Monday, December 20, 2010

Bonding With Bonds: An Introduction

With the stock market ups and downs of recent years, more people are looking to bonds as a safe haven for their money.  Bonds are generally perceived as being a safer investment than stocks.  Here is what the Yahoo! Finance Banking Center says about bonds (specifically U.S. Treasuries):

"U.S. Treasury bills, notes and bonds and U.S. savings bonds are an excellent, risk-free way to preserve capital, get a pretty good return and keep your investment liquid."

Is the prevailing wisdom about bonds really true?  Are bonds really the safe investment that people think they are?  As with most important questions, the answer is not so clear cut.  However, before I delve into that question, it is best to start off with a general overview of what a bond actually is.

A bond is an IOU.  Nothing more.  Nothing less.

The lender loans some amount of money to some entity that needs to borrow money, and in return the borrower gives the lender a bond.  The bond is a piece of paper which says that the borrower will pay the person who owns that piece of paper some amount of money Y at some point in the future.  The amount Y is known as the face amount of the bond.  A bond is said to mature when this final payment becomes due.

Most bonds have an additional feature called the coupon.  This coupon feature pays the holder of the bond some percentage of the face amount periodically from the time the bond is issued until it matures.  The percentage that is paid in interest is known as the coupon rate.  Most U.S. bonds make a coupon payment semi-annually, so they pay half of the coupon rate every six months.  There are some bonds which don't have coupons; these are called zero-coupon bonds.  With these bonds, the only payment the lender receives is when the bond matures.

As a historical note, the reason why this feature is called a coupon is because in the past, the bond was a piece of paper that actually had coupons which the lender had to cut out to receive the periodic payment.  With the advent of computers and electronic banking, lenders no longer have to cut coupons.

Here is an example of a simple bond:

XYZ Corporation needs to raise money to build a new factory so it decides to sell some bonds.  The bond it issues promises to pay $1000 after 10 years with a coupon payment of $10 every six months for a coupon rate of 2% (10 x 2 / 1000).

Many entities can issue bonds.  The biggest issuer of bonds is the United States Government.  Because the Federal Government spends more money than it receives, it must fund this shortfall by borrowing this money from the general public.  It does this through bonds. The Government issues bonds of varying maturities:

Treasury Bills (T-Bills):  These are short term loans that mature in one year or less.  Because they are so short in length, they do not have coupons.

Treasury Notes:  These are bonds which mature in one to ten years.

Treasury Bonds:  These are bonds which mature in ten to thirty years.

The Government also issues Treasury Inflation-Protected Securities (TIPS) where the coupon amount of the face amount grow based upon the inflation rate.  They also issue something called Savings Bonds, which aren't really bonds in the traditional sense.

States and local governments also borrow money through bonds.  These bonds collectively known as municipal bonds.  To entice people to buy these bonds, the interest is exempt from Federal taxes as well as local taxes in the jurisdiction which issues the bond.

Governments aren't the only ones who get in on the bond act.  Private corporations also sell bonds to raise money.  These are appropriately known as corporate bonds.  Some companies may be perceived as being bad credit risks, meaning that there is a strong feeling that they will not make good on the promise to pay the bond back at maturity.  Bonds issues by companies with bad credit are known as high yield bonds or by their more descriptive moniker:  junk bonds.

In addition to all of the above, there are other, more exotic bonds out there:  asset-backed securities (where the principal and interest is "backed" by some specific thing of value), floating rate bonds (where the coupon rate varies based upon some interest rate index), convertible bonds (where the bond can be traded for stock in the company which issued the bond), and others.  As you can see, the bonds come in all sorts of varieties!

In the next post in this series, I will discuss some of the mechanics of determining a bond's value and why bonds may not be as safe as people think.  Stay tuned!

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