Tuesday, May 11, 2010

Bonds explained

By Dr. Jason White
Family Investment Center

One of the bedrock fundamental approaches to successful personal investing is to proper diversify one’s portfolio based on individual factors like age, investment goals and risk tolerance. To diversify means to spread out financial risk by investing in a variety of asset classes including, but not limited to, stocks, bonds and real estate. The focus of today’s column is to provide you with some of the basic terminology from the world of bonds.

A bond represents evidence of a loan made from an investor to government, quasi-governmental agencies or corporations. Bonds are referred to as “fixed-income” securities because they typically pay a fixed rate of interest to the investor. This interest rate is known as the “coupon-rate” of interest.

The face value, known also as the par value of a bond, is paid back to the bondholder at the time of maturity. This is usually $1,000 with many bonds, but it can be just about any amount that the original issuer wished at the time of issuance. At the time of original issue, an indenture contract is put into place specifying the terms of the bond, along with any special provisions the issuer or underwriter think are necessary.

Bonds can be backed by some form of collateral, but many times they are simply debentures, meaning that no specific collateral has been pledged to back that particular bond issue. In the event of default, bondholders who enjoy the protection of specific collateral, such as mortgage bondholders, get paid back before debenture bondholders do. Still, debenture bondholders will be paid before preferred and common stockholders, so their priority claims at least have some chance of recovery.

To assist investors in making informed bond investing decisions, companies like Moody’s Investors Service, Standard and Poor’s Financial Services LLC and Fitch Inc. analyze the financial strength of firms and issue a bond rating for the debt of those companies. The lower the bond rating of a firm is, the higher the risk for the investor. The following chart is a proxy of these rating systems, but I think you’ll get the idea.

Rating Rating Interpretation

AAA Best Quality
AA High Quality
A Upper Medium Grade
BBB Medium Grade
BB Speculative
B Very Speculative
CCC Very Very Speculative
C No Interest being Paid
D Currently in Default

Bonds with a BBB or higher rating are referred to as “investment-grade,” while bonds with a rating below BBB are known as non-investment grade or “junk bonds.” While junk bonds often pay high rates of interest, this is because they are very risky investments and should only make up a very small percentage of your portfolio, at most.

A special feature of some bonds is a call provision. Callable bonds include a provision allowing the issuing company to force early maturity by calling the bonds in. Corporations might issue callable bonds when interest rates are high, hoping to call them in before maturity and refinance the issue if interest rates go down. In the current low interest rate economic environment, I suspect that any bond which can be called already has been, at least where the issuer is financially able to refund debt.

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