Investing in Bond Markets

Introduction

The first thing that comes to most people's minds when they think of investing is the stock market. After all, stocks are exciting. The swings in the market are scrutinized in the newspapers and even covered by local evening newscasts. Stories of investors gaining great wealth in the stock market are common.

Bonds, on the other hand, don't have the same sex appeal. The lingo seems arcane and confusing to the average person. Plus, bonds are much more boring ‑ especially during raging bull markets, when they seem to offer an insignificant return compared to stocks.

However, all it takes is a bear market to remind investors of the virtues of a bond's relative safety and stability. In fact, for many investors it makes sense to have at least part of their portfolio invested in bonds to stocks.

The Law Offices of Robert Wayne Pearce, P.A. focuses its practice on securities, commodities and other investment disputes in courtroom litigation, arbitration and mediation proceedings. We have over 35 years experience representing domestic and foreign investors from offices located in Boca Raton, West Palm Beach, and Fort Lauderdale, Florida. We handle bond fraud and other bond broker misconduct claims involving the municipal, corporate and government bond markets. It is important for all investors to understand the fundamentals of investing and we are pleased to share some of the basics in investing in bonds to help you understand bonds and avoid disputes.

What Are Bonds?

Have you ever borrowed money? Of course you have! Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

Of course, nobody would loan his or her hard‑earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed income securities because you know the exact amount of cash you'll get back if you hold the security until maturity.

For example, say you buy a bond with a face value of $1000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of $80 ($1 000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi‑annually, you'll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you'll get your $1,000 back.

Debt Versus Equity

Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well ‑ he or she is entitled only to the principal plus interest.

To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

Why Bother With Bonds?

It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short‑term volatility of the stock market. Take two situations where this may be true:

  • Retirement ‑ The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
  • Shorter time horizons ‑ Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed‑income securities are likely the best investment.

These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes (cash, stock, bonds, real estate, etc.) throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority of your investments should be in the form of fixed income.

Characteristics

Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.

Face Value/Par Value

The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1000, but this amount can be much greater for government bonds.

What confuses many people is that the par value is not the price of the bond. A bond's price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the 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.

Coupon (The Interest Rate)

The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.

As previously mentioned, most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed‑rate bond. Another possibility is an adjustable interest payment, known as a floating‑rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.

You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.

Maturity

The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 35 years (though terms of 100 years have been issued).

A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.

Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small ‑ so small that U.S. government securities are known as risk‑free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors ‑ this is the risk/return tradeoff in action.

The bond rating system helps investors determine a company's credit risk. Think of a bond rating as the report card for a company's credit rating. Blue‑chip firms, which are safer investments, have a high rating, while risky companies have a low rating. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings.

Notice that if the company falls below a certain credit rating, its grade changes from investment quality to junk status. Junk bonds are aptly named: they are the debt of companies in some sort of financial difficulty. Because they are so risky, they have to offer much higher yields than any other debt. This brings up an important point: not all bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not riskier, than stocks.

Yield, Price And Other Confusion

Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact, many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any other publicly‑traded security. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate ‑ sometimes dramatically. We'll get to how price changes in a bit. First, we need to introduce the concept of yield.

Measuring Return With Yield

Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Yield To Maturity

Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.

Putting It All Together: The Link Between Price And Yield

The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related.

Here's a commonly asked question: How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.

Price In The Market

So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

Different Types Of BondsGovernment Bonds

In general, fixed‑income securities are classified according to the length of time before maturity. These are the three main categories:

  • Bills ‑ debt securities maturing in less than one year.
  • Notes ‑ debt securities maturing in one to 10 years.
  • Bonds ‑ debt securities maturing in more than 10 years.

Marketable securities from the U.S. government ‑ known collectively as Treasuries ‑ follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T‑bills). Technically speaking, T‑bills aren't bonds because of their short maturity. (You can read more about T‑bills in our Money Market tutorial.) All debt issued by Uncle Sam is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments.

Municipal Bonds

Municipal bonds, known as 'munis', are the next progression in terms of risk. Cities don't go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non‑taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after‑tax basis.

