Understanding the Bond Market - Stifel

1 Understanding the bond Market As markets become volatile, many inves- the best bet, as they are backed by the full Corporate Bonds tors turn to bonds as an alternative to faith and credit of the government. Corporate bonds, unlike Treasuries and stocks. While bonds can play an integral The Treasury regularly offers three municipal bonds, are fully taxable and may role in a well-diversified portfolio, investors types of securities: Treasury bills, notes, carry greater risk. At the same time, they should fully understand their character- and bonds. Treasury bills (or T-bills) are may offer higher returns than tax-advan- istics before investing.

2 Bonds are often short-term securities that mature in one taged bonds. Corporate bonds are issued deemed a safe investment. However, year or less from their issue date and by corporations in the need of capital and investors need to be aware that bonds, like are purchased for a price less than their are typically issued in denominations of all investments, do carry some risk, and face value. Treasury notes and bonds are $1,000 with terms of 1 to 30 years. Unlike those risks need to be considered carefully. securities that pay a fixed rate of interest stocks, bonds do not give the holder own- every six months until the security ma- ership interest in the corporation, as they bond Fundamentals tures.

3 Treasury notes mature in more than are simply a tool used to lend the corpora- If you are considering purchasing, or a year, but not more than ten years from tion funds they need to meet their goals. have already purchased, bonds for your their issue date. Bonds, on the other hand, mature in more than ten years from their Because corporate bonds generally portfolio, you should understand that not carry greater risks than government and all bonds are created equal. While they are issue date. Bonds and notes can usually be purchased for a price close to their face municipal bonds, it is critical that investors all considered debt instruments, bonds are understand the quality of the bond they created by different entities for very differ- value.

4 Interest from Treasury securities is exempt from state and local income taxes, are considering for investment. To evalu- ent purposes and carry varying risks and ate the credit quality of a bond , investors tax-related liabilities. Simply put, bonds which make them particularly beneficial if you live in a state with a high tax rate. can look to organizations that rate various are issued by companies and government corporate bonds, such as Moody's Inves- bodies to fund their day-to-day opera- In addition to Treasuries, certain federal tors Service and Standard & Poor's. Those tions or to finance specific projects. When government agencies or government- bonds rated Baa or above by Moody's and an investor buys a bond , he or she is, in sponsored enterprises (GSEs) have been BBB or above by Standard & Poor's are fact, loaning money for a certain period authorized by Congress to issue debt secu- considered investment-grade.

5 Bonds rated of time to the issuer of the bond . In return rities to certain groups of borrowers, such below investment grade are considered for loaning funds, investors receive the as homeowners, farmers, and students. more speculative and carry greater risk. principal amount back, with interest, at the In general, debt securities issued by GSEs time the bond comes due or matures. are considered to have high credit quality. Understanding Yields A bond 's face value, or the price at issue, is However, it is important to recognize that issuers in the Agency Market are corpo- As previously mentioned, the coupon rate known as its par value, and the inter- is the interest rate paid on a bond .

6 This est payment is known as its coupon. rations and that their bonds are not explic- itly guaranteed by the Government. amount is expressed as a percent of par The price of bonds will fluctuate, similar value (normally $1,000). For example, a to stocks, throughout the trading day. 4% coupon would indicate that the annual However, with most bonds, the cou- Municipal Bonds interest paid on the bond is $40. The cur- pon payment will stay the same (some Just as the federal government needs funds rent yield rate indicates the current rate floating-rate securities do exist). If an to operate, local governments and public of return an investor will receive on each investor purchases a bond in the second- entities, such as school districts, often issue dollar invested, without any adjustments for ary Market at the face value, the bond is municipal bonds to meet their financial differences between the purchase price and considered to be sold at par.

7 If a bond 's needs. Municipal bonds can be issued by price is above its face value, it is sold at a states, cities, towns, or public commissions Standard premium. If a bond 's price is below face to provide money for schools, hospitals, Credit Risk Moody's & Poor's value, it is sold at a discount. and other public works. These securi- Investment Grade ties provide income that is free of federal Highest Quality Aaa AAA. In general, there are three main categories High Quality (very strong) Aa AA. that bonds will fall under: Government, and, in some cases, state and local taxes. Upper Medium Grade A A. Municipal, and Corporate.

8 (Although income generated by most Medium Grade Baa BBB. municipal bonds is exempt from taxes, any Non Investment-Grade Government Bonds capital gains earned from the sale of bonds Somewhat Speculative Ba BB. are subject to all federal and most state tax Highly Speculative Caa CCC. For bond investors looking for low risk Most Speculative Ca CC. laws and certain bonds may be subject to Imminent Default C C. investments, Treasuries are typically the alternative minimum tax.) Default C D. the maturity value. The current yield rate is taxable investments in order to determine When the bond is redeemed, the issuer is useful when comparing current yields on the best investment for their situation.

9 Required to pay the bond holder the par various income investments. The yield to value of the bond only, which means the maturity rate indicates the overall rate an In order to compare rates of return on bond holder may get less than the Market investor will earn, including adjustments investments, it is helpful to adjust the tax- price of the bond , but will also have to re- for any differences between the purchase free rates to their taxable equivalent rates. invest his or her funds at prevailing rates. price and the $1,000 maturity value. This is the taxable rate that would have to Credit risk Because a bond is a debt be earned in order to net the same tax-free instrument, there is a risk that the bond The yield to call rate indicates the overall rate, after paying federal income taxes.

10 Issuer will be unable to make its pay- rate an investor will earn, including To calculate the taxable equivalent rate, ments on time, or at all. If a company adjustments for any differences between simply divide the tax-free rate by one minus enters bankruptcy, bondholders will re- the purchase price and the call price, in your federal tax bracket rate. For example: ceive any money due before stockholders the event the bonds are called by the Assuming an investor's federal marginal tax receive their portion. However, depending issuer. It is important that investors make bracket is 28% and an investment offers a on the situation, there are no guarantees note of the yield to maturity and yield to tax-free rate of 4%, the taxable equivalent the bondholder's investment will be call on any bonds they are considering rate would be (4% = ).