The Lifespan of Bonds

Unlike stocks or mutual funds, almost all fixed-income securities have a predefined, limited lifespan. The beginning of that period is usually called the issue date (as with stocks). Unlike stocks, however, there is also a maturity date, the date on which the final payments from the issuer are supposed to be paid. Although stocks can be retired or merged out of existence, they do not have a predefined ending point. This is a key difference between stocks and (almost all) bonds.

A Bond by Any Other Name . . . A Note on Terminology

The bewildering variety and complexity of fixed-income securities is so great that the term fixed has a certain irony—mixed might be more appropriate. The income from many of these instruments is anything but fixed. There are adjustable rates, floating rates, and LIBOR-plus rates. In the global markets, fluctuating exchange rates impact the value of both interest and principal. Junk bonds have a high-risk element that can turn them into “nixed” income securities. And many securities come with complicated options or prepayment features built into them, making their future cash flow a subject for careful analysis by teams of mathematicians working with powerful banks of computers.

LIBOR-plus

Use of LIBOR as benchmark to define a floating interest rate (e.g., LIBOR + 2%).

junk bond

A bond of extremely low credit quality.

Sometimes people refer to bonds and other fixed-income instruments as debt securities; at other times, the term credit instruments is used. Adding to the potential confusion, although most fixed-income/debt/credit instruments trade in an enormous global over-the-counter (OTC) market, many U.S. corporate bonds trade on the New York Stock Exchange. (You might have thought that only stocks trade on a stock exchange; not true. In fact, two of the original five securities traded in the 1790s under the legendary buttonwood tree were government bonds.)

To keep it simple, just remember that bonds and other fixed-income securities may also be referred to as debt securities or sometimes credit instruments. Whenever it will help the flow of explanation, we’ll just call them bonds.

Interest versus Discount

Some kinds of bonds are designed to pay interest; others are purchased at a discount from their face value, or redemption price. Most long-term bonds are of the former variety. Short-term money market instruments are sold at a discount. So are zero-coupon bonds and strips, which have maturities of up to 30 years.

money market instrument

Short-term debt obligations such as Treasury bills, certificates of deposit, and commercial paper.

Perpetual Bonds

It is said that there is an exception to every rule. In the present instance, the rule is that all bonds have a maturity date; the exception is perpetual bonds. Perpetuals, like Peter Pan, never mature. Nor can they be redeemed by their issuer; they pay interest forever. They are also known as annuity bonds.

There is only one well-known example of perpetual bonds: the British consols. These were issued in the days when the sun never set on the British empire to help pay off other debt originally incurred during the Napoleonic Wars. Though we’ve never seen one, we’ve heard that consols are still around, as are proposals to issue perpetual U.S. Treasury bonds instead of constantly refunding debt as it matures. That proposal, whatever its merits, is a perpetual nonstarter.

The amount of interest that a bond pays as a percentage of its face value (also called principal amount) is called its coupon, or coupon rate. For example, a bond with an 8 percent coupon rate pays $8 for every $100 of face value. Individual bonds often come with a face value of $1,000; $5,000 is also a common amount.

Where Have All the Coupons Gone?

The term coupon comes from the originally almost universal practice of selling bonds with detachable coupons that could be presented to a paying agent on the coupon payment date. Such unregistered bonds were also known as bearer bonds, because the bearer’s possession of the coupon was all that was necessary to secure payment. Coupon bonds are gradually disappearing, being replaced by registered book-entry bonds.

Relationship of Price to Yield

When the amount you pay for a newly issued bond is the same as its face value, you are said to have purchased it at par. But the price of bonds varies in response to changing levels of prevailing interest rates and other factors. If you pay less than par for a bond, it is called a discount bond. If you pay more, it is called a premium bond. For example, you might buy a $1,000-face-value bond with a 4 percent coupon for $800. Though the coupon rate is only 4 percent, you are getting more than 4 percent on your money. After all, you’ve only put in $800 and you’re getting $40 per year in interest—that’s 5 percent right there. In addition, you will get the full face value of $1,000 back if you hold the bond until maturity—that’s a $200 bonus. To see how these factors are taken into account, we must turn to the subject of a bond’s yield and the various ways to measure it.

Four Important Yield Measures

The exact definition and measurement of yield is a large and complex subject. Nonetheless, it is possible to get a grasp of the fundamentals by becoming familiar with four ways that yield is measured and quoted by banks, brokers, and in the financial press:

• Current yield

• Yield to maturity

• Yield to call

• Equivalent taxable yield

The current yield on a bond is simply its coupon divided by its purchase price. This is a more accurate gauge of your return than the coupon rate described previously, because current yield takes into account how much you actually paid, which could be more or less than par.