Corporate Bonds

A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short‑term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed‑income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Zero‑Coupon Bonds

This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero‑coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1000 in 10 years.

Bond Type Specifics

Before getting to the all‑important subject of bond pricing, we must first understand the many different characteristics bands can have.

When it comes down to it, a bond is simply a contract between a lender and a borrower by which the borrower promises to repay a loan with interest. However, bonds can take on many additional features and/or options that can complicate the way in which prices and yields are calculated. The classification of a bond depends on its type of issuer, priority, coupon rate, and redemption features. The following chart outlines these categories of bond characteristics:

1) Bond Issuers

As the major determiner of a bond's credit quality, the issuer is one of the most important characteristics of a bond. There are significant differences between bonds issued by corporations and those issued by a state government/municipality or national government. In general, securities issued by the federal government have the lowest risk of default while corporate bonds are considered to be riskier ventures. Of course there are always exceptions to the rule. In rare instances, a very large and stable company could have a bond rating that is better than that of a municipality. It is important for us to point out, however, that like corporate bonds, government bonds carry various levels of risk; because all national governments are different, so are the bonds they issue.

International bonds (government or corporate) are complicated by different currencies. That is, these types of bonds are issued within a market that is foreign to the issuer's home market, but some international bonds are issued in the currency of the foreign market and others are denominated in another currency. Here are some types of international bonds:

  • The definition of the eurobond market can be confusing because of its name. Although the euro is the currency used by participating European Union countries, eurobonds refer neither to the European currency nor to a European bond market. A eurobond instead refers to any bond that is denominated in a currency other than that of the country in which it is issued. Bonds in the eurobond market are categorized according to the currency in which they are denominated. As an example, a eurobond denominated in Japanese yen but issued in the U.S. would be classified as a euro yen bond.

  • Foreign bonds are denominated in the currency of the country in which a foreign entity issues the bond. An example of such a bond is the samurai bond, which is a yen‑denominated bond issued in Japan by an American company. Other popular foreign bonds include bulldog and yankee bonds.

  • Global bonds are structured so that they can be offered in both foreign and eurobond markets. Essentially, global bonds are similar to eurobonds but can be offered within the country whose currency is used to denominate the bond. As an example, a global bond denominated in yen could be sold to Japan or any other country throughout the Eurobond market.

2) Priority

In addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability that the issuer will pay you back your money. The priority indicates your place in line should the company default on payments. If you hold an unsubordinated (senior) security and the company defaults, you will be first in line to receive payment from the liquidation of its assets. On the other hand, if you own a subordinated (junior) debt security, you will get paid out only after the senior debt holders have received their share.

3) Coupon Rate

Bond issuers may choose from a variety of types of coupons, or interest payments.

  • Straight, plain vanilla or fixed‑rate bonds pay an absolute coupon rate over a specified period of time. Upon maturity, the last coupon payment is made along with the par value of the bond.

  • Floating rate debt instruments or floaters pay a coupon rate that varies according to the movement of the underlying benchmark. These types of coupons could, however, be set to be a fixed percentage above, below, or equal to the benchmark itself. Floaters typically follow benchmarks such as the three, six or nine‑month T‑bill rate or LIBOR.

  • Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short‑term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For example, an inverse floater that uses LIBOR as the underlying benchmark might pay a coupon rate of a certain percentage, say 6%, minus LIBOR.

  • Zero coupon, or accrual bonds do not pay a coupon. Instead, these types of bonds are issued at a deep discount and pay the full face value at maturity.

4) Redemption Features

Both investors and issuers are exposed to interest rate risk because they are locked into either receiving or paying a set coupon rate over a specified period of time. For this reason, some bonds offer additional benefits to investors or more flexibility for issuers:

  • Callable, or a redeemable bond features gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond's maturity. The issuer, however, must pay the bond holders a premium. There are two subcategories of these types of bonds: American callable bonds and European callable bonds. American callable bonds can be called by the issuer any time after the call protection period while European callable bonds can be called by the issuer only on pre‑specified dates.

