Fixed Income

Bond Basics

What are bonds?

Bonds are debt securities issued by corporations, governments and municipalities. Bonds are similar to IOUs: Investors lend money to an organization and in return receive interest payments. The organization is obligated to return the principal to investors on a predetermined date in the future. When purchasing bonds, investors become creditors of the issue and, therefore, have priority claim on the issuer’s assets in the event of bankruptcy.

Bond Characteristics

– Par or face value is the bond’s denomination and the amount returned to the investor upon maturity. Par is not the price of the bond. The price fluctuates throughout the lifetime of the bond. If the price is above par, the bond is selling at a premium. If the price is below par, the bond is selling at a discount. Price is generally quoted as a percentage of face value. For example, a price of 98 means 98% of the bond’s $1,000 par value, or $980.

– Coupon rate (or just coupon) is the interest rate paid to investors as compensation for the loan. Coupon payments are generally made semi-annually unless otherwise stated. Many investors depend on this predictable income.

– Maturity is the term of the bond’s life. Bonds range in maturity from three months to 100 years. On the maturity date, the bond's face value is repaid to the investor and the interest payments stop.

– Call features are issued with some bonds and give the issuer, at its discretion, an option to redeem the bond (pay back the principal) prior to the maturity date. The bonds become callable when the situation is most beneficial for the issuer. In general, bonds are called when market interest rates fall, allowing the organization to issue new bonds with a lower coupon rate. For taking on the risk of a possible call prior to maturity, investors are usually compensated with a potentially higher return at the time of purchase.

– Credit rating is a reflection of an issuer’s credit worthiness. Just like individuals, organizations with poor credit have difficulty finding financing at lower costs. “Junk bonds,” or high-yield bonds, have a higher risk of default and, therefore, must offer investors a higher stated return on the borrowed money. High-yield bonds (below investment grade) are not suitable for all investors. The risk of default may increase due to changes in the issuer’s credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, high-yield bonds should only comprise a modest portion of your portfolio.

A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning rating agency. Ratings are subject to change and do not remove market risk.

Price/Yield Relationship

Yield is the annual rate of return investors earn based on a bond’s coupon rate and its current market price. When interest rates rise, the price of an existing bond falls because its coupon becomes less attractive to potential investors. The opposite happens when interest rates fall. Hence, the price of the bond and its yield have an inverse relationship.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

Next: Factors That Affect Prices of Fixed Income Securities