Thursday, February 23, 2012
International
English
USD
Investor
Bond is a loan and its holder is the lender. The borrower is usually the federal government, a state, a local municipality or a big company like “General Motors”. Money, which those entities need they borrow from the public by issuing bonds.
When a bond is issued, the price paid by the client is known as its „face value.“ Once client buys it, the issuer promises to pay back on a particular day – the „maturity date“ – at a predetermined rate of interest – the „coupon.“
Bonds have a reputation as conservative investments.
Any time client lends money, he runs the risk it won't be paid back. Companies, cities and counties occasionally do go bankrupt or default on their debts for extended periods. Government bonds alone are considered the most reliable.
Paradoxically, another source of risk for certain bonds is that the loan may be paid back early, or „called.“ This is known as prepayment risk.
The greatest danger for a buy-and-hold bond investor is a rising inflation rate.
Rising prices make today's dollars worth less in the future than they're worth today. Since a bond can lock up ones money for as long as 30 years, a rising rate of inflation can have a particularly corrosive effect.
The bond market itself is a minute-by-minute referendum on the threat of inflation. If the threat is high, prices fall and yields – or interest rates – rise. This is often an excellent time to buy bonds.
Inflation risk, interest-rate risk, credit risk and prepayment risk are all figured into the pricing of bonds. The more risk, the higher the yield. It's also true that investors demand higher yields for longer maturities.
The credit quality of companies and governments is closely monitored by the two major debt-rating agencies; Standard & Poor's and Moody's Investors Service. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings – expressed as letters (for example: Aaa, Aa, A, etc.) – help investors determine the interest rate that a company or government has to pay when it issues bonds. The market determines the price – and thus the yield – after that.
Most bonds have been issued by one of three groups: the central government, local governments or corporations. But to confuse things, these entities issue many different types of bonds that run the gauntlet in terms of risk and reward. Government bonds are widely regarded as the safest bond Investments, because they are usually backed by „the full faith and credit“ of the government.
Compared with other types of bonds, however, even the 10-year Treasury is considered safe. And there's another benefit to Treasurys: The income one earns is exempt from state and local taxes.
Municipal bonds are a small step up on the risk scale from Treasurys, but they make up for it in tax trickery. Thanks to federal guidelines, the government can't tax interest on most state or local bonds (and vice versa). Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe from city, state and federal taxes. (A happy state of affairs known as being triple tax-free.)
These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds. But depending on tax rate, net returns (or after-tax returns) may be higher than it would be with a regular bond.
Corporate bonds are generally the riskiest fixed-income securities of all because companies are much more susceptible than governments to economic problems, mismanagement and competition.
Corporate bonds can also be the most lucrative fixed-income investment, since the client is generally rewarded for the extra risk he is taking. The lower the company's credit quality, the higher the interest he pays. Corporate come in several maturities:
The credit quality of companies and governments is closely monitored by three major debt-rating agencies: Standard & Poor's, Moody's Investors Service and Fitch Ratings. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings – expressed as letters (Aaa, Aa, A, etc.) – help determine the interest rate that company or government has to pay.
Corporations, of course, do everything they can to keep their credit ratings high – the difference between an A rating and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade (Ba and below) ratings sell bonds to raise money. These securities, known as high-yield, or „junk,“ bonds, are generally too speculative for the average investor, but they can provide spectacular returns.
Zero-coupon bonds are fixed-income securities that don't make interest payments each year like regular bonds. Instead, the bond is sold at a deep discount to its face value, and at maturity the bondholder collects all of the compounded interest, plus the principal. These bonds can be issued by the government, a municipality or a corporation.
Zeros are usually priced aggressively and are useful for investors looking for a set payout on a given date, instead of a stream of payments that they have to figure out where to invest elsewhere. They can, for example, be a handy tool for those approaching retirement.
Zeros do have a tax drawback, however. Since interest is technically earned and compounded semi-annually, holders of zeros are obliged to pay taxes each year on the interest as it accrues. This means – client has to pay the tax before he gets the money, which might be a struggle for some investors.
Like an equity mutual fund, a bond fund is managed by a professional investor who buys a portfolio of securities and makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile – 15-year corporate, for instance, or tax-free municipals – and pay out a coupon to investors – often monthly, rather than annually or semi-annually like a regular bond.
The chief advantage of a bond fund is that it's convenient. It's also true that when it comes to buying corporate and municipal bonds, a professional manager backed by a strong research organization can make better decisions than the average individual investor.
The disadvantage of a bond fund is that it's not a bond. It has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date – the two key characteristics of individual bonds. Then there are the fees and expenses that can cut into returns. Finally, because fund managers constantly trade their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at the whim of the manager.
The other thing about building ones own portfolio of bonds is that he or she can tailor it to meet his or her circumstances, meaning the bonds will mature precisely when he or she needs them. A bond fund cannot deliver that sort of precision.
If someone lacks the time or interest to manage a bond portfolio on his or her own – or if someone wants a mixed portfolio of corporate or municipals – they should buy a bond fund.