What it leaves out of the account, however, is the amount that you will receive if you hold the bond until its maturity date. For this, another measure is used—the yield to maturity. Yield to maturity adjusts your rate of return to reflect the difference between what you paid for the bond and what you will receive on the maturity date. It also adjusts for the exact timing of interest payments (typically, bonds pay interest semiannually).

What if you can’t hold the bond to maturity? Sometimes, as we will see shortly in more detail, bonds are subject to call provisions—the issuer reserves the right to buy the bonds back from you on specific dates at a specific price. In those instances, you may want to know the yield to call, which adjusts your rate of return in a manner similar to the yield to maturity, replacing the maturity date with the first call date, and the principal amount with the call price, which is usually somewhat higher than par to compensate the bondholder for having the bond called away.

called away

Said of an underlying asset exercised away from the call writer.

A final fundamental measure of yield derives from the need to compare tax-exempt municipals to other, taxable, bonds. This is the equivalent taxable yield. For example, starting with a yield of 6 percent on a municipal bond, someone whose marginal tax rate was 40 percent would need to earn 10 percent on a taxable corporate bond to get the same amount of money on an after-tax basis.

Credit Quality, Ratings, and Insurance

So far, we have not discussed perhaps the most important reason people buy bonds: safety of principal. Some bonds, such as those issued by the U.S. Treasury, are generally considered paragons of safety. They have the highest credit rating of any securities in the world, though the financial crisis has highlighted potential long-term problems and led some to speculate that the U.S. dollar might lose its status as reserve currency of the global financial system. Independent credit-rating agencies, such as Moody’s and Standard & Poor’s, score the creditworthiness of issuers and also of specific bond issues. These agencies have been widely criticized for being slow to downgrade issuers and for the inherent conflict of interest stemming from the fact that the issuers pay for their ratings. Credit enhancement, in which an issuer or investor seeks to insure bonds against possible default, was very profitable for insurers like AIG, until the possibility of widespread defaults brought down the house, which turned out to be woefully undercapitalized.

Call and Related Features

Bonds with call provisions require additional vigilance on the part of investors. If you are the owner of a callable bond, what do you need to look out for? When a bond is trading at a discount, it is safe from being called. Interest rates are higher than when the bond was issued, and the issuer has no incentive to buy them back at par. The intrinsic value of the call is zero (see Chapter Sixteen). When the bond is trading at a premium, however, it will probably be called away at the earliest possible call date. The issuer really has no choice—it must act in the best interest of shareholders.

Some bonds come with what are called sinking fund provisions. These stipulate that, under certain conditions, the issuer must retire a certain portion of the bonds outstanding according to a fixed schedule. Which bondholders are affected is determined by lottery.

Occasionally, you may run across a put bond in the corporate bond market. Put bonds allow you to sell back the bond at par on certain date(s), offering some protection from a rising-interest-rate environment that would erode the market value of your bond. Alas, such protection is not free. Put bonds have lower yields than comparable bonds that do not offer this “insurance.” Bonds with detachable put options are gaining in popularity (see Chapter Sixteen for a discussion of puts). The puts are usually purchased by the options trading desks of banks and brokerage firms, leaving the investor (usually an institutional money manager) with a plain old corporate bond.

Fixed versus Floating Rates and Foreign Currencies

Finally, we’re back where we started, looking at the paradox of referring to bonds as “fixed-income securities” when there is so much that is variable about them—even their interest rates. Many issuers offer floating-rate notes that pay a variable interest rate, recalculated periodically to reflect changes in some benchmark rate. Typically, the benchmark is another interest rate of some kind, like the prime rate charged by major commercial banks on loans to their most creditworthy corporate clients, or the London Interbank Offered Rate (LIBOR).

As Time Goes By, Some Bonds Are More Durable than Others

Beyond knowing the maturity date of a fixed-income security, it is useful to understand the idea of duration. Recall that bond prices and interest rates have an inverse relationship: When one moves up, the other moves down. Duration is a measure of how sensitive a bond’s price is to a small change in interest rates. Higher duration equals greater sensitivity. Even if two fixed-income securities mature on the same day, they may have very different cash-flow characteristics and may respond differently to changes in the overall level of interest rates. Putting aside for the moment such complications as callability, a fixed-income security that pays you back all at once on the maturity date is said to have a higher duration than one that pays periodic interest. And, all other things being equal, the higher the rate of interest, the lower the duration of the security.

But the benchmark does not need to be an interest rate. In 1997, the U.S. Treasury introduced Treasury Inflation Protection Securities (TIPS), benchmarked to the U.S. Consumer Price Index. This means, in effect, that TIPS are denominated in real dollars (i.e., dollars adjusted for inflation), unlike the nominal dollars we still use to buy things at the grocery store. Foreign governments and corporations, of course, issue bonds in dozens of different currencies. The rate of return on these bonds depends on the currency of issue and the currency in which the bondholder does the analysis.