Bonds sound boring, but they're not. Nor are they a nice safe haven for rich and retired folks who never want to lose money. They have a role to play in your investment plan for several important reasons.
See Also: The Basics of Investing in Bonds
Types of Bonds
In their basic form, bonds and other credit instruments, such as notes, bills and commercial paper, are IOUs — basically, receipts for money borrowed from the investor. They bind the issuing organization to pay a fixed amount of interest periodically (usually semiannually) and repay the full face amount on the maturity date, which is set when the bond is issued.
Governments and corporations regularly finance their operations by issuing such credit instruments. Municipal bonds, also known as tax-exempts, are issued by state and local governments and are secured by the full taxing power of the issuing organization. Revenue bonds depend on revenue from a specific source, such as bridge or road tolls. Some municipals are secured by revenue from a specific tax.
Secured corporate bonds are backed by a lien on part of a corporation's plant, equipment, or other assets. Unsecured bonds, known as debentures, are backed only by the general credit of the corporation. Zero-coupon bonds are issued at a big discount from face value and pay no interest until maturity. Some bonds are convertible into the corporation's common stock at a fixed ratio — a certain number of shares of common stock in exchange for a certain amount of bonds.
The standard face value for bonds is $1,000 or $5,000. Some are issued in larger denominations, but very few come in smaller denominations. You buy them through a broker, or, in the case of U.S. Treasury bonds, you can buy them directly through the government.
Most bonds pay interest semiannually. Many mutual funds and unit trusts that invest in bonds pay dividends monthly. Discount securities, such as Treasury bills and savings bonds, pay interest by deducting it from the sales price, or face value at the time of issue, then paying full face value at maturity.
When bonds reach their maturity, they pay back the face amount. Bonds that mature in two years or less are usually dubbed short-term bonds; maturities of up to ten years are called intermediate; and bonds maturing in ten or more years get the long-term label. Many bonds are issued with 20- to 30-year maturities. Notes usually run about seven years.
Whatever their maturity, bonds these days usually can be "called," meaning redeemed, by the issuer at a specified date before the scheduled maturity. An issuer may call in its bonds if, for instance, interest rates fall to a point where it can issue new bonds at a lower rate. It has been customary to pay owners of called bonds a small premium over the face value.
The coupon rate is the fixed annual interest payment expressed as a percentage of the face value of the bond. A 9% coupon bond, for instance, pays $90 interest a year on each $1,000 of face value. The payment is set when the bond is issued and does not change as the bond's price fluctuates. Current yield is the annual interest payment expressed as a percentage of the bond's current market price. Thus, a 10% coupon bond selling for $1,100 has a current yield of 9.1% ($100 interest divided by the $1,100 price times 100). The same bond selling for $900 has a current yield of 11.1%.
Yield to maturity takes into account the current yield and the eventual gain or loss it is assumed the owner will receive by holding a bond to maturity. If you pay $900 for a 10% coupon bond with a face value of $1,000 maturing five years from the date of purchase, you will earn $100 interest a year plus $100 five years later when the bond is redeemed for $1,000 by its issuer. If you buy that bond for $1,100, representing a $100 premium, you will lose $100 at maturity. The loss, however, could be more than offset by the extra interest earned on a premium-priced bond if its coupon rate exceeds the current yield available on comparable securities. Tax considerations could also make the capital loss worth taking. For bonds selling at a discount, the yield to maturity probably provides the best estimate of total return. Yield to call is computed the same way as yield to maturity, except that it is assumed the bond will be redeemed at the first call date for the face value plus the call premium.
Bond prices are identified by the abbreviated name of the issuer, the coupon rate and the maturity date. The more common price lists give only the current yield, but your broker can get the yields to maturity and call for you. Prices are reported as a percentage of face value. To get the actual price, multiply the decimal equivalent of the percentage by 1,000. Thus, an AT&T 7% bond maturing in 2012 might be reported as ATT 7s12 101, meaning the issue is selling at the time of the listing for $1,010 (101%) per $1,000 face value, a small premium that produces a current yield of 6.9%.
How Rate Changes Affect Prices
Because the amount of interest paid on a bond or note commonly remains fixed for the life of the issue, the bond adjusts to interest-rate movements by changes in price. As interest rates rise, bond prices fall; as interest rates fall, bond prices rise. Generally, the shorter its maturity, the less a bond's market value is affected by changes in interest rates.
Consider a $1,000 bond with a coupon interest rate of 8% — $80 a year. If interest rates rise to 9% after the bond is issued, you can sell your 8% bond only by offering it at a price that will deliver a 9% current yield. So the price becomes whatever $80 represents 9% of, which is $889. Thus, you lose $111 if you sell.
If interest rates decline to 7%, you can sell your 8% bond for whatever $80 represents 7% of, which is $1,143. That's a $143 capital gain. Congratulations.
How Bonds Are Taxed
Interest and capital gains on corporate credit instruments are normally subject to federal, state and local income taxes. Income from Treasury and agency securities is subject to federal income taxes, but all Treasury and some agency securities are exempt from state and local income taxes. Interest on most municipal bonds is exempt from federal income taxes. Most state and local governments exempt interest on their own bonds but tax income on securities issued by other states. Because of their tax advantage, municipals pay a lower interest rate than taxable bonds.