The Bond Market

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In this section, we will cover the following:

• Why bonds are an attractive investment option.
• What determines a bond's price.
• The different types of bonds.

What is a Bond?

A bond is an agreement between the lender (investor) and the borrower (issuer). In return for up-front cash, the issuer promises to make specific payments to the bondholder on specific dates. Consequently, the bond investors can expect fixed payments, as well as the principle repayment at maturity.

Bonds can be issued by governments, agencies, municipalities, or corporations. Their overall risk and return depend on the credit worthiness of the issuing institution. Bonds have a defined maturity, or end date, and can have a fixed or variable rate of interest that dictates the bond's interest (coupon payments). Fixed rates remain the same through the life of the bond, whereas variable rates fluctuate with changes in interest rates.

Why Buy Bonds?

Bonds have several attributes that make them an attractive investment. First of all, a holder of bonds can usually expect to receive income from regular interest payments, made either semiannually or annually, depending on the bond. Additionally, the borrower (issuer of the bond) is obligated to return the principal at the end of the term of the bond. Because of these fixed obligations, buying bonds is often perceived as less risky than investing in stocks.

On the negative side, bonds can lose value when inflation is high. Because a bond's interest rate is usually not tied to inflation, the inflation can often erode your return. Also, investors should be wary of investing in bonds when interest rates are low because locking in a low rate today can prevent the investor from reaping a higher income should interest rates rise.

What Determines a Bond's Price?

A bond's price is determined by its attractiveness to investors. The key considerations, when determining a bond's price are the bond's coupon, its maturity date, and the credit risk of the issuer.

• The value (and therefore price) of bonds changes as interest rates change. Bonds can sell at a discount, a premium, or at par, depending mainly on the bond's coupon rate relative to current market interest rates. Fixed coupon bond prices and interest rates are inversely related. In essence, bond prices rise when interest rates fall, and vice versa. In particular: If a bond's coupon rate is less than the market interest rate, the bond will sell below par, or at a discount.
• If a bond's coupon is greater than the market interest rate, the bond will sell above par, or at a premium.
• If a bond's coupon rate equals the market interest rate, the bond will sell at par (face amount).

What are the Different Kinds of Bonds?

Bonds vary in terms of their issuers, credit quality, length to maturity, interest rates, and face values. The risk/return opportunity of each type of bond varies with the issuer's ability to pay. To evaluate the different bonds, take a look at the price you pay, the payout you will receive, and the stability of the offering institution. The main bond classifications include:

• US Government Bonds
• Federal Agency Securities
• Municipal Securities
• Asset Backed Securities
• Corporate Bonds
• Zero Coupon Bonds
• Index Linked Bonds
• Convertible Bonds

US Government Bonds
The largest single borrower in the United States is the US Government, which issues short, medium, and long term debt. The market for government bonds is robust, very liquid and has both a primary and secondary market. All government securities are issued in registered form with interest paid semi-annually to the investor. The US Government Bond Market is the safest of all bond markets because the taxing authority of the US Government backs it. This means that the government can always use money collected through taxes to pay back debt obligations if the need arises.

The US Treasury Department holds quarterly auctions of bonds. The dollar value of bonds offered changes each quarter to reflect the US Government financing needs at that time. Short term and long term government bonds have distinct and specific terms that reflect their different levels of risk and duration.

The two types of treasury securities are Notes and Bonds. Treasury Notes are coupon-bearing securities with maturities between two and ten years and Treasury Bonds are U.S. bonds issued with a thirty-year maturity.

Federal Agency Securities
Federal agencies are governmentally established agencies, which are legally authorized to administer selected lending programs on behalf of the US Government. Loan programs are designed to bring private capital to sectors of the economy with inadequate funds, including social and economically disadvantaged areas. The agencies market is very liquid, second only to the US Government Bond market. Securities issued by government-sponsored agencies are not as safe as US government bonds because they are backed by the issuing authority, rather than the US government. This higher risk results in higher returns to the bond-holder. Additionally, there is an implied moral obligation by the US Government to assure that the principal and interest of all agency securities are protected and honored.

Municipal Securities
Local and state issued government bonds are known as municipal bonds or "munis." These governments normally receive grants and subsidies directly from the Federal government, but their financial requirements far outweigh these receipts. Consequently, these authorities have to satisfy much of their own funding requirements by issuing munis.

