“Investing puts money to work. The only reason to save money is to invest it.”
Grant Cardone
Corporations (and governments) frequently borrow money by issuing or selling debt securities called bonds. Here are insights on how bonds can be valued, bought and sold.
Bond features & prices
A bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. For example, a corporation wants to borrow $1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12%. The corporation will pay $0.12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, the corporation will repay the $1,000. A bond is a pretty simple financing arrangement. But, as with all things in finance, the details can get complicated.
In the example, the $120 regular interest payments are called the bond’s coupons.
Because the coupon is constant and paid every year, this type of bond is sometimes called a level coupon bond.
The amount repaid at the end of the loan is the bond’s face value, or par value.
The number of years until the face value is paid is called the bond’s time to maturity. Corporate bonds frequently have a maturity of 30 years.
Bond Values and Yields
As time passes, interest rates change in the marketplace. Because the cash flows from a bond stay the same, the value of the bond fluctuates. When interest rates rise, the present value of the bond’s remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more.
To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features. This interest rate required in the market on a bond is called the bond’s yield to maturity (YTM). This rate is sometimes called the bond’s yield for short. Given all this information, we can calculate the present value of the cash flows as an estimate of the bond’s current market value.
Government Bonds
When the U.S. government wants to borrow money for more than one year, it sells Treasury notes and bonds to the public (almost monthly). Currently, outstanding Treasury notes and bonds have original maturities ranging from 2 to 30 years.
While most U.S. Treasury issues are just ordinary coupon bonds, there are two important things to keep in mind.
- U.S. Treasury issues, unlike other bonds, have no default risk because (hopefully) the Treasury can always come up with the money to make the payments.
- Treasury issues are exempt from state income taxes (but not federal income taxes). In other words, the coupons you receive on a Treasury note or bond are only taxed at the federal level.
State and local governments also borrow money by selling notes and bonds. Such issues are called municipal notes and bonds, or “munis.” Unlike Treasury issues, munis have varying degrees of default risk. The most intriguing thing about munis is that their coupons are exempt from federal income taxes (though not necessarily state income taxes), which makes them very attractive to high-income, high-tax bracket investors. Because of this enormous tax break, the yields on municipal bonds are much lower than the yields on taxable bonds.
Corporate Bonds
U.S. Treasury issues are default-free and municipal bonds face the possibility of default. Corporate bonds face the possibility of default. This possibility generates a wedge between the promised yield and the expected return on a bond.
How Bonds Are Bought and Sold
Most trading in bonds takes place over the counter, or OTC, which means that there is no particular place where buying and selling occur. Instead, dealers stand ready to buy and sell. The various dealers are connected electronically.
One reason the bond markets are so big is that the number of bond issues far exceeds the number of stock issues. There are two reasons for this.
- Corporations would typically have only one common stock issue outstanding, though there are exceptions. However, a single large corporation could easily have a dozen or more note and bond issues outstanding.
- Beyond this, federal, state, and local borrowing is simply enormous. For example, even a small city would usually have a wide variety of notes and bonds outstanding, representing money borrowed to pay for items like roads, sewers, and schools. When you think about how many small cities there are in the United States, you begin to get the picture!
Treasury notes and bonds have three important features that we need to remind you of: They are default-free, they are taxable, and they are highly liquid. This is not true of bonds in general, so we need to examine what additional factors come into play when we look at bonds issued by corporations or municipalities.
- Consider the possibility of default, commonly called credit risk. Investors recognize that issuers other than the Treasury may or may not make all the promised payments on a bond, so they demand a higher yield as compensation for this risk. This extra compensation is called the default risk premium. Earlier in the chapter, we saw how bonds were rated based on their credit risk. What you will find if you start looking at bonds of different ratings is that lower-rated bonds have higher yields.
- Municipal bonds are free from most taxes and, as a result, have much lower yields than taxable bonds. Investors demand the extra yield on a taxable bond as compensation for the unfavorable tax treatment. This extra compensation is the taxability premium.
- Bonds have varying degrees of liquidity. There are an enormous number of bond issues, most of which do not trade on a regular basis. As a result, if you wanted to sell quickly, you would probably not get as good a price as you could otherwise. Investors prefer liquid assets to illiquid ones, so they demand a liquidity premium on top of all the other premiums we have discussed. As a result, all else being the same, less liquid bonds will have higher yields than more liquid bonds.
How Do You Lose Money on a Bond?
Investopedia details 7 ways to lose money on a bond here. The Finance For Fathers take:
- Interest rates! They’ll kill ya.
- Inflation too
- Redemptions
- Exchange and currency rate fluctuations
- Mortgage backed securities (dun dun DUUUNNN)
- Muni’s are surprisingly tricky
- CD penalties but not for punishing people who still own Spin Doctors on compact disc (🤚)
