Bonds and The Bond Market Given today’s uncertain economy, many people are taking time to examine various options for their financial future. Different types of investments are investigated and bonds are one of the more popular choices considered. Many of the same people who talk about investing in bonds, however, do not fully understand them nor where they place in the economy. Many individuals believe that they should simply buy a bond and wait until it matures before cashing it in. These people fail to realize that they may be losing a lot of money due to the fluctuation of bond prices. At some point it may be more profitable for them to sell their bond than to keep it until the payment date is reached.
There are many people who do not understand what bonds really are. A bond is an agreement between two separate entities. One of these bodies gives, to the other, use of their money for a period of time and, in return, may receive a “bond”. The bond issuer agrees to a fixed rate of return which he will pay the supporting person or business. This fixed rate of return is an amount, in percentages, which is paid at regular intervals until some future specified time ( the “maturity date”). Upon reaching the maturity date, one’s original investment is returned to them. As previously mentioned, bonds are one of the more popular types of financial investment in today’s economy.
There are many reasons why people invest in bonds. For example, if one chooses a stable and profitable bond, it will provide a steady source of income through interest payments during the lifetime of the bond. As well, the risk when investing in a bond is considerably less than for most other forms of investment. The bond does not, for instance, experience the volatility of a stock on the stock market, like many other forms of investment do. Also, in instances where the issuer fails to pay the principal amount back to the bond holder, legal recourse is available. Furthermore, in cases of bankruptcy within large corporations with stock holders, bond holders take priority and are guaranteed payment before stockholders. During the past forty five years, bonds have experienced their ups and downs. Represented by the chart on page 343 in Fundamentals of Corporate Finance (Ross), the return rate on bonds has surpassed the inflation rate. Bonds have averaged an interest rate of over six and a half percent, while the inflation rate has averaged under four and a half percent. Although it may seem like an insignificant amount of interest, over time, this difference in interest rates can lead to extremely large profits. If you invested $1 000 dollars in bonds in 1950, by the end of 1995 you would have acquired $17 630. While according to the Consumer Price Index (the cost of living rate), you would only need $7 000 to have the same buying power that you would have had in 1950. That is a difference of $10 630 in purchasing power that you would have gained. This increase in purchasing power seems very significant; however, you must also realize that these profits do not include the numerous times when you could have sold out of your bond for an even greater return. You must also realize that the large difference between bonds and stocks is not fairly represented as well. Although the stocks show a $79 750 increase over the inflation rate, you must keep in mind that stocks carry a lot more risk than bonds do; this volatility could lead to an enormous loss in money if your money is not invested in the right companies.
Let us now examine the various types of bonds available. When people consider investing in bonds they should be aware of their choices and what each different possibility means to them. As with mutual funds and other forms of financial investment, there are many different types of bonds available on the market. Each individual, when considering bonds, must decide which of type of bond is best suited to him. Some bonds provide a stable income from interest earned and must be kept in the form of a bond until maturity, while others give the bearer an the option of whether or not he or she would like to ‘trade’ the bonds in for common stock. U.S Treasury Bonds are labeled as “government bonds”, however, in comparison to regular bonds, their characteristics differ. One advantage of U.S Treasury Bonds is that, unlike most bonds on the market, their prices do not fluctuate with interest rates or credibility ratings. Another advantage that U.S Treasury Bonds have is the stability of their value. At any time, a holder of U.S Treasury Bonds may cash their bonds and receive face value for them. One difference which might be considered a downfall between U.S Treasury Bonds and regular bonds is that the federal government guarantees the interest rate of the bond for the first year only, with annual adjustments to the rates every year thereafter. These adjustments, however, do not necessarily have to mean bad news, as there have been many years when the interest rate have gone up.
Another type of government bond is the “municipal bond”. Municipal bonds are provided as a means of financing public works within a particular municipality; for example, the installation of street lights, establishment of libraries and construction and maintenance of roads. This is one of the only ways that municipalities can raise funds, other than through taxes, donations from the federal government and the introduction of fees for different privileges. Failure to pay either the interest or the principal amount of a municipal bond may be followed by legal action against the issuer of the bond. A big advantage of purchasing municipal bonds is that the interest one earns is tax-free, and can therefore provide you with a tax-sheltered means of income. As well, municipal bonds are more stable than other bonds and are less susceptible to changes in price due to fluctuations of interest rates. Another advantage of the municipal bond is its marketability. Because these types of bonds are in such demand, there is a large market ready to purchase them at a fair price, should one decide to sell. The price of municipal bonds fluctuates. This means nothing to those who intend to keep their money in the bond until the maturity date. On the other hand, if you must sell your bond before its maturity date, there is the risk that it will have a lower value than what you originally paid for it. This, then, could be viewed as a disadvantage when purchasing this type of bond. Another disadvantage is the presence of a ‘call feature’ on many municipal bonds. This means that the issuer can order you to return the bond. At the point of the call-back, all interest payments cease. When you return your bond to the issuer, he will give you its face value, with perhaps a slight premium.
