Advising Clients since 1980
Bond Investing
Bondholders are essentially lenders. When purchasing a bond, an individual is essentially lending money to corporation or governmental entity at a fixed rate of return for a specific period of time. Stock ownership, on the other hand, is a form of ownership through investing in a share of a company. The money you lend to a corporation or governmental entity is known as principal. Issuers of bonds may include:
The federal government and its agencies
State and local governments and entities
Foreign governments
US corporations
Foreign corporations
Special entities that package bonds backed by assets such as mortgages or other loans
Governments issue bonds to pay for refinancing existing debts, operating expenses, schools, highways and infrastructure, and special projects. Corporations issue bonds to pay for acquiring other companies, building plants and buying equipment, expansion, research and development, and financing their operations.
Buying New and “Used” Bonds
New bonds are initially sold through brokers or the US government at or near par (the bond’s face value). So, a $1,000 face value bond is sold for about $1,000 (bonds other than US Savings Bonds are usually sold in units of $1,000 or $5,000).
Some bonds are sold for less than par, such US Savings Bonds, which are sold for 50% of their face value. When these bonds mature (come due), they are paid at 100% of their face value.
Bonds may be resold, but the sales price they’ll bring may be more or less than you paid for them, due to changing interest rates.
Rating the Safety of Bonds
There are rating services that evaluate a corporation’s or a governmental entity’s ability to repay its bond obligations. Examples are Moody’s and Standard and Poor’s. Your library and local brokerage offices have this information.
Bond Interest Rates
When bonds are issued, their interest rate needs to be high enough to attract investors’ dollars. That means the bond interest rate has to be competitive with similar bonds issued by other companies and government agencies, as well as other types of investments.
Usually interest is higher on corporate bonds than on governmental bonds because corporate bonds usually have a higher risk of non-payment, or default.
However, bonds have different types of interest payments: fixed-rate, floating-rate, and zero-coupon. All of which can be found in both the corporate and governmental sectors.
Bond Maturity
When bonds are issued, they have a set date when the principal is to be repaid in full. That’s the maturity date. For most bonds, the issuer pays you interest at set intervals each year until the maturity date.
Sometimes there are other arrangements (such as with certain US Savings Bonds) where you don’t actually receive the interest until the bond matures. And even then, you may be able to let it continue to generate or accrue interest for an additional period.
Early Bond Maturity
Some bonds have the condition that the issuer has the right to pay them off before their maturity date. That’s known as a call feature.
For example, you might buy a 30-year corporate bond that pays 10% interest per year. If, in the fifth year of the bond’s life the market rate of interest falls to 5%, the issuer may not want to face the prospect of paying you 10% interest for the next 25 years. The bond may allow the corporation to call in the bond and pay it off early.
If you’ve been counting on that 10% return to last for 30 years, you may not be very pleased to have your bond called in early. For this reason, always check out the call feature before you invest in a bond.
Bond Mutual Funds
As you’ve probably seen by now, bond investing can be very complex. Success requires considerable research into the provisions in each bond’s indenture-the contract that includes details about call provisions and collateral. Figuring yield to maturity can also require some complex calculating.
One way to enjoy the advantages of bond ownership without research requirements is to simply buy shares in a bond mutual fund. These funds buy and sell a variety of bonds: government, corporate, short-term, long-term, and so on.
Typically, bond mutual funds will be better-diversified than a small collection of individual bonds.
Fixed-Rate Bonds
A fixed-rate bond pays a specified rate of interest that doesn’t change, with regularly scheduled interest payments. An example would be a 6% interest bond that pays interest twice a year until the bond matures in 30 years.
This fixed interest feature is both its stabilizing factor and its risk factor. Knowing that you’re going to receive interest at a certain rate, each quarter or every six months makes it easier to plan your income flow. At the same time, this fixed interest rate can devalue a bond if inflation occurs. This is an important consideration when choosing a fixed rate bond.
