point. All bonds are subject to two market hazards: individual default on a bond, and interest rate risk. Individual default risk can only be mitigated through the accumulation of a portfolio of individual bonds or the purchase of shares in a bond fund. For many investors, it is much easier, and less expensive, to eliminate the risk of default by buying shares of a bond fund.A bond fund consists of shares, and the price is normally quoted as NAV, or Net Asset Value. Bond funds can return earnings to the investor through the interest paid or the trading of securities.
One specialize type of offering is a bond index fund. The purpose of these funds is very similar to the concept of a stock index fund. Bond index fund benchmarks include Citigroup BIG, the Barclays Capital Aggregate Bond Index (the Agg), and the J.P. Morgan Government Bond Index. These indices are broad measures that can be used by investors to gain a better understanding of the performance of global bond markets.
Fee Structure and Liquidity
Some of the more important distinguishing characteristics of bonds and bond funds include:
- Fees: investors in funds typically pay annual management fees, while purchasers of individual bonds pay commissions ranging from 1 to 5% of the investment's value.
- Sensitivity to Interest Rates: the interest rate risk will decline as a bond nears maturity; while funds constantly carry an interest rate risk.
- Purchase: bonds are typically purchased through commercial banks, brokers, or the Federal Reserve. Funds are sold through banks, brokers, fund managers, or even pension and retirement plans.
- Maturity Date: bond funds have no identifiable maturity date.
- Liquidity: funds tend to be extremely liquid, which means an active trading market always exists.
Listed below are some of the common terms investors might encounter when purchasing bonds or investing in funds:
- Coupon Date: this is the date on which the issuer pays the holder of the bond the interest due on the security. In the U.S., most coupon dates are six months apart. In Europe, coupon dates can be 12 months apart, which means interest is paid annually.
- Coupon Rate: the interest rate paid the holder of the security is known as the coupon rate, which typically remains fixed throughout the life of the bond. Some issues contain a feature that links the interest rate paid to a market index such as LIBOR.
- Face Amount: also referred to as nominal, par, or principal amount, the face amount is the value used to compute interest payments, and is the amount due the holder of the bond when it matures.
- Issue Price: the price that buyers paid when the bond was first issued.
- Maturity Date: the date on which the bonds mature. This is also the date the issuer has to pay the holder of the bond the face amount of the security. Securities can have maturity dates of up to 30 years.
- Term: the length of time that elapses between the date of issue and date of maturity. Generally, short-term bonds have maturities of up to 12 months. Mid, medium, or intermediate-term bonds have terms between one and ten years. Long-term bonds include all those securities with terms greater than ten years.
Many bonds issued today contain one or more of the features listed below:
- Callability: a security is said to be callable when the issuer has the right to repay the bond's face amount prior to the maturity date. This is sometimes referred to as a call option. To protect investors, callable bonds often require the issuer to pay a premium.
- Optionality: an issuer may embed options that grant certain rights to either the issuer and / or the holder of the bond.
- Putability: gives the holder the right to force the issuer to repay the bond on a put date, which would occur before the maturity date.
- Exchangeability: allows the issuer to exchange the bond for common shares of a corporation other than that of the issuer.
Types of Securities
The following is a list of the most common types of bonds issued today:
- Asset Backed Securities: issues that have interest and / or principal payments backed by assets that produce cash flows. The most common examples of asset backed securities include collateralized debt obligations (CDO) and mortgage backed securities (MBS).
- Fixed Rate Bonds: securities that have a coupon rate that remains constant throughout their life. This is perhaps the most common type of bond issued today.
- Floating Rate Bonds: also referred to as floating rate notes (FRN), these bonds have a coupon that is linked to a money market index such as LIBOR or EURIBOR. For example, if a floating rate is said to be six months LIBOR +0.5%, then every six months the coupon rate is adjusted to be LIBOR +0.5%.
- High Yield Bonds: refers to a category of securities that carry bond ratings below investment grade. High yields are sometimes referred to as junk bonds, which reflect the higher credit risk the issuing company represents to investors.
- Inflation Protected Securities (IPS): interest rates are linked to a measure of inflation; inflation-protected securities are usually issued by the federal government.
- Zero Coupon Bonds: does not pay interest; instead, these bonds are issued at a discount to the face amount or par value. At maturity, the issuer is obligated to pay the holder the full face value of the bond.
The interest rate on a bond is affected by many factors including current interest rates, the term of the loan, as well as the creditworthiness of the company or issuing agency. Most bonds in the United States are issued with face values of $1,000. Depending on several other market factors, including those mentioned above, the security can be selling at a discount or premium to its par value.
In addition to the credit rating of the bond, investors should be concerned with two important measures of its value:
- Current Bond Yield: sometimes referred to as the earnings yield, the current yield is the effective rate of interest paid to the bondholder, based on the price paid for the security and the interest payments made on the bond.
- Yield to Maturity: the total yield realized by the bearer of the bond if they were to hold the security until its maturity date. The yield to maturity considers the difference in the bond's current price and its par value, as well as the rate of interest paid.
If an investor knows the bond's current price, its par value, the coupon rate, and the years until maturity, then the current bond yield and yield to maturity can be determined. Our bond yield calculator can do these calculations.
If an investor knows both the current yield and its yield to maturity, they have a complete understanding of the effective interest rate, or return on investment, they will receive if they buy the bond in the short-term or hold it to its maturity date.
About the Author - Investing in Bonds and Bond Funds