The optimal time for issuers to call their bonds is when the prevailing interest rate is lower than the coupon rate they are paying on the bonds. After calling its bonds, the company could refinance its debt by reissuing bonds at a lower coupon rate.

  • Convertible bonds give bondholders the right but not the obligation to convert their bonds into a predetermined number of shares at predetermined dates prior to the bond's maturity. Of course, this only applies to corporate bonds.

  • Puttable bonds give bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk. If prevailing bond prices are lower than the exercise par of the bond, resulting from interest rates being higher than the bond's coupon rate, it is optimal for investors to sell their bonds back to the issuer and reinvest their money at a higher interest rate.

Unlimited Types of Bonds

All of the characteristics and features described above can be applied to a bond in practically unlimited combinations. For example, you could theoretically have a Malaysian corporation issue a subordinated yankee bond paying a floating coupon rate of LIBOR + 1% that is callable at the choice of the issuer on certain dates of the year.

Bond Pricing

It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments.

Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) ‑ which is based on the assumption that each payment is re‑invested at some interest rate once it is received‑‑we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield.

Yield and Bond Price

The general definition of yield is the return an investor will receive by holding a bond to maturity. So if you want to know what your bond investment will earn, you should know how to calculate yield. Required yield, on the other hand, is the yield or return a bond must offer in order for it to be worthwhile for the investor. The required yield of a bond is usually the yield offered by other plain vanilla bonds that are currently offered in the market and have similar credit quality and maturity.

Once an investor has decided on the required yield, he or she must calculate the yield of a bond he or she wants to buy. Let's proceed and examine these calculations.

Current Yield

A simple yield calculation that is often used to calculate the yield on both bonds and the dividend yield for stocks is the current yield. The current yield calculates the percentage return that the annual coupon payment provides the investor. In other words, this yield calculates what percentage the actual dollar coupon payment is of the price the investor pays for the bond. The comparison of the bond price to its par value is a factor that affects the actual current yield. The investor must take into account the discount or premium at which the investor bought the bond to ascertain the current yield.

Yield to Maturity

The current yield calculation we learned above shows us the return the annual coupon payment gives the investor, but this percentage does not take into account the time value of money or, more specifically, the present value of the coupon payments the investor will receive in the future. For this reason, when investors and analysts refer to yield, they are most often referring to the yield to maturity (YTM), which is the interest rate by which the present values of all the future cash flows are equal to the bonds price.

An easy way to think of YTM is to consider it the resulting interest rate the investor receives if he or she invests all of his or her cash flows (coupons payments) at a constant interest rate until the bond matures. YTM is the return the investor could receive from his or her entire investment. It is the return that an investor gains by receiving the present values of the coupon payments, the par value and capital gains in relation to the price that is paid.

Calculating Yield for Callable and Puttable Bonds

Bonds with callable or puttable redemption features have additional yield calculations. A callable bond's valuations must account for the issuer's ability to call the bond on the call date and the puttable bond's valuation must include the buyer's ability to sell the bond at the pre‑specified put date. The yield for callable bonds is referred to as yield‑to‑call, and the yield for puttable bonds is referred to as yield‑to‑put.

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the call date. The period until the first call is referred to as the call protection period. Yield to call is the rate that would make the bond's present value equal to the full price of the bond.

Note that European callable bonds can have multiple call dates and that a yield to call can be calculated for each.

Yield to put (YTF) is the interest rate that investors would receive if they held the bond until its put date. To calculate yield to put, the same modified equation for yield to call is used except the bond put price replaces the bond call value and the time until put date replaces the time until call date.

For both callable and puttable bonds, astute investors will compute both yield and all yield‑to‑call/yield‑to‑put figures for a particular bond, and then use these figures to estimate the expected yield. The lowest yield calculated is known as yield to worst, which is commonly used by conservative investors when calculating their expected yield. Unfortunately, these yield figures do not account for bonds that are not redeemed or are sold prior to the call or put date.