Another variety of bond is most often referred to as a “zero coupon bond”. One of the biggest differences between this bond and others is that there is no visible interest being paid throughout the bond’s lifetime. Instead, the issuer sells the bond for less than its actual face value and when the maturity date arrives, the difference between what one paid for the bond and the par, or face value, of the bond, reflects the compounded interest that would have been earned. This type of bond has many advantages. First the investor does not have to keep re-investing his money, as interest is automatically placed back into the bond until it matures. Secondly, you know exactly what you will end up with on the maturity date. A third advantage is that the rate of return on the investment can be easily determined so that it can be compared to other investments before or while you have the bond, so that you can decide whether it might be wiser to sell the bond before it comes due. The two main disadvantages in deciding to purchase this type of bond are that there is no current stream of income and that, in many cases, the interest earned is still taxable.
Convertible bonds, as the name implies, is a security that can be “converted” into pre-determined forms and amounts. When a convertible bond is purchased the owner has the right to convert his investment into common stock at any time he might consider it advantageous to do so. Until the conversion is made, the owner collects interest according to the terms of the bond. Once the transaction of conversion takes place, it cannot be converted back into a bond. After the conversion, the shares of stock that the owner receives are no different from any other shares of common stock in the company. This type of security can be quite advantageous if the price of the bond increases with the prices of stocks in the company. It may also be advantageous to purchase convertible bonds if one is investing in an unstable or questionable business. Bonds rank ahead of all preferred and common shareholders in the event the business declares bankruptcy. It is for this reason that many use the convertible bond as a method of investing in riskier companies. By using convertible bonds to invest in a company, should bankruptcy occur, you are guaranteed to receive your money back before almost any other type of investor. Only a small percentage of companies, however, issue convertible bonds. It is because of this that the issue of marketability must be raised when considering these bonds. There is not as much selection when investing, and the bonds that are available might not be attractive to other investors if or when you decide to sell. Further, these bonds might feel a downward pull if the common stock suffers or interest rates go up (as will be discussed later).
Perhaps one of the most interesting types of bonds is the “foreign bond”, which is often also referred to as an “international bond”. These bonds do not necessarily have to have any ’special’ features, as one is automatically built in. As with regular bonds, the holder will receive interest payments throughout the year and the face value when the maturity date is reached. However, when purchasing an international bond, what you are actually doing is investing in another country’s currency. Consequently, you must take both the bond price and the currency rate into account. This additional ‘investment within an investment’ can greatly increase your profit; however, there is also the risk that the country’s currency might decline in worth, which in some instances could be quite disastrous. This last problem can usually be avoided if an investment is made in a country with a relatively stable economy. Another advantage to foreign investment and international bonds is the choice which you are presented with. Because you are expanding into the international marketplace, you have many more choices as to what you may invest in and, if investing internationally, you also have a wide range of interest rates. There are many companies which rate the different bonds on a bond rating scale. These bond ratings carry with them immense power in the financial marketplace. Many money-lending agencies use these ratings to determine the percentage of interest they will charge others to borrow money. These bond ratings, when changed, may cause a great disturbance in a company and may sometimes even lead to its bankruptcy. Of course, the lower the business is rated on the bond rating scale, the more unstable it will appear to potential investors. Too, businesses that would be considered unstable would also have to pay a considerably larger rate of interest in order to obtain a loan, while other higher rated businesses would not have to pay quite so much. If a business is unable to make its loan payments, its rating will suffer even more and eventually it will enter a downward spiral until it sinks into the depths of bankruptcy.
There are always variations and differences in the rating of companies’ bonds on the bond rating scale. This is because of the number of different companies involved in actually doing the rating. As bond ratings are not derived from applying numerical formulas to financial data, many companies are rated at a level that is higher or lower than the level assigned by other rating agencies. An example of these discrepancies can easily be seen when one looks at the ratings for Calmar Inc. Prior to November 25, 1991, Moody’s Investment Service rated Calmar Inc. with a B rating, while Standard & Poor’s rating was significantly lower at CCC+. On November 25 of that year, Moody revised its rating to a Ba rating, supporting what they believed to be a strengthening trend. Two days later, Standard & Poor’s rating agency decided that the outlook for Calmar Inc had switched from positive to negative. Both of these decisions were made using the same financial data, yet each agency regarded Calmar’s credit quality differently. While Standard & Poor’s agency had remarked that the earnings for the year were the same as last year, Moody’s agency believed that there was a great potential for further growth. The following are but a few of the rating agencies that one can find in today’s financial market: Moody’s Investment Service, Standard & Poor’s, A.M. Best, Duff & Phelps, and Fitch Investors Service.
