Fixed Income

Bond Basics

What are bonds?

Bonds are debt securities issued by corporations, governments and municipalities. Bonds are similar to IOUs: investors lend money to an organization and in return receive interest payments. The organization is obligated to return the principal to investors on a predetermined date in the future. When purchasing bonds, investors become creditors of the issuer and, therefore, have priority claim on the issuer’s assets in the event of bankruptcy.

Bond Characteristics

– Par or face value is the bond’s denomination and the amount returned to the investor upon maturity. Par is not the price of the bond. The price fluctuates throughout the lifetime of the bond. If the price is above par, the bond is selling at a premium. If the price is below par, the bond is selling at a discount. Price is generally quoted as a percentage of face value. For example, a price of 98 means 98% of the bond’s $1,000 par value, or $980.

– Coupon rate (or just coupon) is the interest rate paid to investors as compensation for the loan. Coupon payments are generally made semi-annually unless otherwise stated. Many investors depend on this predictable income.

– Maturity is the term of the bond’s life. Bonds range in maturity from three months to 100 years. On the maturity date, the bond's face value is repaid to the investor and the interest payments stop.

– Call provisions give an issuer the option, at its discretion, to redeem bonds (pay back the principal) prior to maturity after an initial non-call period. Bonds are generally called when the situation is most beneficial for the issuer. In general, bonds are called when market interest rates fall, allowing the company to issue new bonds with lower coupon rates. To compensate investors for the reinvestment risk and unknown final term of investment, callable bonds generally offer higher yields than non-callable alternatives. Learn more about callable bonds.

– Credit rating is a reflection of an issuer’s ability to pay interest and principal and may not fully represent its creditworthiness. Just like individuals, companies with poor credit have difficulty finding financing at lower costs. “Junk bonds,” or high-yield bonds, have a higher risk of default and, therefore, must offer investors a higher stated return on the borrowed money. High-yield bonds (below investment grade) are not suitable for all investors. The risk of default may increase due to changes in the issuer’s credit quality. In addition, investor’s perception of a company’s financial health may greatly affect the market value of its bonds without an official change in credit rating. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning rating agency. Ratings are subject to change and do not remove market risk.

Price/Yield Relationship

Yield is the annual rate of return investors earn based on a bond’s coupon rate and its current market price. When interest rates rise, the price of an existing bond falls because its coupon becomes less attractive to potential investors. The opposite happens when interest rates fall. Hence, there’s an inverse relationship between a bond’s price and its yield. Learn more about factors that may affect prices of fixed income securities.

Asset allocation and diversification do not ensure a profit or protect against a loss.

The securities described above are subject to investment risks, including possible loss of principal amount invested. If bonds are sold prior to maturity, investors may receive more or less than the initial investment. Insurance, if specified, relates to the timely payment of principal and interest. Insurance does not guarantee market value or protect against fluctuations in bond prices. No representation is made as to the insurer’s ability to meet its financial commitments.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

Next: Factors That Affect Prices of Fixed Income Securities