Bonds talk

What a bond is and what you will find here

2010-09-08T04:37:00.001-07:00

A bond is a contract between a lender and an issuer. The principal behind bonds is very simple, the issuer borrows some money and the investor lends some. After the agreed period of time the bond investor will receive its money back plus an interest. Bond issuers can be more or less reliable that's why rating systems are one of the major factors that influences bond prices and interests. Rating agencies assess issuers, the process defines how likely is for the lender to receive the capital plus interest back at the due date of the bond.

Bonds are one of the most reliable financial products. People that invest in bonds are very likely to maintain them until the due date, at which they will receive their principal back plus the interest matured. However, many other investors prefer to buy and sell bonds in a speculative way. Bond maturities range from six months to 30 years. Because of their long term investment nature there are several types of bond ownerships regulated by law, these help us to preserve the capital over the life span of the bond.

American securities are generally traded through a bond broker or directly from Treasury Direct. Depending on the kind of bonds, the investor will receive a bond certificate, this guarantees the possession of the security.. Bonds come in a series of varieties and the income generated by them is taxed differently, depending on a series of factors, mainly on the issuer and the category.

This website plans to be a resource of material for people that are or want to become bond investors. A series of articles will outline the main aspects of investing in bonds: types, risks, ratings, interests.

Investing in bonds, the risks

2010-09-08T04:30:00.000-07:00

This article contains a definition of the risks we may run into when investing in bonds.

Stocks and bonds have always been two very different investment products dedicated to different approaches to saving/investment and to risk. One of their differences is the speed at which they move, stocks move within percentage points everyday, this makes them a very risky investment product for people that don't plan to trade every day. On the other hand bonds move at a much slower pace, within percentage point per month and main thing if interest rates go up the bond's price on the market goes down. If the market price of a bond goes down the best solution is always to wait until the due date at which the principal plus planned interest will be entirely returned to the investor.

The biggest difference between stocks and bonds is the concept behind them. When buying stocks the investor becomes part of the company, when buying bonds the investor is lending money to the company. This changes completely the relation between the two entities, the investor and the financial product. If you are part of a company you will divide with them all the yearly gains if the company is doing well (through dividends), at the same time you will share the losses of the corporation. This means that if the corporation does not do well you will not receive your principal back and anyway you cannot wait for a due date because for stocks there isn't one, this contributes to the increase of the risk of investment in stocks/shares .

When buying bonds we are lending some money to a corporation or an institution. That means that by law at the due date they have to give the entire amount of money back plus the interest that they promised. In this case the law contributes lowering the risk, also in case the market price of the bond goes down we can always wait until the due date to receive everything back. This characteristic makes bonds a very attractive opportunity for people that have the preservation of their principal as a major priority in their investment strategy. Here you will find more details on bond yields.

Bonds as financial products are very safe but not totally, some of the risks we will analyse in the articles related :

Default risk
Market risk
Liquidity risk
Early call risk
Event risk
Tax risk
Political risk
Inflation risk

The Market Risk in bonds

2010-09-08T04:11:00.000-07:00

In this article we will consider how speculative bond investments expose to market risk.

All bond investments are subject to the market risk, this is a risk to keep in consideration in case our goal is to make a profit in a speculative way. That is, if we want to buy and sell securities before their due date at an higher price making a profit from the gain in the bond price.

The market risk influences only the price in the bonds market, when the bond value goes down the face value stays always the same, that means that waiting will return the entire principal (plus interest) no matter the market value of the bond at that time.

One of the main reasons why the market price of a bond goes down is the rise of interest rates.

If the market price of the bond goes down it does not mean that the face value has changed, in fact it stays the same, in case the value of a bond goes down if you keep it until the due date the entire principal plus interest will be given back to you no matter the market value at that time.

The market risk while trading bonds is determined by the market price of securities at that time.

Bond prices are determined by many factors:

Volumes (number of bonds being sold in a transaction)
Number of contracts (availability of bonds)
Demand
Size of the issue
Call features

Substantially the market value of a bond is entirely determined by the amount of people that find it interesting, because of its yield, its face value, its issuer or the price it self. Because all this factors determine the market value of a bond and its yield rates, data given by brokerage houses may be not precise. The market value of a bond is determined by the market itself at the time of a transaction.

The fluctuation of the market value of bonds is a risk to consider when investing in securities, the main cause of drop in the market value may be the rise of interest rates. The best way to prevent the market risk of investments is to buy securities that expire at the time the principal is needed, keeping bonds until their due date will gives immunity from the market price and helps to preserve the principal.

What is liquidity risk in bond terms

2010-09-08T04:10:00.000-07:00

If buying bonds in a speculative way considering their liquidity is essential. Here we see what may cause liquidity risk.
The liquidity risk in bond trading is strictly related to individuals that use bonds in a speculative way. The liquidity risk is given by the difficulty of being able to sell securities quickly at an attractive price. Liquidity risk applies only to whom is looking to sell its bonds before the due date, in fact who keeps them until their maturity will receive its principal plus interests back at the face value of the bond so its not concerned.

Liquidity risk may be caused by a series of events and/or characteristics of the bond itself:

Small market volumes because of poor rating
Small face value(lt;25000)
Callable bonds

Poorly rated bonds have a very high yield rate, at the same time they do not guarantee the principal and interests at the right time. The yield of poorly rated bonds may seem very different and a lot more attractive when buying bonds. However, most of the time the risk is not worth the potential gains achievable through this products. The majority of investors do not buy poorly rated securities.