The two largest rating agencies, Moody’s Investment Service and Standard and Poor’s, are regarded as the paragons of the rating business. Below are the ratings used by Moody’s Investment Service. MOODY’S INVESTORS SERVICE, INC. Ratings Chart: Aaa.: This is the highest rating a bond can receive. Bonds in this category are of the highest quality. These bonds carry with them the smallest degree of investment risk, often referred to as the “glit-edge”. Their interest is protected by a large or exceptionally stable margin, and the principal remains secure. Any changes in the economy are not likely to change the financial position of the company. Aa.: Bonds with this rating are regarded as high quality by all financial standards. The margin of security, however, may not be regarded as large as Aaa bonds. There may also be some slight problems within the company which may make the long-term risks slightly greater than the Aaa bonds. Together with the Aaa group, these bonds comprise what are generally known as the ‘high grade’ bonds. A: These bonds have many favorable attributes and are considered upper medium grade. The security offered on principal and interest are considered adequate but something may be present which might suggest a susceptibility to weakness later on in the life of the company. Baa: This is a medium grade rating. Moody’s believes these bonds to be poorly secured or not highly protected. The interest and principal payments appear good at the present time; however, the long term is uncertain as some protective elements may be lacking. Ba: The bonds falling under this rating are judged to have speculative elements. The future is not well-guaranteed. The security of principal and interest payments is very moderate. Uncertainty characterizes bonds in this class. B: Moody’s Investment Service believes these bonds to lack characteristics of desirable investment. The assurance of stability in these bonds is small. Caa: Bonds belonging to this category of rating are regarded as poor investments. These companies may default on some or all of their payments. There may also be considerable elements of danger present with respect to future principal or interest payments by this company. Ca: This is the second worst rating that can be attained by Moody Investment Service Inc. Bonds which fall into this category are highly speculative. Companies listed under this rating often have marked shortcomings. C: Bonds which receive this rating are the lowest rated class of bonds, and companies with this rating can be regarded as extremely poor prospects of ever attaining any real investment standing. It is quite inadvisable to invest in such companies or corporations.
As is evident, there are many different levels on which a bond can be rated. It is no wonder that a bond can be rated at two different levels by two different rating agencies. In many cases, it is merely an investor’s opinion of an agency’s possible future that decides what rating the bond is to be assigned. Bonds, like many other forms of investment, require potential investors to be aware of current economic conditions. I would stress that a great deal of money can be made if investors consider selling their bonds before they reach their maturity. As with stocks, previously issued bonds are traded every day. The price they are sold for is determined by what the market will bare, that is, the willingness of others to buy a particular bond. People sell their bonds as the interest rates increase and decrease due to different economic conditions. In fact, the two main determiners of bond prices are interest rates and credit risk. With respect to the risk of the credit quality of the bond issuer, imagine if you will, investing money in a nation that is in financial ruin, for example, Somalia. The borrower, in this case Somalia, might not be able to pay interest on a regular schedule or return your principal amount as promised in the end. Somalia might default on some or even all of their payments. As is quite evident, this would not be a wise investment, and this is why the Somalian bond prices suffer as there is no demand in the financial market for them. Bonds issued by the United States federal government are considered to have virtually no credit risk, since the U.S treasury is unlikely to default on a loan. For corporations, however, the possibility of “going broke” is not all that inconceivable. Therefore corporate bond prices fluctuate depending on how well the issuing company is doing in the marketplace.
The other main determinant of bond prices is the interest rates in the current economy. When interest rates rise, bond prices will fall. However, during times of declining interest rates, bond prices will rise. There is quite a logical reason for this change in prices when interest rates fluctuate. When the interest rates fall, many people turn to bonds as there is a greater rate of return. The more people who buy bonds, the greater the demand which leads eventually to higher prices, and for the investor, a large profit on the sale of previously purchased bonds. Interest rates rising, on the other hand, leads to a lesser demand for bonds and consequently the prices of previously purchased bonds decrease. If you are able to hold onto your bond until the maturity date is reached, temporary changes in interest rates will not affect your financial investment; however, if you need to sell the bond before the marked maturity date, you might have to accept LESS than what you paid for it. This volatility can work to your advantage too, because it is possible that your bond could be worth more at the time you decide to sell. This is why it is important to keep up to date on bond prices. You may be able to make money by simply selling your bond before it’s maturity date.
In conclusion, I would suggest that bonds are a wise venue for anybody wanting to financially invest in different corporations or governments. I would caution, however that when selecting a bond, one should seek the guidance of an experienced investor. By choosing a bond that is right for you and your lifestyle, you have the potential of increasing your profits greatly and going home wealthier and happier.