Markets Explained

Bond Basics

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Overview

Bonds are a core element of any financial plan to invest and grow wealth. If you are just beginning to consider investing in bonds, use this section as a resource to educate yourself on all the bond basics. In this section you will learn:

  • what a bond is
  • why financial professionals recommend that you have bonds in your diversified investment portfolio
  • key factors to consider when evaluating a potential bond investment
  • fundamental strategies for investing in bonds
  • about tools and aids that will help you understand bonds
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What are bonds?

A bond is a debt security, similar to an I.O.U. When you purchase a bond, you lend money to the issuer<

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Why invest in bonds?

Whatever the purpose — saving for a new home, planning for your children’s college education, ensuring your retirement income or other financial goals — investing in bonds can help you achieve your objectives and play an important role in a diversified portfolio.

Many financial professionals recommend that investors maintain a diversified investment portfolio of bonds, stocks and cash in varying percentages, depending on your circumstances and objectives. A financial professional can explain the available options, taking into account your investment goals, income needs and risk<

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What factors should you consider when investing in bonds? (Part 1)

Some of the factors you should take into account if you’re thinking about investing in bonds include:

ASSESSING RISKS

All investments carry some degree of risk<

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What factors should you consider when investing in bonds? (Part 2)

THE LINK BETWEEN INTEREST<

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How to invest in bonds?

There are several ways to invest in bonds, including purchasing individual bonds directly, or investing in bond funds or unit investment trusts.

INDIVIDUAL BONDS

There is a wide variety of individual bonds to choose from in creating a portfolio that reflects your investment needs and expectations. Most individual bonds are bought and sold in the over-the-counter (OTC) market, although some corporate bonds are also listed on the New York Stock Exchange. The OTC market is comprised of securities firms and banks that trade bonds; brokers, or agents, who buy and sell bonds on behalf of customers in response to specific requests; and dealers, who keep an inventory of bonds to buy and sell.

If you are interested in purchasing a new bond issue in the primary market

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Investment Strategy Considerations

When building a bond portfolio, there are various techniques that can be used to match your investment goals and risk<

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For More Information

Always talk with your investment advisor to discuss which investments are most appropriate for you. If you choose to pursue an investment in bonds, be sure to receive more detailed information about each of the specific types of bonds in which you are interested before investing.

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Glossary

Accrued interest. Interest deemed to be earned on a security, but not yet paid to the investor.

Ask price (or Offer price). The price at which a seller is willing to sell a security.

Average life. On a mortgage security, the average length of time that each principal dollar is expected to be outstanding, based on certain assumptions about prepayment speeds.

Basis point. One one-hundredth (.01) of a percentage point Yield differences are often quoted in basis points (bps).

Bid price. The price at which a buyer is willing to purchase a security.

Bond fund. A professionally managed investment vehicle, which invests primarily in bonds. Types of bond funds include open-ended mutual funds, closed-end mutual funds, and exchange traded funds.

Bond insurers and reinsurers. Specialized insurance firms serving the fixed-income market that guarantee the timely payment of principal and interest on bonds they insure in exchange for a fee.

Book-entry. A method of recording and transferring ownership of securities electronically, eliminating the need for physical certificates.

Bullet bond / Bullet maturity. A bond that pays regular interest, but that does not repay principal until maturity.

Callable bonds. Bonds that are redeemable by the issuer prior to the maturity date, at a specified price at or above par.

Call premium. The dollar amount paid to the investor by the issuer for exercising a call provision that is usually stated as a percentage of the principal amount called.

Cap. The maximum interest rate that may be paid on a floating-rate security.

Closed-end mutual fund. A mutual fund created with a fixed number of shares via a public offering, which is traded as listed securities on a stock exchange. See mutual fund.

Collar. Upper and lower limits (cap and floor, respectively) on the interest rate of a floating-rate security.

Compound interest. Interest that is calculated on the initial principal and previously paid interest. Also known as “interest on interest”.

Convertible bond. A bond that can be exchanged, at the option of the holder, for a specific number of shares of the issuing company’s stock. Because a convertible bond is a bond with a stock option built into it, it will usually offer a lower than prevailing interest rate.

Coupon. The feature of a bond that denotes the interest rate (coupon rate) it will pay and the date on which the interest payment will be made.

Coupon payment. The actual dollar amount of interest paid to an investor. The amount is calculated by multiplying the interest rate of the bond by its face value.

Coupon rate. The interest rate on a bond, expressed as a percentage of the bond’s face value. Typically, it is expressed on a semi-annual basis.

Credit rating agency. A company that analyzes the credit worthiness of a company or security, and indicates that credit quality by means of a grade, or credit rating.

Current yield. The ratio of the interest rate payable on a bond to the actual market price of the bond, stated as a percentage.

Dated date (or Issue date). The date of a bond issue from which a bond begins to accrue interest.

Default. A failure by an issuer to: (i) pay principal or interest when due, (ii) meet non-payment obligations, such as reporting requirements or (iii) comply with certain covenants in the document authorizing the issuance of a bond (an indenture).

Discount. The amount by which the par (or face) value of a security exceeds its purchase price.

Discount note. Short-term obligations issued at a discount from face value, with maturities ranging from one to 360 days. Discount notes have no periodic interest payments; the investor receives the note’s face value at maturity.

Embedded option. A provision that gives the issuer or bondholder an option, but not the obligation, to take an action unilaterally. The most common embedded option is a call option, giving the issuer the right to call, or redeem, the principal of a bond before the scheduled maturity date.

Exchange-traded fund (ETF). An ETF is a type of fund that is an exchange traded security, experiencing price changes throughout the day as they are bought and sold ETFs own underlying assets that typically track an index.

