So far in this series, 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 article, we are going to finish this series with a discussion of redemption features and quality ratings.
Earlier in this series, the relationship between the bond's maturity date and its yield was explained. Knowing this information also helps investors to understand how long the security will remain issued to the public. Some bonds, however, contain certain redemption features that investors need to be aware of before making a purchase.
The most common redemption feature encountered is a "call" provision, which allows the issuer of a bond to redeem the security at a specified date before the maturity date. Whenever investing in a bond, it's important to ask if it contains a call provision, or is callable. If it contains this feature, the investor should also ask the broker for the bond's "yield to call" in addition to the yield to maturity.
The reason a company might exercise its right under a call provision has to do with interest rates. If interest rates drop significantly between the date of issue and maturity date, the company may be better off redeeming the bonds and issuing new securities at lower rates. This helps to lower the company's cost to borrow money, or interest expense.
This particular feature benefits the issuing entity. In this situation, the investor assumes a "risk" 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.
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 move from the home and payoff the loan.
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.
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 to force the issuing entity to repurchase the bond. This frees up the investor's money, and allows them to purchase new securities with higher yields.
Since this feature benefits the investor, the issuing entity is compensated for their risk, which means these bonds would typically carry interest rates that are lower than they would be without the put feature.
Interest rates on bonds will vary considerably based on the credit quality of the 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 to the investor by either raising taxes or printing more money. Securities issued by the U.S. Treasury are considered high quality, investment-grade bonds.
At the other end of the quality spectrum are companies that are in default on their loans. These companies carry a high degree of credit risk, and investing in their securities is considered speculation. 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 issues in default. There are three credit rating agencies: Moody's, Standard & Poor's, and Fitch Ratings. Each of these agencies has a slightly different 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. Junk bonds will provide the investor with higher yields; however, the risk of default is much higher too.
This article will close out our introductory series to investing in bonds. The bond market is very efficient and is an excellent example of the principle of risk and reward at work. This series should help to make investors more comfortable adding bonds to their financial toolbox, or to the mix of assets in their portfolio.
About the Author - Investing in Bonds Part III