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HomePersonal FinanceBonds Unplugged: The ABCs Every Investor Should Know.

Bonds Unplugged: The ABCs Every Investor Should Know.

Bonds Unplugged

Bonds indicate part or all of a debt to a person, government, or other entity. Bonds have a par value of $1000 or $100, but their prices fluctuate based on interest rates and borrower creditworthiness.

  1. Bond Market Basics:
    • Bonds offer diversification beyond stocks.
    • Characteristics include maturity, coupon rate, tax status, and callability.
    • Risks associated with bonds include interest rate, credit/default, and prepayment risks.
  2. Basic Bond Characteristics:
    • Bonds represent a loan taken by a company, paid back to investors with interest.
    • Terms vary, and it’s crucial to understand indenture details.
    • Six important bond features include maturity, secured/unsecured, liquidation preference, coupon, tax status, and callability.
  3. Types of Bonds:
    • Corporate bonds: Issued by companies, varying yields based on creditworthiness.
    • Sovereign bonds: Issued by national governments, generally low-risk.
    • Municipal bonds: Issued by local governments, often tax-exempt.
  4. Maturity and Security:
    • Maturity categorizes bonds into short-term, medium-term, and long-term.
    • Bonds can be secured (backed by assets) or unsecured (no collateral).
  5. Risks of Bonds:
    • Interest rate risk: Bond prices influenced by interest rate changes.
    • Credit/default risk: Possibility of issuer failing to meet payment obligations.
    • Prepayment risk: Concerns early repayment, impacting returns.
  6. Bond Ratings:
    • Ratings by agencies like S&P, Moody’s, and Fitch assess credit quality.
    • Investment-grade bonds (AAA to BBB) are low-risk; below BB are speculative or “junk” bonds.
  7. Bond Yields:
    • Yield to Maturity (YTM): Most cited, measures return if held to maturity.
    • Current Yield: Compares bond interest income to stock dividends.
    • Nominal Yield: Percentage of periodic interest payments.
    • Yield to Call (YTC): Calculated if a bond is callable before maturity.
    • Realized Yield: Estimated return if holding a bond for a specific period.
  8. How Bonds Pay Interest:
    • Coupon payments: Periodic interest payments during a bond’s lifetime.
    • Zero coupon bonds: No periodic interest; only face value redemption at maturity.
    • Convertible bonds: Combine bond and stock properties, allowing conversion into stock.

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Yield to Call (YTC) A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate the yield to call using Excel’s YIELD or IRR functions, or with a financial calculator. Realized Yield The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel’s YIELD or IRR functions, or by using a financial calculator. How Bonds Pay Interest There are two ways that bondholders receive payment for their investment. Coupon payments are the periodic interest payments over the lifetime of a bond before the bond can be redeemed for par value at maturity. Some bonds are structured differently. Zero coupon bonds are bonds with no coupon—the only payment is the face value redemption at maturity. Zeros are usually sold at a discount from face value, so the difference between the purchase price and the par value can be computed as interest. Convertible bonds are a type of hybrid security that combines the properties of bonds and stocks. These are ordinary, fixed-income bonds, but they can also be converted into stock of the issuing company. This adds an extra opportunity for profit if the issuing company shows large gains in its share price

  • Current Yield: Compares bond interest income to stock dividends.
  • Nominal Yield: Percentage of periodic interest payments.
  • Yield to Call (YTC): Calculated if a bond is callable before maturity.
  • Realized Yield: Estimated return if holding a bond for a specific period.
  • Yield to Maturity (YTM): Most cited, measures return if held to maturity.
  • Current Yield: Compares bond interest income to stock dividends.
  • Nominal Yield: Percentage of periodic interest payments.
  • Yield to Call (YTC): Calculated if a bond is callable before maturity.
  • Realized Yield: Estimated return if holding a bond for a specific period.

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