Now you know that the yield you receive from holding a bond will differ from its coupon rate because of fluctuations in bond price and from the reinvestment of coupon payments. In addition, you are now able to differentiate between current yield and yield to maturity.

The Term Structure of Interest Rates

The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed‑income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk‑free, and as such, their yields are often used as the benchmarks for fixed‑income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed‑income security were a zero‑coupon bond that "matures" on the coupon payment date. The exact shape of the curve can be different at any point in time. So if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy.

There are three main patterns created by the term structure of interest rates:

  1. Normal Yield Curve: As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect higher yields for fixed income instruments with long‑term maturities that occur farther into the future. In other words, the market expects long‑term fixed income securities to offer higher yields than short‑term fixed income securities. This is a normal expectation of the market because short‑term instruments generally hold less risk than long‑term instruments; the farther into the future the bond's maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.
    Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.

  2. Flat Yield Curve: These curves indicate that the market environment is sending mixed signals to investors, who are interpreting interest rate movements in various ways. During such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short‑term interest rates will rise and other signals that long‑term interest rates will fall. This condition will create a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed‑income securities with the least risk, or highest credit quality. In the rare instances wherein long‑term interest rates decline, a flat curve can sometimes lead to an inverted curve.

  3. Inverted Yield Curve: These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long‑term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long‑term fixed‑income investments when there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long‑term investments at present prevailing yields, because future yields will be even lower.

The Credit Spread

The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. Remember that the term structure of interest rates is a gauge of the direction of interest rates and the general state of the economy. Corporate fixed‑income securities have more risk of default than federal securities and, as a result, the prices of corporate securities are usually lower, while corporate bonds usually have a higher yield.

When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds.

When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed‑income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining, the economy is expanding in the long run, so the risk associated with investing in a long‑term corporate bond is also generally lower.

Now you have a general understanding of the concepts and uses of the yield curve. The yield curve is graphed using government securities, which are used as benchmarks for fixed income investments. The yield curve, in conjunction with the credit spread, is used for pricing corporate bonds. Now that you have a better understanding of the relationship between interest rates, bond prices and yields, we are ready to examine the degree to which bond prices change with respect to a change in interest rates.

Duration

The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.

Factors Affecting Duration

Duration changes as the coupons are paid to the bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no longer on the time line, which means it is no longer counted as a future cash flow that goes towards repaying the bondholder.

Duration increases immediately on the day a coupon is paid, but throughout the life of the bond, the duration is continually decreasing as time to the bond's maturity decreases. But duration also increases momentarily on the day a coupon is paid and removed from the series of future cash flows ‑ all this occurs until duration, eventually converges with the bond's maturity. The same is true for a zero‑coupon bond.

Duration: Other factors

Besides the movement of time and the payment of coupons, there are other factors that affect a bond's duration: the coupon rate and its yield. Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. This makes empirical sense, because when a bond pays a higher coupon rate or has a high yield, the holder of the security receives repayment for the security at a faster rate.

Duration and Bond Price Volatility

More than once throughout this tutorial, we have established that when interest rates rise, bond prices fall, and vice versa. But how does one determine the degree of a price change when interest rates change? Generally, bonds with a high duration will have a higher price fluctuation than bonds with a low duration. But it is important to know that there are also three other factors that determine how sensitive a bond's price is to changes in interest rates. These factors are term to maturity, coupon rate and yield to maturity. Knowing what affects a bond's volatility is important to investors who use duration‑based immunization strategies, which we discuss below, in their portfolios.

Factors 1 and 2: Coupon rate and Term to Maturity

If term to maturity and a bond's initial price remain constant, the higher the coupon, the lower the volatility, and the lower the coupon, the higher the volatility. If the coupon rate and the bond's initial price are constant, the bond with a longer term to maturity will display higher price volatility and a bond with a shorter term to maturity will display lower price volatility.

Therefore, if you would like to invest in a bond with minimal interest rate risk, a bond with high coupon payments and a short term to maturity would be optimal. An investor who predicts that interest rates will decline would best potentially capitalize on a bond with low coupon payments and a long term to maturity, since these factors would magnify a bond's price increase.

