Friday, January 4, 2008

Word o' the Day: Bond (ABC’s of Financial Planning)

“The name is Bond, James Bond”.
- James Bond, “007” (numerous books and films)

What exactly is a bond?
A bond is a legal contract between you (the lender) and the issuer (the borrower). It says something like “in exchange for your loan of $X, we promise to pay you interest of Y% every six months on the principal until the maturity date, at which time we will return the amount of your original loan”. The key word here is “loan”. When you buy a bond, you are loaning money to a government or corporate borrower. You may say “But I bought my bond in the market, not from the government – how could I be loaning them money?” When you bought the bond, you stepped into the shoes of the seller. Every time a bond changes hands, the buyer becomes the registered owner to whom interest payments (and the maturity value) are made by the issuer (borrower). Trust me, you are a lender.

Bonds are sometimes referred to as “loanership” assets as distinguished from stocks which are “ownership” assets. Bonds are also often referred to as “fixed income” because the interest payments are (usually) fixed and do not change over the life of the bond.

What is “par value”?
Par value = face value. Bonds are usually issued at “par” meaning a $1,000 bond is sold for $1,000. There are exceptions of course, but most of those are beyond the scope of today’s lesson. One worth mentioning though is Treasury Bills (“T-bills”). T-bills are short-term bonds issued at a discount to their face (par) value by the U.S. Government. The difference between the purchase price and the face value is the interest e.g., a T-bill may be issued at $950 and matures at $1,000 – the $50 difference is the interest earned.

Why do my bonds go up and down in value?
If you buy a bond, you may notice that the value reported to you will go up and down. Bonds are valued in the market based generally on three factors: time to maturity (how long it will be before the principal is returned), nominal interest rate (the rate promised by the bond), and credit quality (how likely it is thought the issuer will be able to repay the principal). Of course, bonds are like any other investment in that the price changes in response to demand. When investors are selling bonds, bond prices (values) will decline. When investors are buying bonds, bond prices (values) will increase.

The value of existing bonds changes inversely in response to changes in interest rates. If interest rates go up, the value of existing bonds tends to go down and vice versa. A helpful analogy I’ve used is that of a teeter-totter. Picture the bond on one end, and interest rates on the other end. If the interest rate end goes up, the bond end goes down, and vice versa.

The financial media regularly reports on the price/value relationship of U.S. Treasury bonds. You may hear “Treasury yields are up”. This means bond values (prices) are down and is often the result of investors selling bonds and investing the cash in the stock market. If you hear “Treasury yields are down”, this means bond values (prices) are up and is usually the result of investors selling stocks and buying bonds in a “flight to safety”.

My bonds are rated BBB – are they safe?
Credit quality is also a factor in bond values. Bonds issued by issuers with (perceived) higher credit quality tend to have higher values when compared to bonds issued by issuers with (perceived) lower credit quality. The credit quality of a bond issuer is determined by a rating agency such as Standard & Poor’s, Fitch or Moody’s (the “Big 3” in the bond rating business). Bonds issued by the U.S. Government are considered AAA, the highest rating, because of the perception that the United States cannot and will not default on its obligations. A corporation may go bankrupt and be unable to repay its bonds, but the United States can’t (hint: they just print more money).

Why buy bonds?
Bonds are a financial asset – they have unique characteristics that make them attractive to investors. As part of an asset allocation plan, bonds are added to a portfolio to reduce risk (lower standard deviation) and help provide a “smooth ride”. Bonds are also used to provide income.

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