Municipal & Corporate Bond Basics
What is a Municipal or Corporate Bond?
Bonds are, at their simplest, loans that investors make to public and private corporations. Consequently, bonds are referred to as debt securities. Municipalities or Corporations generally issue bonds to raise money for capital expenditures, operations, and acquisitions. Typically, bondholders receive interest payments during the term of a bond (or for as long as the bondholder owns the bond), at the stated interest rate—also called the coupon rate. In addition, if the bondholders hold the bond until its maturity date, they also are repaid the principal amount, called par value or face amount.
Bond Price and Yield
Price: If you sell a bond before it matures, you may not receive the full principal amount of the bond. This is because a bond's price is not based on the par value of the bond. Rather, it is determined by the secondary market and is established by the current market values of comparable bonds, which may be more or less than the amount of principal and the remaining interest the issuer would be required to pay the bondholder. Therefore, it is impossible to predict in advance the price that a bondholder will receive if the bondholder sells a bond before maturity. The price of a bond is often above or below its par value because the price is adjusted according to current interest rates in the whole market for comparable debt securities. For example, if the bond you desire to purchase was issued many years ago and has a stated interest rate of eight percent of par and similar quality newly issued bonds have a stated interest rate of five percent, you will have to pay more than the par amount of the bond that you intend to purchase.
Yield is the overall return on the capital you invest in the bond. Yield is not the same as a bond's interest rate. This distinction is important, because as is explained above, while a bond's par value is fixed, its market value almost always changes over time. Because bond prices fluctuate continually in the market, the yield on your bond changes constantly. A bond's price is inversely related to its yield. As a bond's price increases its associated yield decreases; as the price of a bond decreases, the associated yield increases. For example, a bond that sells today for $1,000 and has a coupon rate of eight percent has a current yield of eight percent. Because the "price" ($1,000) equals the face amount of the bond, the current yield of eight percent equals the eight percent fixed interest rate. If the same bond were to sell for $990, instead of $1,000, the current yield would be 8.1%. Conversely, if the bond were to sell for $110, the current yield would be 7.27%.
Yield to Maturity and Yield to Call
Yield to maturity is calculated taking into account the total amount of interest you will receive over time, your purchase price (the amount of capital you invested), the par amount (or amount you will be paid when the issuer "redeems" the bond), the time between interest payments, and the time remaining until the bond matures. If you hold a callable bond, then another type of yield calculation, yield to call, also is important for you to understand. (A callable bond may be redeemed by the issuer under certain circumstances prior to maturity). The yield to call calculation takes into account the impact on a bond's yield if it is called prior to its maturity date and should be calculated using the earliest date on which the issuer could call the bond. A bond's yield to call may be lower than its yield to maturity. Your Sutter broker will be able to provide you with both the yield to maturity and yield to call.
Municipal and Corporate Bond Risks
Like virtually all investments, bonds carry risk. It is important that you fully understand the risks of investing in bonds. These risks include:
Interest Rate Risk
When interest rates rise, bond prices fall, and when interest rates fall, bonds prices rise. Interest rate risk is the risk that changes in interest rates in the U.S. or the world economy may reduce (or increase) the market value of a bond you hold. Interest rate risk increases the longer that a bond has to its maturity date. For example, if interest rates rise throughout the economy, bond issuers will need to offer potential bondholders higher rates to compete with the higher interest rates available elsewhere. Any bonds issued in a period of rising interest rates generally will carry higher coupon rates, which will be more attractive to potential bondholders than the coupon rate paid by bonds issued before the rise in interest rates. This decreased appetite for older bonds that pay lower interest depresses their price in the secondary market, which would translate into your receiving a lower price for your bonds if you chose to sell them in a period of higher interest rates. The opposite holds true as well and the market value of older bonds that pay higher than current interest rates tend to rise in periods where interest rates are generally declining.
Call and Reinvestment Risk
Bonds with a call provision can be redeemed or "called" by the bond issuers, requiring bondholders to redeem their bonds at face value before their maturity dates. Bonds often are called when market interest rates are falling because bond issuers want to refinance their debt at lower interest rates (similar to when a home owner seeks to refinance a mortgage at a lower rate when mortgage interest rates decrease). This is known as call risk. With a callable bond, a bondholder might not receive the bond's coupon rate for the entire term of the bond, and it might be difficult or impossible to find an equivalent investment paying rates as high as the called bond. This is known as reinvestment risk. Additionally, at any given point in time, the stream of a callable bond's cash flow is uncertain and the market value of the bond may not rise above the call price.
Refunding Risk and Sinking Fund Provisions
A sinking fund provision, which often is a term included in bonds issued by industrial and utility companies, requires a bond's issuer to retire a certain number of bonds periodically. This can be accomplished in a variety of ways, including purchases in the secondary market or forced purchases directly from bondholders at a pre-determined price. Holders of bonds subject to sinking funds should understand that they risk having their bonds called prior to maturity. Unlike other bonds subject to call, depending on the sinking fund provision, there may be a relatively high likelihood that the bondholders will be required to sell their bonds prior to maturity even if market-wide interest rates remain unchanged. It is important to understand that there is no guarantee that an issuer of these bonds will be able to comply strictly with any redemption requirements.
