How to: Investing In Bonds

how to investment tips Jun 15, 2021

When you acquire an asset such as a house, car etc. knowing everything about it comes naturally to mind. Same principle applies to lending money to a borrowing entity. The entity can be an individual, a corporation, an institution or even a government. You still have to, and should, do your due diligence before lending.

Structured entities like corporations and governments raise funds by issuing debt securities to the public. These securities come in the form of bonds, debentures or structured notes. A bond is simply a loan taken out by a government or a company. The borrower gets the money from investors, who buy its bonds. The borrower pays an interest coupon at predetermined intervals, which is the annual interest rate paid on a bond expressed as a percentage of the face value. The principal is repaid to the lender on the maturity date, ending the loan. Bonds are a form of IOU between the borrower and the lender. 

Let us look at some of the basic features of bonds you should check before investing.

Issuer (Borrower)

The first thing that pops in an investor’s mind is who is the issuer of the bond. For instance, a government bond has the sovereign backing thereby making it the safest issue in the lot. Although it is entirely possible to have a strong leading corporation in a country having a higher rating than the sovereign debt, especially in the developing world. And, even in the government issues, bonds can be issued by a municipal authority, or a state or county. Then, there are corporate bonds issued by corporations to fund their capital expenditure or working capital. It is advisable to check the bond issuer’s track record. Knowledge of the company background can be crucial in deciding whether to invest in their bonds.

Quality (Ratings)  

The easiest way to determine the financial health of the issuer and its ability to pay the interest  and return the capital in full is to look at the rating of the issue. Yes, you read it right, rating of the issue, not the issuer. An issuer can issue multiple bonds at different stages with varying maturities and coupons. The rating agencies rate each issue on its own merit such as issuer’s provision or plan for repayment, any asset backing the bond etc. That means different bonds issued by the same issuers can have different credit ratings. Moody’s, Standard & Poor’s, and Fitch are three prime bond rating agencies in the business of gauging the bonds’ creditworthiness. Higher the rating, lower the interest an issuer has to pay as the former makes it easier to borrow, and vice versa.

Bonds rated BBB Baa or above are called investment grade. These bonds are unlikely to default and tend to remain stable investments. Bonds rated BB to Ba or below are called junk bonds, wherein default risk is high, and they are more speculative with higher price volatility.

Here are the ratings. 

Bond Ratings

 

Moody's

Standard & Poor's

Fitch

Investment Grade

Aaa

AAA

AAA

 

Aa1

AA+

AA+

 

Aa2

AA

AA

 

Aa3

AA-

AA-

 

A1

A+

A+

 

A2

A

A

 

A3

A-

A-

 

Baa1

BBB+

BBB+

 

Baa2

BBB

BBB

 

 

 

 

Junk

Baa3

BBB-

BBB-

 

Ba1

BB+

BB+

 

Ba2

BB

BB

 

Ba3

BB-

BB-

 

B1

B+

B+

 

B2

B

B

 

B3

B-

B-

 

Caa1

CCC+

CCC+

 

Caa2

CCC

CCC

 

Caa3

CCC-

CCC-

 

Ca

CC

CC

 

C

C

C

 

 

D

D

 

Important reminder, not all bonds are rated. Some of the best bonds around have not subscribed to any ratings agencies, but are not inferior by any standard.

Safety (Secured/Unsecured)

Bonds can be secured or unsecured.

A secured bond is backed by specific assets pledged by the issuer to meet the obligation upon maturity if it cannot repay the principal. These assets are also known as collateral on the loan. In case of a default by the bond issuer, the asset is transferred to the investor. A mortgage-backed security (MBS) is one such type of secured bond backed by titles to the homes of the borrowers.

Unsecured bonds, on the other hand, are not backed by any collateral. The principal and interest, in that case, are solely subject to the ability of the issuer to repay. Unsecured bonds, also called debentures, run a risk of high dilution with a small percentage of return of the original investment in the event of a default. Unsecured bonds, therefore, are much riskier than secured bonds.

