Thursday, December 22, 2016

Bond Basics: Part 1

One of Warren Buffett's famous maxims is, "Never invest in a business you cannot understand." I would expand on this to say that you shouldn't invest in anything you don't understand. An annual National Financial Capability Study has found that only 28% of American adults understand the relationship between interest rates and bond prices, yet bonds comprise one of the major asset classes that most investors own. My goal in this blog post series is to aquaint you with the basics of bonds so that you can make informed decisions about including bonds in your investment portfolio.

If you own bonds, you probably own them in the form of a bond mutual fund (or simply bond fund), which basically is a collection of individual bonds. It's easier to understand an individual bond than a bond fund, so I'll start with the basics of individual bonds.

A bond is basically a loan in which you are the lender, and a corporation or government entity is the borrower. You probably are more familiar with a loan in which you are the borrower and a bank is the lender, such as a car loan, student loan, or home mortgage, but a bond basically is the same thing in reverse. From the bank's perspective the loan you get from it is a bond. The bank may even sell this loan to another entity who then packages your loan with other loans, and then sells the package as a special type of bond known as a mortgage backed security (MBS) or asset backed security (ABS).

When you want to borrow money you typically borrow it from a bank. When a government or company wants to borrow money they may do so by selling (issuing) bonds to investors. One of the biggest borrowers (sellers/issuers of bonds) is the US government; the US Treasury held 272 public auctions to sell bonds in 2015.

To define it more precisely, a bond is a contract that defines the terms of a loan. Historically bonds were issued as paper certificates that stated the terms of the loans, and the lender received this certificate in exchange for lending money to the bond issuer. Of course now all of this is handled electronically.

Any loan has terms that specify a principal amount, which is the amount originally borrowed, an interest rate, a payment schedule, and a date by which the loan must be repaid in full. This is true for bonds as well, but bonds have their own language to describe these characteristics.

With a typical loan, each payment consists of interest plus a repayment of a small portion of the principal, but this isn't always the case. There also are interest-only loans, where you make only interest payments, and then pay back all the principal on the due date. A typical bond is more like an interest-only loan.

For a bond, the principal amount is called the face value. When bonds were issued in paper form, this was the value that was printed on the face of the bond. Another term used for this is par value or simply par.

Bonds typically are sold in increments of $1,000, so the face value of one bond typically is $1,000. However, bond prices typically are quoted as a percent of face value (percent of par). So when the bond is initially sold at face value its price would be quoted as 100, which means 100% of face value. A bond price of 99 would mean that the bond's market value is $990, or 99% of the $1,000 face value, and a bond price of 101 would mean that the bond's market value is $1,010, or 101% of $1,000. In the next post in this series, I'll explain why market value can be different than face value.

The payment due date for a bond is called the maturity date or simply maturity, and the amount of time left until maturity is called the term to maturity, or simply term. Bonds sometimes are referred to using term to maturity, so a 5-year bond is a bond with five years remaining until maturity.

The annual interest rate for a bond is called the coupon rate, and interest payments are called coupon payments or simply coupons. Historically coupons were printed on the bond, and were detached (or clipped) and presented to collect the interest when it was due. Of course now all of this is handled electronically. So a bond with a face value of $1,000 and a coupon rate of 2% will pay $20 per year in interest, since 2% of $1,000 equals $20.

The loans you are familiar with typically have monthly payments, but a bond typically pays interest every six months, with the full principal amount due at maturity (again, like an interest-only loan). So our example bond with a face value of $1,000 and a coupon rate of 2% would issue a coupon payment of $10 every six months for a total of $20 in interest each year.

If you own a bond fund, you might be thinking, "But my bond fund pays monthly dividends." This is true, but it's also true that the individual bonds held by the bond fund typically pay interest every six months. The bond fund holds many bonds with coupon payments on different dates, and they distribute these interest payments monthly in the form of dividends.

In addition to buying bonds directly from the issuer, such as from the US Treasury through one of the US Treasury auctions, bonds also are bought and sold after issuance in the secondary bond market. The price of a bond will vary due to changing interest rates and declining term to maturity, which I'll explain in the next blog post in this series, so in addition to a face value, a bond has a market value which could be lower or higher than the face value.

In addition to coupon rate, bonds also are characterized by their yield to maturity (YTM), which factors in the difference between the market price and the face value of a bond to provide a more meaningful measure of the rate of return a bond holder will receive if the bond is held to maturity. The YTM of a bond often is referred to simply as the yield of the bond, so if the term yield is used in reference to a bond, it's usually the YTM that's being referenced.

At maturity the bond holder collects the face value of the bond. If the market price of the bond is less than face value, the yield to maturity will be higher than the coupon rate. This incorporates the price appreciation the investor will receive into the rate of return, or yield, of the bond. Similarly, if the market price of the bond is greater than the face value, the YTM will be less than the coupon rate, since this incorporates the price depreciation into the rate of return, or yield, of the bond.

So YTM (or simply yield) incorporates both the coupon rate and the price appreciation or depreciation to provide a meaningful rate of return for a bond held to maturity. As explained in the previous paragraph, yield and market price are inversely related--when one is higher the other is lower. But why would the market price of a bond be different than the face value? This is best explained with an example, which I'll provide in Part 2 of this series.

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