Investing in Bonds and Bond Funds

There are basically two ways that individuals can invest in fixed-income securities - bond funds or individual bonds.  The vast majority of bonds are held by large institutions such a banks, pension plans and insurance companies.  Roughly 10% of all bonds are held directly by individuals.

Bonds versus Bond Funds

In this publication, we're first going to discuss the advantages of holding bonds versus investing in bond funds.  Later on, we'll cover some of the basics that anyone investing in bonds should understand before purchasing the bond itself or shares in a bond fund.  That discussion will include bond terms, features, various types of bonds issued and finally a quick lesson on valuing bonds.

Investing in Bonds

Individual bonds offer investors a dependable source of income and a pathway to diversification relative to a portfolio that consists solely of stocks and stock funds.  Since bonds offer investors a predictable stream of payments and the eventual repayment of principal, they are viewed as a means of creating a dependable source of income and a way to preserve net worth.

Investing in Bond Funds

Bond funds are a portfolio of fixed income securities selected and maintained by the fund's management team.  As is the situation with stock funds, a bond fund greatly reduces the risk associated with default or bankruptcy.

This is an extremely important point.  All bonds are subject to two market risks - the risk of individual default on a bond and interest rate risk.  Individual default risk can only be reduced through the accumulation of a portfolio of individual bonds or the purchase of shares in a bond fund.  For most investors it is much easier, and less expensive, to eliminate the risk of default by buying shares of a bond fund.

A stated earlier, when an investor decides to purchase interest in a bond fund, they are purchasing shares in that fund rather than individual bonds.  The price of a share is normally quoted as NAV - or Net Asset Value.  Bond funds can return earnings to the investor either through the interest paid on the bonds or by actively trading bonds for profit.

Investing in Bond Indices

A subset of bond funds is what is referred to as bond index funds.  The purpose of these funds is very similar to the concept of a stock index fund.  The more common bond index benchmark funds include Merrill Lynch's US Domestic Master Index (IDM), the Lehman Aggregate Bond Index (the Agg) and Salomon Broad Investment Grade Index (BIG).  These indices are broad measures that can be used to get a feel for more global bond markets.

Fee Structure / Liquidity of Bonds and Bond Funds

Some of the more important distinguishing characteristics of bonds and bond funds include:

• Fees - Investors in bond funds typically pay annual management fees, while purchasers of individual bonds pay commissions ranging from 1 - 5% of the bond's value.
• Sensitivity to Interest Rates - With individual bonds, the interest rate risk declines as the bond nears maturity, while bond funds constantly carry an interest rate risk.
• Purchase - Individual bonds are normally purchased through commercial banks, brokers or the Federal Reserve.  Bond funds are sold though banks, brokers, fund managers, or even pension and retirement plans.
• Maturity Date - Bond funds have no identifiable maturity date.
• Liquidity - Bond funds tend to be extremely liquid.  This means that a market to purchase the bond funds back from the investor nearly always exists.

Common Bond Terms

Listed below we've got a list of some of the more common terms you might encounter when buying a bond or investing in a bond fund: 

• Coupon Date - the date on which the issuer of the bond pays the holder of the bond the interest due on the security.  In the US, most coupon dates are six months apart, while in Europe, coupon dates might be 12 months apart - meaning interest is paid annually.
• Coupon Rate - the interest rate the issuer pays to the holder of the bond.  This rate typically remains fixed throughout the life of the bond.  Some bonds contain a feature that links the interest rate paid to a market index such as LIBOR.
• Face Amount - also referred to as nominal, par, or principal amount, this is the value used to compute interest payments and is the amount due the holder of the bond when it matures.
• Issue Price - this is the price that buyers of the bond paid when the bonds were first issued.  This is also the amount the issuer received when the bonds were issued minus the costs associated with issuing the bonds.
• Maturity Date - the date on which the bonds mature.  This is also the date the issuer has to pay the holder of the bond the face amount of the security.  Typically, bonds can have maturity dates of up to 30 years.
• Term - the length of time that elapses between the date of issue and date of maturity is called the term of the bond.  Generally short-term bonds have maturities of up to 12 months, mid, medium, or intermediate-term bonds have terms between one and ten years and long-term bonds include all those securities with terms greater than ten years.