Yield (Income)

At the time of issuance, bonds have a stipulated coupon interest, payable at predetermined regular intervals. So, a $1,000 face value bond with a 7% coupon (on face value) maturing in ten years will have 7% nominal yield. As the price of the bond fluctuates in the secondary market, so does the yield. If the above bond trades @$1,050, the yield will drop because 7% is paid on $1,000. A new buyer will have to shell out extra $50, therefore he will end up making less than 7%. Conversely, a drop below the face or par value will benefit a new buyer as he will be paying less than $1,000, and still collect 7% on $1,000 thereby enhancing his yield. The price and yields have an inverse relationship.

A word of caution though. Many investors get lured by high yield, especially during the low interest rate environment. Higher rates of interest are good, but remember the higher the yield, the higher the inherent risk of default on the issuing institution.

Maturity (Lifetime of the Bond)

This is the date when the principal or par amount of the bond is due for repayment and the issuer’s bond obligation ends. A bond’s maturity is one of the main considerations an investor weighs against their investment objectives and time horizon. Maturity often has three classifications:

·         Short term: Bonds that come in this category usually have a maturity of one to three years.

·         Medium term: Bonds that fall into this category normally mature in over ten year.

·         Long term: These bonds generally have longer periods of maturity – ten to thirty years. Some do not even have a specific date, and are known as perpetual bonds.

Bond investors, often, make the mistake of overlapping maturities. True diversification includes issuers, ratings, coupons, types, sectors and maturities.

Call Option (Early Repayment)

Some bonds have call provision giving the issuer the option to pay off the loan before maturity, usually at a slight premium to par. Call option is beneficial to the issuer during the easing monetary cycle as it allows the company to call its original bonds, and borrow again at a cheaper rate (issue new bonds with lower coupon).

Callable bonds also appeal to investors as they offer better coupon rates. If called, investors will realize a slight premium on the bonds giving a slightly higher yield on the bonds, which is called “yield-to-call”. But, if the call option date falls much before your original time horizon, it may entrap you into giving away the original bond with a higher coupon, leaving you to buy a new bond with lower coupon.    

Liquidation Preference (Repayment Line)

Issuers raise capital from the financial world via private placement or direct auction or open offers. Since there are different types of securities issued versus the capital raised, it is better to know where you are stacked up in the food chain. When a firm goes belly up, it repays the investors in a particular order as the liquidation progresses. After the sale of its assets, the firm begins to repay the shortest term obligations such as commercial papers, certificates of deposit etc. Next in line come the senior bonds, followed by junior (subordinated) bonds. Preferred shareholders are the next ones to recover their money, while common stockholders are in the last category of investor to lay its claim on the leftovers. No wonder then the last category has the highest risk but it also enjoys the maximum upside gain potential.

Liquidity (Easy Trade)

Like other asset classes, some bonds also are stapled with thin liquidity. Many exotic issues – emerging market debt, bonds of small less-known companies, low outstanding holders, etc. – come with the risk of thin volume. This widens the spread between the bid (buyer) and the offer (seller) resulting in a potential loss. It is best avoided to venture into such issues.  

Pricing (Markets)

You should check the bond prices from more than one source. The price usually includes the broker commission or mark up. Depending upon the size of the order and your relationship with the intermediary, you can negotiate the price.  

Taxation (Status)

Taxes are part of our life, and cannot be avoided. Depending upon the country of your domicile and that of the issue, tax implications differ. Federal or central government bonds tend to have different tax treatment from corporate bonds. Municipal bonds generally are tax-exempt, but not in every country. Taxation makes a significant impact on your returns, and therefore, you must know your post-tax returns with reasonable expectation of all probabilities.

Bottom Line (Summary)

As we have outlined in our previous papers, have a proper asset allocation plan. Invest with a long time horizon. Bonds, just like other asset classes, have their own trade-offs. A debt (fixed income) investment is subject to risks. Some of these include prepayment risk, credit (default) risk, interest rate risk. Although the bond market, to some, may appear complex, it is really driven by the same risk/reward comparisons as the stock market. Once an investor has done the primary due diligence they can become a competent bond investor.

 

- Ramesh Sadhwani

– Former Wall Street Broker, Global Portfolio Manager, and Senior Technical Analyst.

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