Bond basics

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A bond is a debt investment. Investors loan money to corporations or governments for a set term and interest rate. After they have been issued, bonds trade on the over-the-counter market, where their principal value fluctuates according to changes in interest rates and any changes in the bond's credit quality. Newly issued corporate bonds are syndicated by investment banks who initially buy an offering for resale to investors. Government bonds are offered by auction, where investors tender bids for the issue. Investors typically use bonds to stabilize the value of a portfolio, or to produce a stream of income, or both.

Note: Those looking for a "very basic" introduction to bonds should start with the tutorial at the bottom of this page.

Features


Bonds have some distinctive features. These include include:
 * Coupon rate: the interest rate paid by the bond. The rate may be fixed, floating, or inflation indexed, depending on the specific issue. The coupon date gives the frequency of interest payments, usually biannually for US bonds. Bonds which pay a fixed coupon rate based upon the principal (face amount) are called nominal bonds.
 * Maturity date: the date at which the bond principal will be repaid. Bonds are usually issued with maturities ranging from 1 year to thirty years.
 * Options: the most common option involving bonds is a call feature. This gives the issuer the right to repay the bond before the maturity date. Because an issuer will call bonds when the interest rate is lower than the coupon rate, it is not advantageous to the buyer of the bond, who must then reinvest the proceeds of the redeemed bond in a lower interest rate environment. Because of this, a callable bond usually offers a higher coupon than an uncallable bond, to compensate for the risk of early redemption. Some callable bonds also add a small sum to the par value of a redeemed bond. Alternatively, some bonds are issued with a put feature which gives the bond holder the right to force the issuer to repay the bond before the maturity date, usually on predefined put dates.
 * Sinking funds provide a means of repaying a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. Sinking funds tend to reduce the risk of default, which lets the issuer of a bond to pay a lower interest rate on the bond.
 * Senior debt and Subordinated debt: Senior debt has priority over other debt in case of default; Subordinated debt is unsecured and, in a default, is repayable after other debts have been paid.

Types of bonds
There are three main issuers of bonds in the U.S.: the Treasury; corporations; and municipalities.

Treasury bonds
Treasury Bonds are issued by the US treasury in groups of three maturity ranges
 * Bills have a range up to one year;
 * Notes have a range between one year and ten years;
 * Bonds have a range greater than ten years.

Treasury bonds are usually not callable. Treasuries also carry the full faith and credit backing of the U.S. government. The interest income is exempt from state tax. You can purchase Treasuries through brokerages and banks as well as through an individual account at Treasury Direct. Government agencies also issue debt, some of which is backed by the full faith and credit of the government, and some which is not.

Treasury Inflation Protected Securities (TIPS) give you both inflation indexed income and inflation protection for the bond's principal. The bond pays a fixed real interest rate based on a principal value indexed to the CPI-U inflation measure. Like all treasury bonds, inflation indexed treasuries have the "full faith and credit" backing of the Treasury and interest income and inflation adjusted accruals are exempt from state taxation. However, you must pay federal tax annually on the inflation adjusted accruals. This tax on "phantom income" means that you should try to hold these bonds in tax-advantaged accounts.

Corporate bonds
Corporate bonds are issued by corporations and are often callable. Because a corporation can default on its debts, corporate bonds have credit risk, and so usually pay higher coupon interest rates over comparable term treasury maturities as compensation for this risk. Corporate bonds are taxable, both for federal and for state income tax.

Municipal bonds
Municipal bonds are issued by states and localities. These bonds have credit risk. Many municipal bonds are also callable. The bonds are generally exempt from federal tax, although some private revenue municipal bonds are subject to the federal alternative minimum tax. A tax exempt bond is also usually state tax exempt for residents of the state issuing the bond. Because of these tax preferences, municipal bonds usually offer lower coupon interest rates than do comparable term treasuries and corporate bonds.

Zero-coupon bonds
Zero Coupon bonds are accrual bonds and do not pay current coupon interest. They are issued at a deep discount from par value and compound continuously at the coupon rate. Holders receive the full principal amount as well as the value that has accrued from interest on the redemption date. Financial institutions can create zero coupon bonds from fixed rate bonds by "stripping off" the coupons. In other words, the coupons and the final principal payment of the bond are separate, and trade independently. Holders pay tax on the annual accrual of income, although they receive no current interest payment.

