All About Bonds - Bond Basics

Last edited Mon Jan 16, 2017, 05:16 AM - Edit history (7)

Let me start with the obligatory disclaimer!
What follows is for informational purposes only and should not be construed as a solicitation to buy, nor a recommendation to purchase ANY SPECIFIC SECURITY. Potential investors should do their utmost to fully understand ANY security before investing. Not all investments/securities are right for all investors. One should know and understand their tolerance for risk and how a particular security impacts that tolerance and whether or not it is appropriate for their portfolio. Investing in bonds carries numerous risks up to and including loss of principal.

Just as with the Mutual Fund thread I put up back in 2013, please note and look for the hedging words I will use in the following like "Almost" and "Most of" etc. The old adage "There are exceptions to every rule" is true for many things, and this subject is no different. If I say Most Of, for example, it means that there will be and likely are situations that are different or that a specific rule does not apply in every case. There is an awful lot of information to be learned about Bonds that can help the average investor, so don't be overwhelmed.

I will try not to get into too much of the minutia of the issuance process, as it really has no relevance to the SOP of this forum.
A good but basic write-up of the process can be found here
This is merely meant as a way for the reader to gain a little more understanding of these securities and perhaps increase confidence in considering individual bonds as an investment choice. That by the way, is the primary focus of this report and the ones to follow - individual bonds as opposed to Bond Mutual Funds, Bond Closed End Funds or Bond Exchange Traded Funds.

I will not claim that this report and the ones to follow will include the answer to every possible question nor will they be 100% complete, but I'll do my best to cover the most important aspects. I am going to concentrate on the basics of terms and nomenclature, definitions of terms, how to read a report on one, what to look for in a report and what is most important from the perspective of the novice investor. I am sure I will miss something important, but that's what the "Reply to this thread" button is for! Please, PLEASE feel free to ask questions if you have any. There are several regulars in this group that are very knowledgeable and If I don't answer your question, one of them will I'm sure, chime in.
(For a bit more on my history and experience, please read the OP in this thread.) Substantial edits in text will be accompanied by the identifier "Ed." and will appear at the end of a paragraph.

What are Bonds?

A Bond is a debt security or Instrument (these two terms are interchangeable) that as a general rule, has a finite lifespan, called a Maturity Date and the vast majority pay regular interest payments, typically twice a year, on the maturity day and 6 months later. These payments are based on the Coupon Rate of the bond, calculated against the standard Par Value. These payments never change during the life of the bond and for this reason Bonds are often called "Fixed Income Investments" or Fixed Income Securities. The income they produce is fixed at the time of issuance. Bonds are considered safer investments than ordinary common stock because they are guaranteed a place in line, so to speak, to recover funds should the company go under. A shareholder has no such guarantee. However, in exchange for this reduced risk the bondholder forgoes any access to increased company profitability in the case of a rising stock price. Bondholders also have no voting rights like stock holders do.
The bond market globally is almost twice the size of the equity market and in the US the Bond market amounts to some $37 TRILLION whereas the market capitalization of the stock market totals roughly $21 trillion. The words "Bond", "Paper", "Issuance/Issue/Issues", "Note", "Bill", "Security" and "Instrument" are synonymous in this writing when used in the context of nomenclature for a bond.

For the purposes of clarity and understanding, here is a short glossary of terms common to these securities that I will use;

Par or Par Value; This is the dollar amount at which the bond will be redeemed at maturity. In the United States, the overwhelming number of bonds issued, be they Corporate, Municipal or US Treasury have a "Par Value" of $1,000.00, that is to say, when they mature, the issuer gives you one thousand dollars back for each individual bond REGARDLESS of what you paid for it. You can buy a bond for less than par, (A Discount) at Par or for more than Par (a Premium). There are instances where bonds can be issued with par values above or below $1,000, but for the purposes of simplicity and ease of understanding, when I refer to par, I'm speaking of $1000.

Maturity; The date on which the issuer will redeem the bonds at par.

