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This is the final article in this investing in bonds series. To date, we've discussed the reasons companies or government agencies issue bonds, and the different types of bonds issued. We also covered some of the more common bond terms, and how to calculate bond yields. In this publication, 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 factor when calculating the bond's yield. It also helps to set investor's expectation as to how long that bond will remain issued to the public. Some bonds, however, contain certain redemption features that investors 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 security 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 bond's "yield to call" in addition to the yield to maturity.
The reason a company might exercise its right to a call provision 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. This helps to lower 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 investors should be aware of 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, then you should quickly understand this concept. When interest rates fall, homeowners will attempt to refinance their homes. 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 investors 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 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 U.S. Treasury will issue securities with a nearly zero risk of non-payment or default. Since these securities are backed by the U.S. government, interest payments can always be made by either raising taxes or simply printing more money. Bonds and other securities issued by the U.S. 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 their 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 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 with higher yields; however, the risk of default is much higher too.
This publication will close out our 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 toolbox, or recognize them as an important element in the mix of asset allocations in your portfolio.
About the Author - Investing in Bonds Part III
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