Asset-backed securities
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), which include GNMA securities backed by the full faith and credit of the US treasury, collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), whose underlying securities are often assets such as auto loans or credit card receivables.

High yield bonds
High yield bonds are corporate bonds with lower credit quality than top credits. These companies are at much greater risk of default than higher quality credits and, as a result, pay higher coupon interest rates than comparable high quality corporate bonds.

Sources of return
There are three sources of return for a bond:
 * 1) Return of principal
 * 2) Interest (coupon payments)
 * 3) Interest-on-interest (reinvested coupon payments)

According to Frank J. Fabozzi in the The Handbook of Fixed Income Securities (1991, page 97): "In high interest rate environments, the interest-on-interest component for long-term bonds may be as high as 70 percent of the bond's potential total dollar return." In low interest rate environments, the principal is likely the largest source of value of all but the longest bonds. The figure below illustrates the three sources of bond return:



Risks
Each of the following risks of bonds carries some premium as compensation for bearing these risks. The amount of that premium varies according to the market's assessment of the likelihood of the adverse event occurring.

Interest rate risk
Interest rate risk, also called price risk, is that the value of a bond fluctuates depending on the interest rate. Also known as "market risk." The amount of interest rate risk assumed is measured primarily by the duration, and secondarily by  convexity. See below for more information on how bond prices react to interest rate changes.

Interest rate risk is in some sense an artifact of the traditional framework which looks at short-term returns. Over longer periods, longer duration bonds will have a more certain return than short-term bonds, as a quote from John Campbell and Luis Viceira's academic text, Strategic Asset Allocation (pages 86-87), makes clear: "If one uses conventional mean-variance analysis, it is hard to explain why any investors hold large positions in bonds. Mean-variance analysis treats cash as the riskless asset and bonds as merely another risky asset like stocks. Bonds are valued only for their potential contribution to the short-run excess return, relative to risk, of a diversified risky portfolio. ... A long-horizon analysis treats bonds very differently, and assigns them a much more important role in the optimal portfolio. For long-term investors, money market investments are not riskless because they must be rolled over at uncertain future interest rates."

Because unexpected inflation changes that picture somewhat, the reduced risk of longer-term bonds is primarily true when discussing inflation-protected bonds in real dollars (or nominal bonds with nominal liabilities).

Credit risk
Credit risk is a risk that the issuer of a bond may default. Also known as "default risk."

The major ratings agencies (Moody's, S&P, and Fitch) assess credit risk. Each credit rating has an expected rate of default, which increases substantially in lower tiers. For a given credit rating, the default rate has historically been lower for municipal bonds than for corporate bonds. Wikipedia has tables] of how the ratings compare between ratings firms and of historical default rates.

Call risk
Call risk is a risk that the issuer may call the bond, terminating a stream of income for investors. This risk is often called prepayment risk for mortgage backed securities. Call options embedded in a bond lead to negative convexity.

Reinvestment risk
Reinvestment risk is a risk that when a bond matures or is called, an investor may have to reinvest the proceeds in a bond yielding a lower interest.

Inflation risk
Inflation risk is a risk that the interest from a bond may not keep up with inflation. TIPS are inflation-adjusted and therefore largely immune to inflation risk. Also known as "purchasing power risk."

Liquidity risk
Liquidity risk is the risk that you may not be able to extract the remaining value from your bond in the timeframe needed without losing a disproportionate amount of value. Thinly-traded issues (such as most corporate, municipal, and TIPS issues) have liquidity risk. The liquidity premium is expected to rise in times of crisis. Also known as "marketability risk."

Liquidity risk can be seen most clearly in "off-the-run" Treasury bonds, where an older but otherwise identical bond trades at a reduced price (or higher yield) simply because it is less liquid.

Other risks
These risks are either not important for individual investors or are generally wrapped into the risks above (for example, credit risk commonly encompasses event risk). They are included here for completeness.