Factor 3: Yield to Maturity (YTM)

The sensitivity of a bond's price to changes in interest rates also depends on its yield to maturity. A bond with a high yield to maturity will display lower price volatility than a bond with a lower yield to maturity, but a similar coupon rate and term to maturity. Yield to maturity is affected by the bond's credit rating, so bonds with poor credit ratings will have higher yields than bonds with excellent credit ratings. Therefore, bonds with poor credit ratings typically display lower price volatility than bonds with excellent credit ratings.

All three factors affect the degree to which bond price will change in the face of a change in prevailing interest rates. These factors work together and against each other. If a bond has both a short term to maturity and a low coupon rate, its characteristics have opposite effects on its volatility: the low coupon raises volatility and the short term to maturity lowers volatility. The bond's volatility would then be an average of these two opposite effects.

Understanding what duration is, how it is used and what factors affect it will help you to determine a bond's price volatility. Volatility is an important factor in determining your strategy for capitalizing on interest rate movements.

Furthermore, duration will also help you to determine how you can protect your portfolio from interest rate risk.

Convexity

For any given bond, a graph of the relationship between price and yield is convex. This means that the graph forms a curve rather than a straight‑line (linear). The degree to which the graph is curved shows how much a bond's yield changes in response to a change in price.

Properties of Convexity

Convexity is also useful for comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. A bond with greater convexity is less affected by interest rates than a bond with less convexity. Also, bonds with greater convexity will have a higher price than bonds with a lower convexity, regardless of whether interest rates rise or fall.

What Factors Affect Convexity?

Here is a summary of the different kinds of convexities produced by different types of bonds:

  1. The graph of the price‑yield relationship for a plain vanilla bond exhibits positive convexity. The price‑yield curve will increase as yield decreases, and vice versa. Therefore, as market yields decrease, the duration increases (and vice versa).

  2. In general the higher the coupon rate, the lower the convexity of a bond. Zero‑coupon bonds have the highest convexity.

  3. Callable bonds will exhibit negative convexity at certain price‑yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.

Convexity is the final major concept you need to know for gaining insight into the more technical aspects of the bond market. Understanding even the most basic characteristics of convexity allows the investor to better comprehend the way in which duration is best measured and how changes in interest rates affect the prices of both plain vanilla and callable bonds.

How Do I Buy Bonds?

Most bond transactions can be completed through a full service or discount brokerage. You can also open an account with a bond broker. If you do decide to purchase a bond through your broker, he or she may tell you that the trade is commission free. Don't be fooled. What typically happens is that the broker will mark up the price slightly; this markup is really the same as a commission. To make sure that you are not being taken advantage of, simply look up the latest quote for the bond and determine whether the markup is acceptable. Remember, you should research bonds just as you would stocks.

Conclusion

Investing in the municipal, corporate and government bonds can become very complicated and oftentimes bond brokers are not as knowledgeable or trustworthy as one might be led to believe. As a result, investments in the bond markets can be mismanaged, misrepresented and unsuitable investments offered and sold in violation of federal and state securities law and in breach of a bond broker's fiduciary duty. Bond brokers can also be held responsible for their negligence and failure to abide by commodities industry rules and regulations. At the Law Offices of Robert Wayne Pearce, P.A. we know the nature, mechanics and risks of investing in the bond markets as well as the applicable laws, rules and regulations governing those investments. Please contact us for a free consultation if you believe you have been harmed by brokers misconduct in connection with your municipal, corporate and government bond market investments.

Free Consultation With Attorneys Who Can Handle Your Securities and Commodities Problems

Contact The Law Offices of Robert Wayne Pearce, P.A., in Boca Raton to discuss your fraud or misrepresentation claim. The firm can be reached by phone at 561-338-0037, toll free at 800-732-2889 or via e-mail.

Contact Us For A Free Consultation
Phone Numbers: 800-732-2889 561-338-0037
I have read the disclaimer