Investing in Bonds - Corporate, Treasury Or Municipal?

When you buy a bond, you are actually loaning your money to the organization that issued the bond. That is why bonds are often called "debt instruments." The principal (the "face value" of the bond) is repaid on the maturity date. In the meantime, you are paid a set amount of interest, usually every six months. This interest is called the "coupon" or "coupon rate." It's called that because bonds used to come with little coupons attached that you would cut off and send in twice a year to receive the interest payment. Nowadays, the coupon rate is nothing more than the annual interest rate.

When deciding which types of bonds to invest in, it's important to know all you can about each. Among the types of bonds you can choose from are:

Treasury Bonds

Treasury bonds, also known as "T-bonds" for short, are issued by the United States government and are considered to be the safest of the three bonds. The only risk is if they are sold prior to maturity (but this holds true for all bonds). Super-safety comes at a cost, though, and in the case of treasury bonds that means lower returns than other bonds.

Interest is paid on treasury bonds twice a year, and can be purchased in maturities ranging up to 30 years. All T-bonds bonds are issued in face values of $1,000 with different purchase minimums with each type of security. It is impossible to redeem a treasury bond before maturity, and interest payments stop as soon as the bonds mature.

Corporate

Corporate bonds are issued by companies in order to raise capital. While they can be very safe investments when issued by strong, established companies, the reverse is true for companies that are not rock solid. Unlike treasury bonds, corporate bonds have what is known as a "call provision", which allows the bond holder to get their principle investment back before maturity.

Most corporate bonds have fixed interest rates, and some, called "zero coupons" are sold at a significant discount in exchange for the bondholder agreeing to wait until maturity to receive interest payments.

Because determining which companies are strong and which aren't can be very tricky, there are companies who evaluate the fiscal integrity of various corporations to determine their bond-worthiness. Moody's Investors Services and Standard and Poor are two examples of such rating companies.

Municipal

Municipal bonds are issued by state, county, or city governments for the purpose of financing government sponsored functions (I.E., building a highway or a school), or for other "non governmental" purposes, such as raising money for low income housing or student loans.

Municipal bonds, like T-bonds, pay interest twice a year. These investments can be very safe, but do carry risks as well. Moody's and Standard & Poor rate municipal bonds based on their credit quality, so when investing in them, it's a very good idea to use these ratings as a guideline.

Municipal bonds are subject to significant market risk if sold before maturity.

Maintaining a Diversified Portfolio

Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income. Whatever the purpose-saving for your children's college education or a new home, increasing retirement income or any of a number of other financial goals-investing in bonds can help you achieve your objectives.

Assessing Risk

All investments offer a balance between risk and potential return. The risk is the chance that you will lose some or all the money you invest. The return is the money you stand to make on the investment.

The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also have the lowest returns.

The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for several reasons:

o Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.

o Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.

o Historically the bond market has been less vulnerable to price swings or volatility than the stock market.

The average returns from bond investments have also been historically lower, if more stable, than average stock market returns.

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What Are Corporate Bonds?

Introduction

Continuing economic and financial volatility has cemented in investors' minds the importance of diversification across asset classes. As interest rates have been driven down, and government gilt yields have fallen, investors seeking income or a higher rate of interest are increasingly turning to corporate bonds.

What is the bond market?

The bond market, also known as the debt, credit, or fixed income market, is a financial market where

participants buy and sell debt, usually in the form of bonds (1). As of 2006, the size of the global bond market was an estimated $45 trillion with Corporate bonds accounting for $15 trillion in issue (source: Merrill Lynch Bond Index Almanac). Since the mid-1990s, corporate bond markets have become an increasingly important source of financing for companies, even more so with the recent credit and liquidity crunches (2) which have caused banks to reduce their lending.

What is a Corporate Bond?

A 'corporate bond' is an 'IOU' issued by a company (corporation) rather than a government, typically with a maturity of greater than one year; anything less than that is often referred to as commercial paper (3). They are a way to raise money for projects and investment and are also known as credit. The issuance of a bond will often provide low cost finance, especially the case in recent years with low inflation, interest rates and good corporate stability. The low cost of the interest or coupon payments can be further reduced by the fact the payments are generally tax deductible. By issuing bonds, rather than equity, a company will also avoid diluting the equity in the company.