 * Yield curve or maturity risk: Generally only important in hedging situations.
 * Exchange rate or currency risk: Only relevant for non-dollar-denominated bonds. John Bogle does not recommend these.
 * Volatility risk: Volatility affects bonds with embedded options (commonly a corporate bond with a call option), because an option's value depends on volatility. If the price of an issue is highly volatile, the likelihood of a random fluctuation straying above the strike price is much greater.
 * Political or legal risk: Tax-code changes and regulatory decisions can all affect the value of a bond.
 * Event risk: A type of credit risk which affects many firms due to a single event (and therefore event risk cannot be fully diversified away).
 * Sector risk: A type of credit risk which affects all or many firms in a single sector.

Credit ratings
Three major ratings agencies assess the likelihood of a bond defaulting and assign that bond ratings according to a standardized scale.

For a given credit rating, the default rate has historically been lower for municipal bonds than for corporate bonds.

Factors affecting bond prices
See Bond pricing for definitions of bond pricing terminology. (This is an advanced topic.)

New issues
Two major factors primarily set the coupon of a newly issued bond: the credit quality of the bond, and the maturity of the bond. Investors taking on higher risks expect higher return. Because of this, the US Treasury can pay a lower coupon on its debt than corporate borrowers, who are subject to default risk. Three credit rating agencies trade non treasury debt. The table above describes the ratings.

The longer the maturity of a bond, the greater the risk to the bondholder. Longer time horizons increase the likelihood that a bond issuer will become a greater credit risk through bad management decisions, the deterioration of economic conditions, or the company engaging in future merger and acquisition activity which changes the leverage of a company's balance sheet. Longer horizons also increase the likelihood that a bond's coupon income will be eroded by higher than expected inflation.

Finance economics defines a bond's expected return as comprising three basic building blocks:
 * Default risk premium: the risk-free rate as defined by the current yield of a treasury bill
 * Time horizon premium: a time horizon premium to compensate investors for the risks of longer maturities
 * T-bill rate: and a default risk premium to compensate investors for bearing credit risk.

Bonds on the secondary market
Once a bond is issued, it trades on the secondary market, and fluctuates in price until it matures. A bond will change in price for two main reasons:
 * The bond's credit rating has changed (either upgraded or downgraded).
 * Interest rates have changed.

Unless a bond is falling into or out of default, price movements associated with changes in credit rating are usually infrequent, although during periods of economic distress and economic recovery credit rating changes can be significant price factors. The ever present driver of changes in a bond's market value comes from fluctuations in current market interest rates.

An example can illustrate how bond pricing works. Suppose you purchase, at issue, a $1,000 ten year bond yielding a 5% coupon. This entitles you to $50 of annual income. The, suppose that one year later, interest rates have risen to 6% and you wish to liquidate the bond. No rational investor will pay you $1,000 for $50 of income, when they can receive $60 annually for the same $1,000 dollar investment. In this scenario, your 5% bond will have to decrease in market value until its current yield approximately produces a 6% return.

A similar, yet opposite price movement occurs if interest rates fall. Suppose instead that interest rates fall to 4 percent during the year after your purchase. Your $1,000 bond produces $50 of annual income in an environment where investors can only receive $40 of annual income from a newly issued bond. Your bond will therefore rise in price until it provides a purchaser with a 4% return.

This is the basic rule of bond price movements in the open market.

To calculate how much prices will rise or fall, please see Duration.

A corollary to this is that, all other things being equal, price fluctuations are greater for long maturities than for shorter maturities. At any given time in the secondary market you are likely to find any number of bonds selling at a discount over par value, or at a premium to par value.

Role in a portfolio
Investors typically use bonds to stabilize the value of a portfolio, or to produce a stream of income, or both. For more see Asking bond questions for tips on how to ask about bonds on the Forum.

Long- vs. short-term
Boglehead and financial expert William Bernstein recommends limiting bond holdings to short-term funds, because of their relative immunity to the risk of unexpected inflation.

However, an article by Vanguard argues that when the yield curve is particularly steep, running to short-term bonds for safety can result in losses if the yield curve flattens.

A common recommendation of other experts is intermediate-term funds. Long-term bonds have historically returned no more than intermediate-term bonds, but with far greater volatility--in other words, their risk has not been rewarded. Yale endowment manager David Swensen recommends long-term Treasuries, however, as part of a portfolio dominated by equities, as they will provide the biggest counterweight to the collapse of other asset classes during a deflationary crisis.