Common Bond Features

If you're thinking about buying an individual bond, you should also be familiar with some of the common features that issuers of bonds might attach to their securities.  Many bonds issued today contain one or more of the features listed below:

• Callability - a bond is said to be callable when the issuer has the right to repay the bond's face amount prior to the maturity date.  This is sometimes referred to as a call option.  To protect investors, callable bonds often require the issuer to pay a call premium to the bond holder.
• Optionality - a bond issuer may embed certain options within the bond.  These options can grant certain rights, or options, to either the issuer of the bond and / or the holder of the bond.
• Puttability - bonds that give the bond holder the right to force the issuer to repay the bond on a put date, which would occur before the bond's maturity date.
• Exchangeability - and exchangeable bond allows the issuer to exchange the bond for shares of a corporation other than that of the issuer.

Types of Bonds Issued Today

Now that you're more familiar with bond terms and features, we're going to discuss some of the different types of bonds issued today.  Then we're going to finish up with a quick lesson on valuing bonds.

• Asset Backed Securities - these are bonds that have interest and / or principal payments that are backed by assets that produce cash flows.  The most common examples of asset backed securities include collateralized debt obligations (CDO) and mortgage backed securities (MBS).
• Fixed Rate Bonds - fixed rate bonds have a coupon rate that remains constant throughout the life of the bond.  This is perhaps the most common type of bond issued today.
• Floating Rate Bonds - also referred to as floating rate notes (FRN), these bonds have a coupon that is linked to a money market index such as LIBOR or EURIBOR.  For example, if a bond is said to be six months LIBOR +0.5%, then every six months the coupon rate is adjusted to be LIBOR +0.5%.
• High Yield Bonds - the term high yield bonds is often used to refer to category of bonds that carry bond ratings that are below investment grade.  High yield bonds are sometimes referred to as junk bonds.  The yield on these bonds reflects the higher credit risk the issuing company represents to investors.
• Inflation Protected Securities - the interest rate on these bonds are linked to a measure of inflation.  Inflation bonds are usually issued by the federal government.
• Zero Coupon Bonds - with zero coupon bonds, the issuing company does not pay interest on the bond.  Instead these bonds are typically issued at a discount to the face amount or par value.  At maturity the issuer of these bonds is obligated to pay the holder the full face value of the bond.

Valuing Bonds

The interest rate on a bond is affected by many factors including current interest rates, term of the bond, and even more importantly the creditworthiness of the company or agency issuing the bond.  Most bonds in the United States are issued carrying face values of $1,000.  Depending on several other market factors, including those mentioned above, the bond can be selling at a discount or premium to its par value.

Besides the credit rating of the bond, most individuals that have invested in bonds before are really just concerned with two measures of the bond's value:

• Current Bond Yield - sometimes referred to as the earnings yield, the current bond yield is the effective rate of interest paid to the bond holder based on the price paid for the bond and the interest payments made on the bond.
• Yield to Maturity - the bond yield to maturity is the total yield realized by the bearer of the bond if they were to hold the bond until its maturity date.  The bond yield to maturity considers the difference in the bond's current price and its par value as well as the rate of interest paid on the bond.

If an investor knows the current bond price, the bond's par value, the coupon rate and the years until maturity, then the current bond yield and yield to maturity can be calculated.  You can use our bond yield calculator to do these calculations for you.

In fact, if an investor knows the bond's current yield and its yield to maturity, then they have a complete understanding of the effective interest rate, or return on investment, they will receive if they buy the bond in the short-term or hold it to its maturity date.

About the Author - Investing in Bonds and Bond Funds

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2007 Money-Zine.com

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