Extension risk. The risk that investors’ principal will be committed for a longer period of time than expected In the context of mortgage- or asset-backed securities, this may be due to rising interest rates or other factors that slow the rate at which loans are repaid.

Face (or Par or Principal). The principal amount of a security that appears on the face of the bond.

Fixed rate bond. A bond with a set interest rate to maturity.

Floating rate bond (or Variable rate bond or Adjustable rate bond). A bond with an interest rate that is adjusted periodically according to a predetermined formula; it is usually linked to a benchmark interest rate such as LIBOR.

Floor. The lower limit for the interest rate on a floating-rate bond.

Future value. The value of an asset at a specified date in the future, calculated using a specified rate of return.

High grade bond. See Investment-grade bond.

High-yield bond (or junk bond). Bonds rated Ba (by Moody’s) or BB (by S&P and Fitch) or below, whose lower credit ratings indicate a higher risk of default. Due to the  increase risk of default, these bonds typically offer a higher yield than more creditworthy bonds.

Interest. Compensation paid or to be paid for the use of assets.

Investment-grade bond (or high grade bond). Bonds rated Baa (by Moody’s) or BBB (by S&P and Fitch) or above, whose higher credit ratings indicate a lower risk of default. These bonds tend to offer a lower yield than less creditworthy bonds.

Issue date. See Dated date.

Issuer. The entity obligated to pay principal and interest on a bond.

Junk bond. See High-yield bond.

LIBOR (London Interbank Offered Rate). A benchmark interest rate some banks charge each other for short-term loans. LIBOR is set daily in f1ve currencies (US dollar, Euro, pound sterling, Japanese yen and Swiss franc) for seven different maturities (overnight , on week, and 1, 2, 3, 6 and 12 months). LIBOR is frequently used as the basis for resetting rates on floating-rate securities, as well as currency and interest rate swaps.

Liquidity (or marketability). A measure of the relative ease and speed with which a security can be purchased or sold in a secondary market.

Marketability. See Liquidity.

Maturity. The date when the principal amount of a security is due to be repaid.

Mortgage pass-through security. A type of mortgage-backed security representing a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects payments on the loans in the pool and “passes through” the principal and interest to the security holders on a pro rata basis.

Mutual fund. An investment vehicle that invests pooled cash of many investors to meet the fund’s stated investment objective.

Non-callable bond. A bond that cannot be called for redemption by the issuer before its specified maturity date.

Offer price. See Ask.

Offering document (Official Statement or Prospectus). The disclosure document prepared by the issuer that gives detailed security and financial information about the issuer and the securities being issued.

Official statement. See Offering document.

Open-end mutual fund. Open-end mutual funds stand ready to sell and redeem their shares at any time at the fund’s current net asset value: total fund assets, less any liabilities, divided by the number of shares outstanding. See mutual fund.

Par value. See Face.

Paying agent. The entity, usually a designated bank or the office of the treasurer of the issuer, that pays the principal and interest of a bond.

Premium. The amount by which the price of a bond exceeds its par value.

Prepayment. The unscheduled partial or complete repayment of the principal amount outstanding on a loan, such as a mortgage, before it is due.

Prepayment risk. The risk that principal repayment will occur earlier than scheduled, forcing the investor to receive principal sooner than anticipated and reinvest at lower prevailing rates. The measurement of prepayment risk is a key consideration for investors in mortgage- and asset-backed securities.

Present value. The current value of a future payment or stream of payments, given a specified interest rate; also referred to as a discount rate.

Primary market. The market for new issuances.

Principal. See Face.

Prospectus. See Offering document.

Ratings. Designations used by credit rating agencies to give relative indications as to opinions of credit quality.

Reinvestment risk. The risk that interest income or principal repayments will have to be reinvested at lower rates in a declining interest rate environment.

Risk. The chance that an actual return will be different than expected, including losing  some or all of the invested amount. There are many types of risk such as market risk, credit risk, interest rate risk, exchange rate risk, liquidity risk, and political risk.

Secondary market. Market for previously issued securities.

Secured bond. A bond repayment that is backed by collateral.

Senior bond. A bond that has a higher priority than other bond’s claim to the same class of assets.

Settlement date. The date for the delivery of bonds and payment of funds agreed to in a transaction.

Subordinated bond. A bond that has a lower priority than another bond’s claim to the same assets.

Trade date. The date upon which a bond is purchased or sold.

Transfer agent. Also known as the bond registrar and is the party appointed by an issuer to maintain records of bondholders, and transfers ownership when bonds are acquired or sold.

Trustee. An institution, usually a bank, designated by the issuer as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure compliance with the trust indenture and represent bondholders to enforce their contract with the issuers.

Unit investment trust. An investment fund created with a fixed portfolio of investments.

Unsecured bond. A bond repayment that is not secured by collateral.

Yield curve. A line tracing yields on a type of bond over a spectrum of maturities.

Yield to call. The yield to call is a calculation of the total return of a bond if held to the call date. It takes into account the value of all the interest payments that will be paid until the call date, plus interest on earned on those payments (using the current yield), the principal amount to be received on the call date and any gain or loss from the purchase price expressed as an annual rate.

Yield to maturity. The yield to maturity is a calculation of the total return of a bond if held to maturity. It takes into account the value of all the interest payments that will be paid until the maturity date, plus interest on earned on those payments (using the current yield), the principal amount to be received and any gain or loss from the purchase price expressed as an annual rate.

Zero-coupon bond. A bond that does not make periodic interest payments; instead, the investor receives one payment, which includes principal and interest, at redemption (call or maturity) See Discount note.

 

 

 

 

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