Convertible Bonds
Some bonds come with a feature that allows you to convert the bond into shares of a company instead. This can be a valuable if you think your loan to the company can be more profitable if it’s changed into an ownership interest down the road.
Inflation-Protected Bonds
The principal value of these bonds increase at the rate of inflation. For example, if $100,000 were invested and the inflation rate was 2%, the value would increase by 2% or $2,000 to adjust for/protect against inflation. The U.S. Treasury is one of the issuers of these type of bonds and are often known as TIPS (Treasury Inflation Protected Securities). More often than not, these bonds tend to be purchased within mutual funds. While the value of this type of bond generally won’t increase as much as fixed rate bonds in a declining interest rate environment, they also tend not to decrease as much with rising interest rates due to the protection offered by their value increasing at the inflation rate.
Zero-Coupon Bonds
Some bonds are sold for less than their face value. You receive the full value when the bond matures. The most common type of this bond is a zero-coupon bond.
The difference between the maturity face value and the original discounted price is called the original issue discount. Consult with your tax advisor for tax rules on these bonds.
Fluctuations in Bond Values
A $1,000 face-value bond isn’t always worth $1,000. Its value can change over time, because:
When interest rates go up, most bonds fall in value
When interest rates go down, bonds rise in value
However, if you sell your bond before its maturity date, it’ll be worth more or less than its face value, depending upon whether the bond’s interest rate is higher or lower than the current interest rate for that type of bond. Because inflation can influence interest rates, it can also affect the value of bonds.
Bond Yield and Yield-to-Maturity
The two kinds of yield to consider are the current yield and the yield-to-maturity.
The current yield gives you a short-term snapshot of your bond investment. But it’s important for you to have the bigger picture in mind. That’s where the yield to maturity comes in.
The yield-to-maturity indicates the total return if you keep the bond to maturity. The yield to maturity incorporates the interest you’ll receive until the bond matures, plus any capital gain you’ll have at maturity if you bought the bond for less than its face value, or less any capital loss if you paid more than face value.
Lending Risks
Bonds are loans. Sometimes loans go bad. If the corporation or entity issuing your bond goes bankrupt or has severe financial problems, that’s a problem for you, too. One consolation is that bond owners have priority over shareholders in getting paid from a corporation’s assets.
However, bondholders may not have priority over other creditors, depending on the terms of the bond and whether special assets (collateral) have been pledged to secure it. Remember, bonds are loans. When you buy a bond you’re a lot like a banker. There are secured and unsecured bonds. A secured bond gives you priority over certain other creditors, but it comes with a lower interest rate. There are many types of secured bonds with varying degrees of security. Get all the details and know your chances of recovering your principal if something goes wrong.
Inflation Risk
In many cases, a bigger (and less obvious) risk for bonds is inflation. Inflation is the rise in the cost of living and it can affect both the value of your bond and the value of its interest. Here’s one example how.
If you buy a 30-year $10,000 bond that pays interest at 6% per year, you receive $600 each year in interest payments for the next 30 years. But if inflation heats up, that $600 will have less buying power. Your real interest rate will go down proportionately.
Of course, it works the other way, too. If your original bond interest rate turns out to be higher than the market rate as the years go by, you could sell your investment for a premium.
Interest Income Tax
Bond interest is usually taxed at ordinary income tax rates. If you own bonds in a mutual fund, you’ll receive your share of the interest income as taxable dividends from the fund. However, interest on some municipal bonds may be exempt from federal or state or local income taxes-or any combination. Interest on federal bonds is exempt from state and local income tax.
Capital Gains & Losses
You may sell a bond for more (or less) than you paid for it. That gain or loss affects your income tax. The gain may be taxed at ordinary federal income tax rates or long-term federal capital gains tax rates (and possibly at the state and local level, as well).
Retirement Plans & IRAs
Income tax may be delayed for interest or capital gains on bonds on a tax-deferred retirement account or traditional IRA. However, generally all distributions from these retirement plans and IRAs are subject to ordinary income tax rates, including the interest and capital gains. (Roth IRA distributions may be income tax free).
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Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.
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