Coupon or Coupon Rate; This is the interest rate paid by the bond, represented as a percentage of the Par. In other words, a Bond with a Coupon of 5% and a par of $1,000 will pay $50.00 per year in interest payments. Except in very rare circumstances, the coupon rate never changes. The vast majority of bonds issued carry such a coupon rate. Typically the coupon is paid in two installments, 6 months apart. They make these payments on the day of the year that the bond will mature in the future and 6 months later. As an example, if the bond matures on January 1st, 2020, it will pay half the coupon payment on June 1st and half on January 1st, every year till maturity. On the day it matures you will get the second interest payment for the year and your $1,000 back. The coupon rate is ALWAYS calculated against that $1,000 par. It's called a Coupon because in the old days when you bought a bond, you would receive a paper certificate with literal coupons around the edge, that the bond holder would clip off and take to the bank or broker to receive his interest payment. These days the vast majority of bonds are held "In Street Name" or "Book Entry", so actual certificates are exceedingly rare.

Yield; This is the amount of total income (or loss) a buyer can expect over the life of the bond at the time of purchase, expressed as a percentage of the Par on an annual basis. Yield changes with the price a Bond is trading at, and moves inversely to price. The yield on a purchased bond will NOT change with respect to the owner. Once you have bought it, the stated yield is what you will realize. (More on this later)

Zero Coupon Bonds or "Zeros"; These are bonds that have no coupon rate and are issued at a discount to par. Since they mature at par, the difference between what you pay and the par is your yield.

Issuer; The entity that initiated the offering in the first place and whose revenues will satisfy both interest payments and redemption at maturity.

Underwriter; A bank or other financial institution that facilitated the issuance by providing the funds the issuer needs. Underwriters act as an intermediary between the issuer and potential buyers at the outset.

Over-The-Counter or OTC;
The vast majority of the bond market is traded "Over-The-Counter" as opposed to on an exchange. The primary difference is that OTC trades do NOT guarantee a buyer or a seller. The stock Exchange virtually guarantees there will be a buyer and a seller for any given stock one would like to trade, but this is not the case with an OTC market. On the NYSE for instance, there exists "Market Makers", typically brokerage houses who facilitate the trading of shares. While there is an OTC equity market (The "Pink Sheets" or Penny Stocks is a good example), the vast majority of higher quality stock shares are sold via one of the major exchanges (The New York Stock Exchange and the NASDAQ are the two largest). Bonds however are primarily sold OTC. Market Makers exist in the OTC market in the form of Broker/Dealers, but they buy and sell for and from their own inventory, so much like items on a store shelf, if a given broker doesn't have any of a particular bond in its inventory, you can't buy it from them, although they can go to another broker/dealer who does and procure it for you. Also since OTC trades are essentially one on one. Subsequent requests to buy or sell if the first is unsuccessful are known as a "pass". There are some issues Exchange traded, but they are the minority.
A short but good article on OTC can be found here.

Bond Quotes

Bond prices are quoted as a percentage of par. You may see a bond quote that looks like this; 98.64. That means the bond is selling for ninety eight point six four percent of one thousand dollars. In this case it is a simple enough exercise to move the decimal point over one spot to the right and you have the price in dollars and cents. A bond quoted at 98.64 will cost you $986.40

Treasury Bonds however, are quoted a little differently. Still as a percent of par, but the digits to the right of the decimal are usually (I say usually because some quote platforms do not do this) in 32'nds of a percentage point. So you might see a 10 year or a 30 year quoted like this; 103-19. That is one hundred three and nineteen thirty seconds percent of one thousand. The easiest way to get to the actual dollar amount then is to divide one by 32;

1 / 32 = 0.03125. Multiply that by the number to the right of the dash (19) and you get 0.59375. Stick that next to the 103, move the decimal over and you get $1035.94 as the cost of the bond, rounded up, of course. I'll use that simple quote logic for the rest of these threads, so if you see me say "a bond priced at 101" or whatever, just keep in mind it is a percent of 1000. Some quote platforms will state the price of a bond like this; $103.52. That STILL means it is a percent of par, as the number of issues that have a cost in the one hundred dollar range is minuscule.

