Financial Guides: Bonds FAQ
What is a bond?
A bond is simply a certificate which the borrower promises to repay within a certain time period. For the privilege of using the money, the government entity, municipality or company will agree to pay a certain amount of interest per year, usually an exact percentage of the amount loaned.
Bondholders do not own any part of the companies they lend to – they do not receive the benefits of dividends or the privilege to vote on company matters as stockholders would, and the success of the investment isn’t related to that company’s record in the market either. A bondholder is entitled to receive the amount that was agreed upon, as well as the principal of the bond.
Corporate bonds are generally issued in the denominations of $1000. This price is referred to as the face value of the bond – this is the amount that is agreed to be paid by the company at the time that it matures. Bond prices can differ from their face values, because the prices of the bonds are correlated to the current market rates. When these rates change, the value of the bond will as well. If one were to sell the bond before the time that it matures, the bond may be worth less than was initially paid. A callable bond is one that the issuer may choose to buy back at full face value before the maturity date.
There are three major features of bonds:
- Issuing Organization
Short Term Bonds mature in two years or less and long term bonds mature in ten or more. Intermediate is between two and ten years.
What is bond quality?
Bond quality is the rating of the creditworthiness of an issuing organization. There are organizations that specialize in judging bond quality. The higher the rating, the lower the risk of the investment. The rating system uses letters A through D. The only bond considered to be risk free is the U.S. Treasury Bond.
How does the bond rating system work?
|Highest Quality||Moody’s||Standard & Poor’s|
How do interest rates affect bond prices?
Generally bond prices and interest rates have an inverse relationship – as interest rates drop, bond prices rise and vice versa.
How does maturity affect bond prices?
Bond prices are heavily influenced by maturity – the longer the maturity, the greater the change in price for a change in interest rates. If interest rates rise, it would make a larger difference in the 20 year bond, as opposed to a 10 year bond. Because of this, bond fund managers will attempt to change the fund’s average maturity to anticipate changes in interest rates.
What is a bond call provision?
A “call” is when the issuer of the bonds has an opportunity to redeem the bonds after a certain specified amount of time has passed. This doesn’t guarantee a continuation of a high yield after the call date – it limits the appreciation of the bonds, and it makes the investment more risky. These call provisions can be complex, so it is best for investors that don’t have strong knowledge to avoid bonds with a call feature.
Should I buy bond funds directly or go through a mutual fund?
A bond mutual fund has within it multiple bonds, and for that reason it is impossible to lock in the payment rate or the principal, which you would be able to do if you were directly buying a fund.
A bond mutual fund is an investment company which manages a portfolio of individual bonds. The investors buy ownership in the company, and each share represents ownership in all of the company’s holdings. Managers will use these investments to buy and sell bonds that align with the objective of the fund.
Because a bond fund manager has more resources to deal with, they can invest in a vast array of bonds – many more than could any individual investor. There are also certain investments that cost tens of thousands of dollars a share – a bond fund costs far less.
Liquidity plays a major role in bond buying. If you purchase a bond individually and wish to sell it, you must find a buyer for your bond, but if you are invested in a bond fund, that fund has to buy your shares back at any time you wish.
What are the different issuing organizations?
- Municipal bonds are offered by local governments, states and cities. The interest of these bonds is not subject to federal income tax, and if the bondholder lives in the jurisdiction of the governing authority, the interest is exempt from state and local tax. Because of all of these tax advantages, the interest rates paid on these bonds is usually lower than others.
- Like municipal bonds, the U.S. government also issues these securities. Since they are issued by the U.S. Government, they are considered to have the best safety of all bonds.
- Treasury bills can be bought through a broker or directly from the Federal Reserve.