Like government bonds, munis have a fixed maturity date and make semi-annual
coupon payments. Municipals are free from federal and/or state taxation and are therefore attractive to certain investors who wish to shelter their income against taxation. Municipal bonds range widely in their credit quality and are less liquid than government securities.

Asset Backed Securities
Asset backed securities are backed by collateral in the form of receivables that are pooled and offered to investors in the form of a bond. The collection payments on the receivables are accumulated and then used as payments on the bonds.

Asset backed securities typically vary based on prepayments of receivables and trade quite differently from straight bonds. Interest rate fluctuations can continually affect the average maturity and outstanding monetary amount of any given pool of securities. Thus, the secondary market for asset backed bonds is dominated by institutional investors who can evaluate the worthiness of these investments with the help of sophisticated computer valuation models and trading tools.

While they can also be backed by payments on credit cards or consumer loans, the most common asset backed securities are Mortgage Backed Securities (MBO), or "Pass-through's." These generally refer to mortgage pools established by the following organizations:

• FNMA ( Fannie-Mae: Federal National Mortgage Association)
• FHLMAC ( Freddie Mac: The Federal Home Loan Mortgage Corp.)
• GNMA ( Ginnie-Mae: Government National Mortgage Association)

Corporate Bonds
The corporate bond market in the United States is the largest corporate bond market in the world in terms of both dollar value issued and turnover. Here's how it works:

• Corporations including utilities, transportation companies, and commercial and financial organizations issue debt in maturities varying from one to thirty years.
• Corporate bonds are issued in registered form and normally provide semiannual interest payments called coupons.
• These issues are rarely traded and have been predominantly held by institutional investors such as insurance companies.

The majority of the corporate bonds are straight bonds (bonds with a stated maturity and semi-annual interest payments). However, over the years, corporations have issued zero coupon bonds (bonds with no coupon payments) and deep discount bonds (bonds selling for a discount of more than 20%), depending upon market conditions. The benefit to the corporation for issuing zero coupon bonds is that they can save their cash in the near term by avoiding paying coupon payments. Floating rate or variable rate coupons have also become a popular structure for corporate bonds. All corporate bonds are guaranteed by the borrowing (issuing) company, and the risk depends on the company's ability to pay the loan at maturity.

How risky are corporate bonds?
There are bond rating systems that indicate the degree of credit risk for a corporate bond. The rating that is attached to a bond is an indicator of the issuing company's ability to honor its debt. This rating tool enables the investor to evaluate how much credit risk they are willing to assume when investing in particular bond. There are three major bond rating agencies in the US:

• Standard and Poor's
• Moody's
• Fitch

The main factors that determine the issue's rating are:

• The company's capital structure
• Leverage ratios (how much debt the company has)
• Solvency
• Liquidity
• Earnings growth
• Performance of previous bond issues.

Investment Grade vs. Junk bonds
Highly rated bonds have less risk and will obviously carry a lower yield than lower rated issues. Investment grade issues are those corporate bonds that are considered to be of higher quality and are therefore more secure. On the contrary, high-yield ( junk ) bonds are issued by corporations whose ability to repay is questionable. Due to their high risk levels, these bonds are also called "junk" bonds by many investors. Returns tend to be more volatile due to the relatively high default risk embodied in the security.

What are callable bonds?
Some corporates are issued with a call feature and referred to as "callable bonds." This call feature varies from issue to issue and indicates that the bond may be redeemed at a preset price, at the discretion of the issuer, usually prior to the stated maturity date of the bond.

Zero Coupon Bonds
These bonds are issued with no coupon and the issuer pays all interest and principal when the bond matures. Because the entire payment to the bond holder takes place at maturity, holders are more exposed to valuation swings should interest rates change. Consequently, zero coupon bonds are much more volatile than straight bonds. Also they are treated differently from a taxation point of view, so investors should check with their tax consultant for the appropriate use of these bonds.

Index linked Bonds
Index linked bonds are bonds with their coupon tied to an index (commodity index, inflation rate). This causes the pay-out to generally fluctuate over the life of the bond (index goes up, pay-out goes up; index goes down, pay-out goes down). Index-linked bonds are gaining in popularity because the Treasury introduced an inflation-linked bond, designed to pay a variable rate of interest that reflects a common inflation index.

Convertible Bonds
Convertible bonds are bonds issued by a corporation with an imbedded exchange feature. This means that the bonds can be exchanged for the common stock of the underlying issuer, usually defined by a specific set of circumstances and at a pre-set conversion ratio.