Ed; To further clarify the last couple sentences above, it should be noted that the US Treasury does indeed offer bonds at a one hundred dollar par (sold primarily to individuals as opposed to institutions and/or banks), so if you were to look at the "Treasury Direct" website and search for price quotes, you would see bonds quoted in this fashion that are a $100 par. The vast majority of Treasuries that are auctioned to the primary dealers are of the $1,000 par variety, which BTW, represent the bulk of the debt of the United States Government.



YIELD IN DETAIL

Yield is a calculation based on price versus coupon or price versus redemption value (Par). Example;

If you buy a 5% coupon bond at par, your yield is 5%. If that bond has been bid down to say...95, your yield will be higher than 5% because you stand to gain fifty dollars if you hold it to maturity PLUS you gain the interest along the way. Remember, ALL bonds mature at par. Conversely if the bond has been bid into premium territory, say 105 then you stand to LOSE fifty bucks when it matures but you will still have gotten that interest. Clear? Calculating actual yield in the examples I give above requires knowing time to maturity, but we'll let that go for the purposes of this simple illustration.

When you hear Kai Ryssdal of NPR's "Marketplace" program say "Bonds rallied today, the 10 year Treasury fell to 2.35%" (or whatever) he is saying that bond prices were bid UP so therefore the yield fell. If he says "Bonds took a hit today and the ten year rose to 2.6%" then he means the prices were bid DOWN and the yield therefore went up. The yield YOU realize is set by the price you pay on the day of settlement and does not change. (The Treasury does offer variable yield bonds called "TIPS" for "Treasury Inflation Protected Securities" but they tend to be a little complex and not worth the money, in my opinion. More on those in another thread)

It is important to remember that the holder of a bond is due ALL interest up to the day of settlement of a sale. So if you buy a bond 45 days after the last coupon payment as an example, YOU must pay the holder the 45 days worth of interest and this is added to the cost of the bond. You get it all back and more when the next coupon payment hits though. A typical bond trading platform/program does all this automatically.

There are numerous ways yield is expressed. The most common is "Yield to Maturity" (YTM). Others are "Yield to Call", "Current Yield", "Running Yield" and "Yield to Worst". An excellent page from Investopedia describing these terms can be found here.

There is also "Phantom Yield" and this applies to Zero Coupon bonds. This refers to yield or income a Zero would pay on an annual basis even though no actual income is realized until maturity or the bond is sold. Example; You buy a 2 year T-Bill that has a yield of 1%. Since Zeros are sold at a discount to par, you stand to gain 1% per year until the bond matures but you don't receive a coupon payment. The IRS can tax you on such 'Phantom' income so one must be prepared for this. Although I stated above in the glossary that most Zeros are of short maturities, longer maturity Zeros have been issued in the past (and likely still are) by corporations and governments. If you come across one of these in a search, just keep in mind that you may be liable for taxes owed on income you have yet to receive.

There are exceptions (of course!) and most of them have to do with "Call" provisions. More detail on callable bonds below.

Why Issue Bonds?

Most companies and even local governments for that matter, have a couple avenues to raise capital. In the case of a company, it can do an Initial Public Offering" or IPO and issue company stock (if it is not already publicly traded) to be traded on an exchange or it can sell "reserve shares" if they already are public. A company can also approach a bank for a loan, just as you would for a house or car, but this tends to be much more expensive and restrictive than making a public bond offering, as banks will require much more oversight and control of a firm when a direct loan in used.

Bond Ratings and Rating Agencies

The overwhelming number of bonds issued in the USA are given a credit rating by one or more of the 3 main rating agencies in this country. They are Moody's, Standard and Poors (The same S&P as the S&P 500) and Fitch. These companies are in the business of assessing financial risk and do research on companies as well as municipalities and assign a credit grade to the bonds issued by those entities. Their ratings are on a letter scale, with each firm using a slightly different format.