A company seeking to raise money issues corporate bonds. These will typically be bought by investors at what is known as "par", usually for 100p. Like equities, bonds can be bought and sold until maturity and values can fluctuate depending on supply and demand. Other external factors, such as interest rates, can also impact the price. The company commits to pay a coupon or rate of interest to the investor. This will generally be a fixed amount and is paid annually or semi-annually. After a defined period, set at outset, the bond is repaid by the company. Bonds will typically redeem at par or 100p irrespective of how the market price has fluctuated before maturity.

How are Corporate Bonds rated and by whom?

Independent ratings agencies are responsible for researching companies and supplying 'grades' or 'ratings' to companies' debt (bond issues). The most readily recognized ratings agencies are Standard & Poor's, Moody's and Fitch Ratings.

There are two main subdivisions of corporate bonds depending on their 'credit rating', which indicates to investors the level of risk associated with the bond.

Investment Grade Bonds - With investment grade bonds it is assumed that the chance of non-repayment or default is low due to the issuing company having a comparatively stable financial position. As a result of the increased stability, the income or coupons offered are usually lower than those from sub or non-investment grade.

Sub-Investment Grade Bonds - High yielding, sub-investment grade bonds are higher risk investments. They are sometimes referred to as junk bonds. These tend to be issued by less financially secure companies or those without a proven track record. The default rate of these bonds is expected to be higher than investment grade corporate bonds.

What are the ratings?

The ratings depend on how the credit rating agencies view the financial standing of the company issuing the bond, its ability to continue to make payments to its bond holders in the future and what protection the bondholder has should the company face financial difficulties.

How are returns measured?

The income generated from a bond is referred to as the yield. There are typically two yields to indicate the return the bond provides to an investor (4);

Income Yield - also called the interest yield or running yield, is a simple measure of how much annual income a bond will provide to the investor. The diagram below shows the relationship between yield and the price of a bond.

In this example, the bond yields 4.00% based on its par value of 100p, i.e. 4p. If the market value of the bond drops to 90p it still pays out 4p. This means any purchaser at this price will receive a yield of 4.44%. If the price of the bond drops further the yield will increase. Conversely, as the price of a bond increases the yield decreases.

Redemption Yield - takes account of both the income received until maturity and the capital gain or loss when the bond is redeemed. If a bond has been purchased at a market price higher than the par value at redemption then there will be a capital loss. This would mean the redemption yield will be less than the income yield. Depending on market conditions, there can be a substantial difference between the redemption yield and the income yield.

What impacts bond valuations?

Interest rates - the relationship between interest rates and corporate bond prices is usually negative, i.e. corporate bond prices fall when interest rates rise. A rising interest rate makes the present value of the future coupon payments less attractive in comparison and investors may sell bonds, in order to move their monies. Any new issues of bonds must raise their yields in order to attract investors so older issues with lower yields become less popular. Conversely, declining interest rates cause investors to seek higher yields from bonds, increasing the price.

Inflation - Similar to interest rates, the relationship between inflation and corporate bond prices is usually negative. A high rate of inflation reduces the value of future coupons or redemption value causing investors to seek alternative investments. Inflation and interest rates are often linked; predominantly because interest rates are commonly used by central banks as a way of moderating inflation.

Like all asset classes, valuations can be impacted by a wide range of factors, both general economic and financial, as well as specific to the issuing company. The performance of other asset classes can also impact valuations as they attract investors away from or to bonds.

What are yield curves and spreads?

A yield curve illustrates the 'yield to maturity' of a range of similarly rated bonds with different periods to maturity. In the yield curve chart below bonds issued with longer maturity will typically offer higher yields to compensate for the additional risk of time.

The illustrated yield curves also demonstrate that credit spreads (yield on the type of bond illustrated

minus the yield on government gilts of an equivalent maturity) are typically higher for riskier debt.

Why do investors buy Corporate Bonds?

Companies typically offer higher yields than comparable maturity government bonds, bearing in mind the higher level of risk. Since corporate bonds can be bought and sold, supply and demand can also generate capital appreciation in addition to income payments.

Similar to equities corporate bonds provide the opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet investment objectives. At the same time should an investor need to sell a bond before it reaches maturity, in most instances it can be easily and quickly sold because of the size and liquidity of the market. Most importantly for those seeking an income coupon payments and final redemption payments are usually fixed; this means there is a certainty about both the amount and timing of the income an investor will receive.

A financial term explained every week at http://www.aag.co.uk

David Alexander
CEO
The Alexander Associate Group
http://www.aag.co.uk