Fixed Income Securities: Bonds

IRG

Wednesday 29th May 2013

What is a Bond?

A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer. In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.

Although the fixed-income market is more than twice as large as the equity market, it is generally followed less closely by the media and is less well understood by the general investing public.

Why Invest in Bonds?

Many financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages. The main concept of diversified portfolio is similar to extensively used phrase which many investors are familiar with “Do not put all your eggs in one basket”.

Typically, bonds pay interest annually, semiannually or quarterly, which means they can provide a predictable income stream. Many people invest in bonds for that expected interest income and also to preserve their capital investment. Understanding the role bonds play in a diversified investment portfolio is especially important for retirement planning. Whatever the purpose—saving for your children’s college education or a new home, increasing retirement income or any of a number of other financial goals—investing in bonds may help you achieve your objectives.

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Key Bond Investment Considerations

Assessing Risk
All investments carry some degree of risk and a good rule of thumb is the higher the risk, the higher the return. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you.

Price
The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par (100 percent of the face, or principal, value). Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates, credit quality, general economic conditions, and supply and demand. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Fixed rate bonds carry any interest rate that is established when the bonds are issued (expressed as a percentage of the face amount) with semi- annual interest payments. For example, a $1,000 bond with an eight percent interest rate will pay investors $80 a year, in payments of $40 every six months. This $40 payment is called a coupon payment. When the bond matures, investors receive the full face amount of the bond, $1,000.

Maturity
A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Generally, bond terms range from one year to 30 years.

Redemption Features
While the maturity date indicates how long a bond will be outstanding, many bonds are structured in such a way so that an issuer or investor can substantially change that maturity date.

Call Provision
Bonds may have redemption – or call provision that allows or requires the issuer to redeem the bonds at a specified price and date before maturity. For example, bonds are often called when interest rates have dropped significantly from the time the bond was issued. Since a call provision offers protection to the issuer, callable bonds usually offer a higher annual return than comparable non-callable bonds to compensate the investor.

Put Provision
A bond may have a put provision, which gives an investor the option to sell the bond to an issuer at a specified price and date prior to maturity. Since a put provision offers protection to the investor, bonds with such features usually offer a lower annual return than comparable bonds without a put to compensate the issuer.

Conversion
Some corporate bonds, known as convertible bonds, contain an option to convert the bond into common stock instead of receiving a cash payment.

Yield
A bond's yield is the return earned on the bond, based on the price paid and the interest payment received. There are two types of bond yields: current yield and yield to maturity (or yield to call).

Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought a $1,000 bond at par and the annual interest payment is $80, the current yield is 8% ($80 / $1,000).
Yield to maturity is the total return you will receive by holding the bond until it matures. This figure is common to all bonds and enables you to compare bonds with different maturities and coupons.

Yield to call is the total return you will receive by holding the bond until it is called – or paid off before the maturity date – at the issuer's discretion. Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive the face value of the bond plus any premium on the call date.

The Link Between Price and Yield
From the time a bond is originally issued until the day it matures or is called, its price in the marketplace will fluctuate depending on the particular terms of that bond as well as general market conditions. In general, when interest rates fall, prices of outstanding bonds with higher rates rise. The inverse also holds true: when interest rates rise, prices of outstanding bonds with lower rates fall to bring the yield of those bonds into line with higher-interest bearing new issues.

The Link Between Interest Rates and Maturity
Generally, the longer a bond's term, the more its price may be affected by interest rate fluctuations. Investors, generally, will expect to be compensated for taking that extra risk. As a bond investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation and deflation. As a general rule, the bond market, benefit from steady, sustainable growth rates. Such moderate economic growth benefits the financial strength of governments, municipalities and corporate issuers which, in turn, strengthens the credit of those bonds you may hold.

But steep rises in economic growth can also lead to higher interest rates because, in response, the Federal Reserve Bank may raise interest rates in order to prevent inflation and slow growth. An increase in interest rates will erode a bond’s price or value.

Default
Default is the failure of a bond issuer to pay principal or interest when due. Bondholders are creditors of an issuer, and therefore, have priority to assets before equity holders (e.g., stockholders) when receiving a payout from the liquidation or restructuring of an issuer.
Secured bonds are bonds backed by collateral. If the bond issuer defaults, the secured debt holder has first claim to the posted collateral.
Unsecured bonds are not backed by any specific collateral. In the event of a default, bond holders will need to recover their investment from the issuer. Unsecured debt will generally offer a higher interest rate than those offered by secured debt due to a higher level of risk.

Credit Quality
The array of credit quality choices available in the bond market ranges from the highest credit quality Treasury bonds to bonds that are below investment-grade and considered speculative, such as bond issues by a start-up company or a company in danger of bankruptcy. This information can be found in a document known as an offering document, official statement or prospectus, which is the document that explains the bond's terms, features and risks that investors should know about before investing. This document is usually provided by your investment advisor and helps an investor evaluate whether the bond issuer will be able to make its regularly scheduled interest payments for the term of the bond.

Credit Ratings
In the United States, major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower ratings are considered high yield, or speculative.

If you are interested in investing in BONDs, call us on 0800 447 669 or email offer@irg.co.nz or Click Here to register your interest for NEW INFRATIL BOND paying 6.85% p.a.

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