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 This is the final article in this series outlining concepts dealing with investing in bonds. To date we've discussed why companies or government agencies issue bonds and the different types of bonds issued. We've also covered some of the more common bond terms you might encounter and how to calculate bond yields. Here we are going to finish up by discussing bond redemption features and bond quality ratings.
Bond Redemption Features
Earlier in this series we described how the maturity date of a bond was an important consideration when looking at the bond's yield. It is also helps to set the expectation in the investor's mind as to how long that bond will remain issued to the public. Some bonds, however, contain certain redemption features you need to be aware of before making a purchase.
Call Provisions
The most common redemption feature you will encounter is a "call" provision. Simply stated, a call provision allows the issuer of the bond to redeem the instrument at a specified date before the maturity date. Whenever investing in a bond, you should always ask if the bond has a call provision or is callable. If so, then you should also ask for the "yield to call" in addition to the yield to maturity.
The reason a company might exercise its right to a call provision really has to do with interest rates. If interest rates drop significantly between the date of issue and maturity date, then the company may be better off redeeming the bonds and issuing additional bonds at lower interest rates - essentially lowering the company's cost to borrow money.
This particular bond feature benefits the issuing company. In this situation the investor assumes a "risk" that the bond will be redeemed before maturity. In order to compensate the investor for this risk, bonds issued with call provisions usually carry higher interest rates or contain a premium provision whereby the company pays the holder a premium when calling in the bond.
Average Life Features
A second feature you should be aware of when investing in bonds is a statement of "average life." This feature is somewhat unique to mortgage backed securities (MBS) where the homeowner has the ability to prepay, refinance a mortgage or simply move from the home and pay off the mortgage.
If you are a homeowner and have experience with mortgages you should quickly understand this concept. Interest rates fell pretty dramatically over the past several years and many homeowners rushed out to refinance their homes. Add to that the fact that nationally about 17% of people move their homes each year. Needless to say, many mortgages are redeemed well before their maturity date. The yield on these types of bonds is usually stated over an average life or time span.
Bond Put Features
In the same way that some bonds contain "call" features, others contain "put" features. In times of rising interest rates, a put feature allows those investing in bonds to be able to force the issuing company to repurchase the bond. This frees up the investor's money and allows them to purchase different bonds with higher yields.
Since this feature benefits the investor, the issuing company is compensated for the additional risk. This means these bonds would typically carry interest rates that are lower than they would be without the put feature.
Bond Credit Quality
Interest rates on bonds will vary considerably based on the credit quality of the bond issuing entity. For example, the US Treasury issues securities with a nearly zero risk of non-payment or default. Since these securities are backed by the US government, interest payment can always be made by either raising taxes or simply printing more money. Bonds and other securities issued by the US Treasury are considered high quality, investment grade bonds.
At the other end of the bond quality spectrum are companies that are in default on their bonds. These companies carry a high degree of credit risk and investing in these bonds is considered speculation. In total, there are roughly ten ratings or bond grades, and even these grades can be subject to a plus or minus modifier.
Bond ratings run from AAA for the highest credit quality companies through D, which are those bonds in default. There are three bond credit rating agencies - Moody's, Standard & Poor's and Fitch Ratings. Each of these agencies has a slightly different rating system. In general, bonds carrying a rating of BBB or better are considered of investment quality.
Bonds with higher credit quality will always carry lower interest rates because the investor assumes less risk of default. For example, junk bonds will provide the investor will higher yields, however the risk of default is much higher.
That's enough of an introductory series to investing in bonds. As you may have observed, the bond market is a very efficient market and is therefore an excellent example of the principle of risk and reward at work. Our hope is that this series will make you more comfortable adding bond investments to your financial toolboxor as a very real part of the asset allocation in your portfolio.
About the Author - Investing in Bonds Part III
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