Default and Credit Risk
Some loans are riskier than others. The same is true when you invest in bonds. You are taking a risk that the issuer's promise to repay both principal and interest will be upheld. In the case of Treasuries and other government-issued bonds backed by the "full faith and credit of the U.S. government," that risk is zero. However, corporate bonds face the possibility of default. This means the corporations issuing them will either be late paying bondholders or — in worst-case scenarios — be unable to pay at all.
Bond ratings are a way of measuring default and credit risk. Three ratings agencies have been designated by the Securities and Exchange Commission to be a Nationally Recognized Statistical Rating Organization. They are Fitch Ratings, Moody's Investors Service, and Standard & Poor's. These organizations review all information known about the issuer, especially all financial information, such as the issuer's financial statements, and assign a rating—AAA (or Aaa) to D (or not rated). Generally, bonds are categorized in two broad categories — investment grade and non-investment grade. Bonds that are rated BBB (or Baa) or higher are considered investment grade. Bonds that are rated BB (or Ba) or lower are non-investment grade. Non investment grade bonds are also referred to as high yield or junk bonds, and in some cases, distressed bonds. These bonds are considered riskier investments because the issuer's general financial condition is less sound, and the issuer may default— may not be able to pay the interest and principal to bondholders when they are due.
Bondholders should weigh the rating of a particular corporate bond in determining if the corporate bond is an appropriate and suitable investment for them. Although credit ratings are an important indicator of creditworthiness, you should also consider that the value of the bond might change depending on changes in the company's business and profitability. The credit rating could be revised downward. In the worst scenario, corporate bankruptcy, holders of corporate bonds could suffer significant losses, including the loss of their entire investment. Finally, some bonds are not rated. In such cases, it may be difficult to assess the overall creditworthiness of the issuer of the bond. In most cases, Sutter will be able to inform you of a bonds' rating.
You should determine whether the bond in which you are interested has traded frequently, infrequently, or not at all in recent months. While certain bonds are very actively traded and are relatively "liquid," other bonds, including many high yield bonds, are traded much less frequently and may not be easy to sell. If you think you might need to sell the bonds you are purchasing prior to their maturity you should take this into consideration when deciding which bonds to purchase. It is possible that you may be able to re-sell a bond only at a discount to the price you paid (loss of some principal). Additionally, bonds that are less frequently traded may be subject to wider "spreads" in the secondary market, which means that you would receive less for your bond if you are selling, or pay more if you are buying, than might otherwise would be the case.
Bonds with Special Features
It also is important to understand any special features a bond may have before you buy since these features may affect risk.
Floating Rate bonds have a floating or variable interest rate that is adjusted periodically or floats using an external value or measure (for example, the prime rate or a stock index). Such bonds offer protection against interest rate risk, but their coupon rate is usually lower than those of fixed rate bonds.
Zero-coupon bonds, unlike other bonds, don't make regular interest payments. Instead, the bondholder buys the bond at a discount from the face value of the bond, and, when the bond matures, the issuer repays the bondholder the face amount. The difference between the discounted amount the bondholder pays upon purchase and the face amount later received is the imputed interest. Because zero-coupon bonds don't pay any interest until maturity, their prices may be more volatile than other bonds with similar maturities that pay interest periodically. If you buy or sell a zero-coupon bond, the valuation will reflect the accrued interest on the bond.
Secured bonds are backed by collateral that the bond's issuer has pledged to secure these bonds, if it otherwise is unable to meet its obligation when the bond matures. For example, a bond might be backed by a specific factory or industrial equipment. However, any such backing is only as good as the value of the asset being used as collateral, the value of which can change during the term of the bond. Bonds that are not backed by any collateral are unsecured and are sometimes called debentures. Debentures are backed solely by an issuer's promise to repay you. Most corporate bonds are debentures.
Guaranteed and Insured Bonds. Certain bonds may be referred to as guaranteed or insured. This means that a third party has agreed to pay the principal and often the interest if the issuer is unable to make these payments. You should keep in mind that such guarantees only are as valuable as the creditworthiness of the third party making the guarantee or providing the insurance.
Convertible bonds may be converted into the common stock of the bond's issuer. A bondholder should be careful to understand the conditions under which the bonds may be converted as this right often is contingent upon, among other things, the issuer's stock reaching a certain price level. In some cases, the bondholder may be required to convert into stock.
Junior bonds issued by a company typically are referred to as subordinated debt because a junior bondholder's claim for repayment of the principal of such bonds is subordinated to the claims of bondholders holding the issuer's more senior debt. Additionally, other types of claims also may have priority on the issuer's remaining assets over the claims of all bondholders (e.g., certain supplier or customer claims). Therefore, although bondholders are paid prior to stockholders in a bankruptcy proceeding, this may offer little comfort if the issuer's assets are pledged in other creditors that have the right to be paid before bondholders of a particular class of bonds.
Broker Compensation for Selling Bonds
Although Sutter does not charge a commission on the purchase or sale of a corporate bond, we are compensated for our services. In most bond transactions, the transaction is structured as a principal transaction (i.e., we sell you a bond we own). Our compensation is the difference between the bid and asked price of the bond. Sutter is never influenced by the markup or mark down in its decision to recommend a particular bond.
For more information on bonds, please visit the Bond Learning Center at the FINRA website.