Questions to Ask

Once you have outlined a financial strategy for investing you are ready to investigate how bonds work and to consider how they can be a part of your well-balanced portfolio.

At its most basic, a bond is an IOU. You lend money to an institution, as an investment, so that it can use your principal (amount invested) to meet its goals and objectives. The bond issuer provides you with an IOU, or indenture, that outlines the terms and conditions of repayment.

Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds. There are also many short-maturity options such as Treasury bills, bank certificates of deposit and commercial paper.

Most bonds are “straight bonds,” meaning that they cannot be exchanged for investment in another asset. A convertible bond, however, can be switched to an investment in another asset, for example, common stock.

A bond fund is a company that invests in a pool of mixed debt instruments, or bonds. Bond funds can vary according to what types of bonds it invests in (corporate, munis, U.S. Treasuries, global bonds, or a mix). When a broker creates a unit investment trust, or fixed trust, he/she assembles a portfolio of varied investments and then sells pieces, or “units” of that portfolio to other brokers for them to offer their investors. “Units” typically sell for around $1,000.

The way a debt is structured refers to who is promising to repay the bond and with what money are they promising to repay it. For example, if the State of Kansas issues a bond for highway construction, how will the state raise the money (i.e. through taxes) to repay the investors? Other bonds offer collateral (such as mortgage debts) to secure their debt offering.

Special features, such a call feature, allow either the bond issuer or the bond investor to redeem the bond at full value before the stated maturity date. Treasury bonds are not subject to “call risk.” It is important to know if there are any special features or conditions associated with a bond you are considering for investment because that may affect your decision-making and potential income (from interest if it is callable).

Several factors are reflected in bond pricing including its coupon rate, maturity date, credit quality, tax status and risk features as well as market forces including supply and demand and interest rate trends. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

Bond investors identify a bond’s value in terms of its yield, generally the coupon rate divided by the market price. The yield should be high enough to compensate investors for the risk of holding the bond. If it’s not, the price may be too high.

Transaction costs can also affect a bond’s price and yield. When you buy a bond from a dealer that holds it, the dealer may “mark up” the price to reflect its compensation, which in turn reduces the investor’s yield. When you sell a bond, the amount you receive may also be reduced by a percentage taken by the dealer as compensation for completing the transaction. The best way to determine markup is to compare the price the dealer is quoting to you to prices of the same bond or comparable bonds as listed in the newspaper or in bond pricing services.

A bond issuer legally agrees to repay the investor through periodic interest payments (the coupon) until the bond’s maturity date (the date upon which the issuer will repay the investor’s principal.) The face value of a bond is the dollar amount on which interest is calculated. Simply multiply the coupon by the face value of the bond to determine the dollar amount of your annual interest payments.

Credit risk is the likelihood that the bond issuer (corporation, state or local government agency, etc.) will be able to repay the principal and interest on the bond in a timely manner. You can determine a bond issuers’ creditworthiness by the credit rating assigned to the bond. Independent agencies assign credit ratings to every bond offering.

Investment grade bonds are those bonds that have been deemed “suitable for purchase” by institutional investors. Investment grade bonds carry a credit rating of BBB and above (Standard & Poor’s) or Baa3 (Moody’s). High-yield bonds, also referred to as “junk bonds,” offer higher rates of return, and therefore carry a higher rate of risk, than investment grade bonds. Consequently, high-yield bonds are rated lower than investment grade bonds.

All investments carry risk. While bonds are often referred to as “fixed-income” securities they carry risks such as interest rate risk (the movement of interest rates that can positively or negatively affect the value of the bond at redemption) and default risk (the risk that the bond issuer will go bankrupt or become unable to repay the loan). It is best to consult a registered, licensed broker to ensure that you understand all risks associated with investments of any kind.

Bond prices usually include a markup (when you are buying) or a markdown (when you are selling), that reflects the cost the broker-dealer firm incurs for holding the bond in inventory plus a profit. If you buy a bond from a broker whose firm has to go into the marketplace to get it because it’s not in the firm’s inventory, there may also be a commission charged on the transaction. The individual broker typically gets a portion of this markup or commission.

There are reasons that even an investor following a buy-and-hold bond investment strategy may decide to sell a bond prior to maturity:

1. You need the principal. While buy-and-hold is generally the best long-term investment strategy, life does not always work out as planned. When you sell a bond before maturity, you may get more or less than you originally paid for it. If interest rates have risen since the bond was purchased, its value will have declined. If rates have declined, the bond’s value will have increased.
2. You want to realize a capital gain. If rates have declined and a bond has appreciated in value, you may decide that it’s better to sell before maturity and take the gain rather than continue to collect the interest. This decision can have tax consequences since the proceeds of the transaction may have to be reinvested at lower interest rates.
3. You need to realize a loss for tax purposes. Selling an investment at a loss is one strategy for offsetting the tax impact of investment gains. Bond swapping may help you achieve a tax goal without changing the basic profile of your portfolio.
4. You have achieved your return objective. Some people invest in bonds with the objective of total return, or income plus capital appreciation or growth. Achieving capital appreciation requires market timing, or selling an investment for more than its purchase price.

There is a wealth of information specifically tailored to bond investing on this site. Here you will find booklets on investing in various types of bonds, information on pricing of bonds, tips on how to buy and sell bonds, links to other Internet sites where bond market information is available, and more. Consult your investment representative or tax adviser before making a specific investment.

An investment representative at a brokerage firm or bank can provide more specific information about investing in bonds. There are numerous public sources of information available including major personal-finance magazines, the business page of your daily newspapers, and your local library.