Moody's uses a format that includes both capital letters and lower case, and their top rating is "Aaa"
S&P uses all caps, so their top rating is "AAA"
Fitch's uses a format similar to S&P



Callable Bonds

An issuer can place "Call Provisions" in the prospectus and offering letters as a way of recalling bonds in the event they are able to take advantage of a lower interest rate environment subsequent to the issuance. For instance, say XYZ company issues 20 year paper at a 6% coupon and 2 years later they are able to issue similar bonds at 4.5%. If they put a call provision in, they can literally call in the 6% bonds and reissue at 4.5% (or whatever). The specific terms of the call are spelled out in the Indenture and can vary wildly in effect. There are occasions where the call might be for 104 instead of par, or any figure above par, ensuring compliance and agreement with the bond holders.

Another type of call is known as a "Make Whole Call". This type is essentially a lump sum payment made to the holder that includes not only the par value but the value of all future interest payments yet to be made. These are rarely exercised as one might imagine, because of the enormous cash outlay they require.

A call provision represents a risk to a bondholder, because when they are exercised they remove the income stream from the portfolio and force the holder to take cash that must be reinvested at a lower prevailing interest rate. Once a bond is called, the holder has no choice but to give it up.

A little more info on calls can be found here

Putable Bonds or Bonds with a "Put Provision"

A bond issued with a Put provision is essentially the opposite of a Call provision, in that it allows the holder to force the issuer to redeem at par at any time. To save my fingers(!), the following is cut and pasted directly from here.




Types of Risk

Bonds come with various types of risk and it is important for the potential investor to be familiar with them. The most obvious of course, is Default Risk, wherein the issuer fails to pay either a coupon payment or is unable to pay redemption on maturity. Overall, considering the sheer number of bonds on the market, a full default is actually fairly rare, but they do occur. Probably the most famous of late was the default of General Motors during the process of saving the firm from utter destruction during the financial crisis. Another that made major headlines was the default of Orange County California in 1994 where $110 million worth of that county's munis went into default.

Here is a list of the common risk factors;
(Again, to make things easier on myself, the following is cut and pasted directly from here)



Where to find Bonds and quotes
If you deal with a "Brick and Mortar" broker/dealer, most of the large ones will have a "Bond Desk" and your broker can access their own inventory on his computer terminal. If you do business with one of the many online brokers, some of them will have bonds offered as well. I have a Roth IRA with E-Trade and they have a bond page, as an example. But where to find bonds and quotes otherwise?

FINRA (The Financial Industry Regulatory Authority) together with Morningstar has a resource for that very thing.

Here's a link to that page.

How to navigate the FINRA Bond Center
First, click the link above (Makes sense, huh?...lol)
The page looks like this; (BTW.. I apologize in advance for my photo sharing skills. Screwing around with Photobucket to enlarge these shots is time I don't have! So just follow along on your own, OK? The pages are obviously easier to read on your own PC)

In order to find a bond, click on the "Search" tab.
Now the page looks like this;

To get a general idea of the total amount of Corporate issues listed, highlight the "Corporate" radio button and then the "Bonds" radio button under "Show Results As", then click the blue "Show Results" tab. As of this writing (2:24 PM 11/5/2016) the results are 2,154 PAGES of 40 entries per page! That's a tad overwhelming, so let's narrow it a bit. Go back to the previous page, click Search and type "Caterpillar" (or any other firm you wish) in the "Issuer" box. Again make sure the Corporate and Bonds radio buttons are lit and hit Show Results.

That page as of today looks like this;


Let's have a look at a single issue in detail. I'll pick the 5th one down that has the letters "CAT.HNY" highlighted in blue. If you click that blue hyperlink (Or any other one you wish, of course), you'll open a page with all the pertinent information on that bond. That page looks like this; (2 screen shots separated at the "Project Name" line)



The top line describes the issue, in this case it is "CATERPILLAR FINL SVCS CORP MEDIUM TERM N" or Caterpillar Financial Services Corporation Medium Term Note.
Under that it shows the Coupon (7.050%) the Maturity date (October 1st 2018) The Symbol, The CUSIP, Next Call Date and Callable. In this case both of the last two are blank, so this bond is not callable.