Institutional customers tend to buy securities with high face value so to preserve their capital from speculation. Bonds with a small face value are traded mainly by the retail customers, because of their nature they tend to be traded with smaller volumes, therefore they are less liquid.

Callable bonds are securities that can be repaid early by the issuer. The majority of investors do not think that callable bonds are appropriate to their portfolio strategy. The fact that a bond is callable does not guarantee the achievement in yields scheduled by the investor through compound interest, that makes this kind of bonds less attractive and therefore less liquid.

To prevent the liquidity risk is necessary to buy bonds with a maturity date near to the time in which we will need the money. Keeping securities until their due date is normally one of the best ways to prevent capital and/or principal loss in the world of bonds investments.

What happens to bond investors when a company defaults

2010-09-08T04:09:00.000-07:00

The default of a corporation is a rare event. However, if we want to preserve our capital we have to look after every aspect of our investment. Here we see how to prevent buying risky bonds.

The default is one of the risks to take in consideration when investing in bonds but mainly when picking a bond to buy. A default is caused by the issuer of the bond not being able to pay the interest or the principal back to the investor at the right time. When this happens the issuer is obliged by law to pay the principal back, so to honour the contract that a bond represents. This may happen with a different time scale or at a different interest rate, in any case the investor will have its principal back.

The default risk has to be taken considered when choosing the bond to buy, normally rating agencies help us choosing, giving a lower rating to bond issuers that cannot guarantee interests and or principal back or that have an history of not being able to pay back. Also, rating agencies normally never give a triple A (AAA) rating to issuers that don't have an insurance on the capital. The insurance would guarantee the debt towards the investors to be extinguished in the event of default.

In case a default happens, given the nature of the investment as lenders, by law the bond investors have precedence compared to the stock investors. The principal is always going to be paid back to the bond investors at a different time, the interest may be paid back at a different time and or at a lower rate.

When a default happens the corporation is not allowed to issue a new bond or in the best case not at the same rate, this gives a margin of security to investors. In any case bond investors that incur in a default, will receive their principal back only with a different time scale.

Why is the early call clause important when buying bonds

2010-09-08T04:08:00.000-07:00

Here we see what happens if an early call to a bond issue is made.

The early call is one of the characteristics we need to double check while buying bonds. The call is made by the bond issuer and consists in terminating the bonds life span early. Issuers use the call feature of bonds because at that time they are able to pay back the debt to the lenders.

Calls are normally made when interest rates go down, that makes it financially dis favourable to the investor in two ways: less compound interest from the actual investment and potential rise of interest rates for future investments.

Compound interest is one of the most relevant yield producer in bond investments. When the yearly yield is calculated, compound interest is normally included and it is one of the major sources of value gains in our principal. When a bond issuer takes advantage of the early call clause of a bond it causes the lifespan of the bond itself to be reduced. In this case the compound interest effect is going to be shorter, limiting our yields on the principal.

Bonds investments are strictly related to interest rates, when selling or buying bonds in a speculative way it is necessary to guess what is going to happen to interest rates in the future. When interest rates go up the market value of bonds goes down and vice versa. In case an issuer takes advantage of the early call the interest rates may be lower, limiting our yield on the investment. At the same time if the interest rates are lower there is a possibility of them to be raised, that would erode the market value of our future bonds investments.

When buying bonds early calls will have to be considered as they can make radical changes in the gains of our portfolio. Early calls can unbalance our plans and ideas of gains throughout time especially if we are planning to keep the principal invested for long terms. To prevent the early call risk we can buy non callable bonds or to consider how a call would influence the gains made in your portfolio. Planning ahead will diminish the effect of bond calls on our overall gains.

How a bond makes you money - the bond yield

2010-09-08T04:07:00.000-07:00

Bond yield is the amount of money gained by an investor during the bond's life span.

The yield gained through bonds will not be as high as the yield that more risky investments may return to an investor. Bonds are considerate a safer option for people that want a small constant stream of income. The yield of a bond is calculated by multiplying the face value of the bond issue times its yield rate. For example a bond with a face value of 100 multiplied .06 (6 % gain) equals 6 gain per year. However, this is not a precise way to calculate the real gain generated by the investment . There are different ways to calculate bond yields. Here we will see which we will need to keep in mind when considering to buy bonds.

The current yield, generally over considered by investors is often misleading. To calculate the current yield of a bond the interest received for the year is divided by the face value of the security. Although this way may seem rational it does not consider the real market value of the bond neither if the bond was bought at premium or discount price. This may cause a substantial difference in the gains expected by the investor.

The yield to maturity is the way we can compare different bond issues and see which is appropriate to our needs. Bond investments come in a variety of maturities, the longer the time the higher the gains, compound interest is what does the magic. The yield to maturity method, however does not consider capital gain taxes. This way of calculating bond interests leads to close but not precise figures.

The yield to maturity after taxes is a tool that gives us how much is the gain generated by the bond investment. The capital gain the majority of bonds generate is subject to income tax. This is a component to keep in mind when buying bonds to have a clear idea of what to expect from the investment.

The yield to call is the yield an investor earns when a bond is called. A call is caused by an issuer paying off its debts (bonds) early. A called bond is an incomplete issue. The smaller life span of the bond causes the investor not to receive the interest expected and reinvestment expenses. Callable bonds are generally priced less on the market and are considered more risky as an investment.