Bond basics

Note: The tutorial referenced below is suggested for those wishing a "very basic" introduction to bonds.

A bond is a debt investment. Investors loan money to corporations or governments for a set term and interest rate. The initial face value of most bonds is $1,000. After issuance 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 consortiums of investment banks who initially buy an offering for resale to investors. Government bonds are offered by auction, where investors tender bids for the issue.

Features


Bonds possess a number of distinctive features. Common features 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 spells out the frequency of interest payments, usually biannually for US 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 the existence of a call feature. This feature gives the issuer the right to repay the bond before the maturity date. Since an issuer will call bonds when the interest rate is lower than the coupon rate, this feature is not advantageous to the buyer of the bond, who is then faced with reinvesting the proceeds of the redeemed bond in a lower interest rate environment. Thus it is usual for a callable bond to offer a higher coupon than an uncallable bond as compensation for the risk of early redemption. Some callable bonds also provide for a small sum to be added to the par value of a redeemed bond. Alternately, 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 prescribed 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, and thus allow the issuer of a bond to pay a lower interest rate on the bond.
 * Senior vs. Subordinated Debt Senior Debt is given 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.

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 US government. The interest income is exempt from state tax. Treasuries can be purchased 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 provide for 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. The inflation adjusted accruals, however, are taxable to the federal government as they accrue. This "phantom income" taxation makes the bonds candidates for placement in tax-advantaged accounts.

Corporate Bonds are issued by corporations and are often callable. Since a corporation can default on it's debts, corporate bonds are subject to credit risk and usually  pay higher coupon interest rates over comparable term treasury maturities as compensation for this risk. Corporate bonds are subject to federal and state income tax. (Refer to Corporate Bond Defaults and Recovery Rates 1920-2006 and Historical Default Rates of Corporate Bond Issuers, 1920 – 1996 for data on defaults)

Municipal Bonds are issued by states and localities. These bonds are subject to 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. Due to these tax preferences, municipal bonds generally offer lower coupon interest rates than do comparable term treasuries and corporates. (Refer to Moody's US Municipal Bond Rating Scale 1970-2000 for default and recovery data on municipal bonds.)

Other types of 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. The bond holder receives the full principal amount as well as the value that has accrued from interest on the redemption date. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently. Individuals are taxed on the annual accrual of income, although the investor receives no current interest payment.

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 such assets as auto loans or credit card receivables.

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 Fabozzi in the Handbook of Fixed Income Securities, 1991, p97: "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.

Illustration of 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 (pp86-87), 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."

Credit risk is assessed by the major ratings agencies (Moody's, S&P, and Fitch). 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 the investor. This risk is often called prepayment risk for mortgage backed securities. Also known as "call risk."

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."

The presence of 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/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 (e.g. credit risk commonly encompasses event risk). They are included 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, which are not recommended by Mr. Bogle.

Volatility Risk
Bonds with embedded options (commonly a corporate bond with a call option) are affected by volatility, because the value of an option 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.

New Issues
The coupon of a newly issued bond is primarily set by two major factors: the credit quality of the bond and the maturity of the bond. It is axiomatic in the investment markets that if investors are to invest in risky securities higher risk must be compensated by higher expected retum. Thus the US Treasury pays a lower coupon on its debt than do corporate borrowers subject to default risk, Non treasury debt is graded for credit quality by three rating agencies. The following table 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 to be comprised of three basic building blocks: first, the risk-free rate as defined by the current yield of a treasury bill; a time horizon premium to compensate investors for the risks of longer maturities; and a default risk premium to compensate investors for bearing credit risk. These building blocks can be visualized in the following table:

Bonds on the Secondary Market
Once a bond has been issued, it trades on the secondary market, and fluctuates in price until it matures. A bond will change in price for two main reasons:

1. The bond's credit rating has changed (either upgraded or downgraded).

2. Interest rates have changed.

Unless a bond is falling into or out of default, price movements associated with changes in credit rating tend to be 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. We can understand this law of bond pricing by considering the following scenario. Let us assume that we purchase at issue a $1,000 ten year bond yielding a 5% coupon. This entitles us to $50 of annual income. Assume that one year later, interest rates have risen to 6% and we wish to liquidate the bond. No rational investor will pay $1,000 for $50 of income, when he can receive $60 per annum for the same $1,000 dollar investment. In this interest rate scenario, our 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, in our scenario above, interest rates fall to 4 percent during the year after our purchase. Our $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. Our bond will therefore rise in price until it provides a purchaser with a 4% return. Thus we come to 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 principle to this price movement is the fact that, all things being equal, fluctuations in price are greater for long maturities than for shorter maturities. At any given time in the secondary market one is 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
Bonds are typically used to stabilize the value of a portfolio and/or produce a stream of income. Longer-term bonds have higher correlation with equities; shorter-term bonds provide more diversification benefit but lower yield.

Long- vs. short-term
Boglehead and financial expert William Bernstein recommends limiting bond holdings to short-term funds, on the basis of their relative immunity to the risk of unexpected inflation. 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 encourage 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 been rewarded with higher overall returns.

Credit quality
The Bogleheads' Guide authors recommend the use of Vanguard's Total Bond Market, which contains investment-grade Corporate Bonds. Mr. 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 been historically rewarded. 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 predominance of highly respected and 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, prudence suggests that you take the funds from the equity portion of your asset allocation rather than the bond portion.

Taxes
Bonds are typically placed in tax-advantaged accounts first, as they are widely regarded as being less tax-efficient than equities. For investors in high tax brackets without sufficient taxable space, Municipal Bonds are likely the preferred solution. Investors in low tax brackets should calculate their after-tax return on taxable bonds in taxable accounts to determine whether or not to use municipal bonds.

Links
Bonds: Advanced Topics

Tutorial
Easy to understand, fundamental information about bonds. From Investopedia
 * Bond Basics: Introduction
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 * Advanced Bond Concepts: Introduction