Under that row appears; Last Trade Price ($110.73) Last Trade Yield (1.314%) and Last Trade Date (11/02/2016). It also shows US Treasury Yield which is blank, as this is unrelated to US Treasury Bonds. Keeping in mind what I discussed about pricing and yield earlier, this bond has been bid up to over $107 above Par, primarily because of the very high coupon relative to today's market and the relatively short time left till maturity (Just under a year).

There are two hyperlinks visible as well, "Trade History" and "Prospectus". The Trade History will show how much a quantity of this bond sold for on a particular date. That tab allows you to adjust the time frame viewed by altering the "From" and "To" dates. The Prospectus will bring up exactly that - The original Prospectus of the issue which spells out pertinent details of this bond, and in this case is a 2 page .pdf document. This is different from the Indenture document which is not available on this page, but likely numbers over 100 pages of legalese.

Below that you will see a chart displaying either price or yield, depending on which tab is chosen and can show history from the last 5 days to "Max" which is typically the life of the bond. According to the price chart, this bond had been bid up to over $130 above par back in October of 2012.

Next to and below the chart appears sections which describe other vital information. You can find the original issue date (9/23/2008) the original size of the offering ($550 million), its rating from the 3 agencies discussed above, the type of bond it is, the original offering price etc. etc. One thing of interest is the "Day Count" under "Issue Elements" Note it says "30/360". What this means is the interest payments are calculated on a year consisting of 12 30 day months and a year of only 360 days. This is very common in the industry and essentially means they don't pay interest on the 5 common holidays! It simplifies many things, basic math being one of them!

So which parts of the above should one pay the most attention to if you were interested in adding a bond like this to your portfolio? Well, the old broker in me says the first thing I would look at is YTM. It has a BIG ass coupon, but I'm only going to get 2 more payments, one in March and the final on maturity and that will total only $70.50. I'll be due the interest from the day I buy it to the next coupon, but I'm still looking at a Yield To Maturity only slightly higher than a 5 Year CD. I like the ratings, as it is still a high quality bond, even though it is on the low end of the "A" ratings and I am familiar with the issuer. They are a Blue Chip (Hell, Caterpillar sort of defines the term!) company, a member of the 30 Dow Industrials and make products I know and understand. BUT..... I'm going to have to pay around $1100 for this bond so it isn't cheap and I'm only going to have an income stream for a short term. As for me (And in this case I speak STRICTLY for myself) This isn't one I would consider. Frankly at this point, it's a traders bond. Buy it, hold it for a coupon payment or a few months, see if the price rises and sell it.

So...what do I look for? I look for yield that is a point or two higher than the 30 Year Treasury Yield, priced below or at least close to par with a coupon payment that makes sense. In other words, I won't chase yield. I won't buy a bond with a 4% coupon that has been bid into the toilet so it yields 8%, as an example. That's a SERIOUS red flag. I won't necessarily shy away from the "B" or Triple B rated issues as long as I know the company is on solid financial footing. The biggest point for me, and again, I speak ONLY FOR MYSELF HERE, is price vs. value. How much am I going to have to spend to make a return competitive with what I know to be a benchmark - either the ten or 30 year US Treas.

Whew! That took a while. This is just the beginning! I hope what I have written so far gives you enough information to at least remove any intimidation or trepidation you may have about these securities. Bonds most certainly have a place in most portfolios and can literally save your savings in times of crisis. They are what most financial professionals will suggest that the older you get, the more you should have.

In subsequent threads I'll delve deeper into Corporates, Municipal and US Treasury bonds, as well as a thread on Debt Preferred securities. These are unique in that they have a Par of $25 and are exchange traded.

I truly hope that this effort has been of some help, and as I said above, if you have any questions at all, dear reader, please ask in a reply. If I don't answer, I know there are several regulars that peruse this Group that are VERY knowledgeable. Also, if any of those knowledgeable people note a mistake or bad information, PLEASE PLEASE PLEASE LET ME KNOW! I'll correct it immediately and give you the direct credit for the correction. It is my sincere desire to provide only accurate information, without editorializing or hyperbole. With the exception of the 2 short segments of personal experience I placed in the excerpt boxes, I hope I have done this.

All the best, and may all your trades be net gains.


Paul