Even proponents of short-term bonds such as Dr. Bernstein are comfortable with longer-term holdings in inflation-protected securities such as TIPS, as they no longer carry any risk of unexpected inflation, leaving them vulnerable only to a real rate rise (which if held to the duration incurs only an opportunity cost).

While you should always keep the duration less than or equal to your investment horizon, unless you have a specific funding need to be met at a specific date (in which case a Zero-coupon bond is the risk-free solution), you should choose between short-term and intermediate-term funds. The former is lower risk but the latter has historically given investors higher overall returns.

Credit quality
The Bogleheads' Guide To Investing authors recommend Vanguard's Total Bond Market, which contains investment-grade corporate bonds. John Bogle also recommends Total Bond Market, although he seems to prefer Vanguard's Intermediate-Term Index Fund for its lack of MBS's.

By contrast, Boglehead and bond expert Larry Swedroe recommends only the very highest quality investments for bonds (and specifically recommends against Total Bond Market because of its negative convexity), citing evidence in which the risk of corporate bonds has not historically rewarded investors. Yale endowment manager David Swensen also recommends only Treasuries.

Finally, Boglehead and financial expert Rick Ferri advocates for not only the inclusion of investment-grade corporate bonds but also high yield bonds, on the basis of their diversification benefits.

Perhaps the best conclusion that can be drawn from the highly respected but conflicting advice is to:
 * Ensure that your bond holdings are built around a core of Treasuries.
 * If you choose to include corporate bonds, understand the risks you are taking (moderate in relation to stock investing but nevertheless quite real), and do not include too high a proportion. A good benchmark would be the market portfolio represented by Vanguard's Total Bond Market fund.
 * If you choose to include high-yield bonds which incorporate considerable default and call risk, you take the funds from the equity portion of your asset allocation rather than the bond portion.

Taxes
Almost all of the return on a bond or bond fund comes from the dividend yield, which is fully taxed; in contrast, stocks get most of their return from price appreciation, which is not taxed until the stocks are sold and is taxed at the capital-gains tax rate. Therefore, when bond interest rates are relatively high, bonds are widely regarded as being less tax-efficient than stock index funds (which rarely sell stock) and should be held in tax-deferred accounts when possible.

If you are in a high tax bracket and without sufficient taxable space, Municipal bonds are likely the preferred solution; these bonds are not taxed but there is a cost in lower yield. If you are in low tax brackets, you should calculate your after-tax return on taxable bonds in taxable accounts to determine whether or not to use municipal bonds.

Style boxes
"Style boxes" are 3 x 3 grids that categorize securities. Different investment styles have various levels of risk which leads to differences in returns. This visualization allows investors to compare securities using an easy-to-understand standardized format.

Fixed income funds (bonds) classify risk as levels of credit risk (credit quality) on the vertical axis, and  interest rate risk (term risk) on the horizontal axis.

There are a number of ways to characterize interest rate risk, such as duration (sensitivity to changes in interest rates) and various maturity measures. In either case, the objective is to categorize interest rate risk into short-term, intermediate-term, and long-term periods of time.

Morningstar (interest rate sensitivity) and Vanguard (maturity) provide fixed income fund style boxes. Either format can be used to compare funds, but compare using the same methodology. When comparing only Vanguard funds, Vanguard's style box is valid. Otherwise, if no Vanguard style box is available, use Morningstar's style box for all funds. Vanguard funds will be shown on Morningstar's site using the Morningstar style box.

Equity style boxes (stock funds) and fixed income style boxes (bond funds) represent two-dimensional (horizontal and vertical axis) views of risk versus return. However, the background behind these boxes is based on very different concepts. Only compare stocks-to-stocks and bonds-to-bonds.

Both equity and fixed income style boxes are a way to visualize how diversified your portfolio is with respect to the main characteristic of each asset class - size and value for equities; credit risk and term risk for fixed income.

For example, you are interested in Vanguard's balanced funds which contain both stock and bond funds. The style boxes show you a simple collection of colored boxes, and this can make asset allocation decisions easier.

Tutorial
Easy to understand, fundamental information about bonds. From Investopedia:
 * The Basics Of Bonds, Investopedia (updated July 31, 2022)