By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor
Part 1, Bond Basics and Bond Jargon
This series has been difficult to write. For those of you who have read my Talking Shop posts on stocks, I hope you have found that one of my primary goals is to keep things high-level, easy to read, fun, and entertaining. Maybe even give my readers a little soundbite to impress their friends at a cocktail party.
I completely met my match with bonds. Perhaps I should have known better than to try and make bonds fun and entertaining. They are jargon heavy (Part 1), there are myriad of bond types (Part 2), there are obscure risks involved with bond investing (Parts 3 and 4), and building a portfolio with them can be quite complex (Part 5).
Having said that, I still hope to cover the wide world of bonds in a way that is both approachable and entertaining – here we go:
What is a Bond?
A bond is a loan – and they are typically repaid over a fixed time period with a fixed interest rate. This is why bonds are often called “fixed income.” The bond world is full of jargon, which we’ll cover in this first part of this series.
Bonds are created when an organization wants to raise money. This could be a corporation like Apple or Microsoft; a government agency like a country, a state, or local municipality; or even a church. A corporation may be looking to build a new office building or purchase new equipment. A government agency might be looking to build a new bridge or water treatment plant.
Fun fact: The first bonds date to at least 2400 BC in ancient Mesopotamia.[i] In ancient Sumer, temples also functioned as banks, and loans were made at a fixed 20% interest rate. This custom was later written into the Code of Hammurabi.[ii]
Let’s learn some of the jargon:
We’ll start with what I call a “plain vanilla” bond – this is the structure in which most bonds nowadays are issued. Bonds get nearly infinitely more complex and turn into alphabet soup (IG, HY, MBS, ABS, CDS, CDOs, CLOs), but most bonds are issued in a pretty simple structure, which I’ll describe here.
Most bonds are issued in $1000 increments. This is your principal, and is also called the “par value” or “face value” of the bond.
Most bonds are issued in a “bullet” structure where an investor lends the full par value up front, collects the interest payments along the way, and then gets the full par value at the end, known as “at maturity” – as long as the borrower is able to pay everything back and avoid what is called “default.” More on this later.
Most bonds are issued with a fixed interest rate, called the “coupon,” and make two payments per year, six months apart.
Fun fact: When bonds were issued on paper, they would literally have little paper coupons attached to the bond that the owner would tear off and take down to the bank to receive their payment. Each coupon had a date, often every six months; the coupon wasn’t valid until that date had passed. This is where the term coupon comes from.
Bond Pricing
Bond prices fluctuate frequently around their par value. If the relative value of a bond goes up after it is issued, investors will pay more than the par value. This is called the “premium.” Likewise, if the value of a bond drops after issuance, investors will pay less than the par value and this is called a “discount.” Someone may pay $1080 for a high quality, $1000 face value bond, or $900 for a low quality, $1000 face value bond, but no matter what you pay up front, you will still only get the face value at maturity.
Getting a little into the weeds: The “yield” of a bond is a function of the coupon relative to the price. If a bond pays a 4% coupon and you pay par value for it, then the yield is also 4%. If you pay a premium for that bond, then your yield will be less than 4%; if you pay less than par your yield will be greater.
Bonds also have a fixed end-date, called the “maturity date.” The length of the loan is called the “term,” and is typically 10 years. Keep in mind that there are benefits to owning bonds maturing at different times. You may buy a 10-year bond that is five years old; therefore it will mature in five years.
Most bonds are also rated on their credit worthiness by a third-party rating agency like Moody’s, Standard & Poor’s, or Fitch. They attempt to evaluate the likelihood that the issuer will be able to make the promised coupon payments. There are many different ratings but the bond world is basically split into two major categories: the higher-rated bonds are called “investment grade,” and everything else can collectively be called either “below investment grade,” or “high yield,” or “junk.”
Summing all that up
A plain vanilla bond, for example, would be issued with a $1000 par value and a 10-year term; a 4% interest rate would result in two $20 coupon payments each year for 10 years. At the end of 10 years, the investor would get their $1000 back.
Now that we’ve covered bond basics and much of the jargon involved, in the next piece we’ll cover the more common types of bonds.
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Disclaimer:
The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.
[i] http://bondfunds.com/education/a-brief-history-of-bond-investing/
