Type of Yields
Bond Rating Agencies
The Yield Curve
Types of Bonds
- Corporate Bonds
Asset Backed Securities
High-Yielding Securities –
Enhanced Trust- Preferreds
Corporate bonds are debt
obligations issued by a corporation to raise money needed to fund
operations, grow the business, or refinance existing debt (at longer
maturities or lower rates). Bonds offer investors a way of preserving their
capital while getting a steady and predictable cash flow stream.
Corporate bonds can be
either unsecured debentures or secured by a particular asset. Sinking fund
bonds are also available. They require the issuer to retire a certain
percentage of the outstanding bonds each year, either by open market
purchases or by a lottery. There are also guaranteed bonds, where in the
event of a default by the issuer, a third party, usually a bank or insurance
company, will repay the bondholders.
Bonds are normally
issued in denominations of $1,000. The original bond principal, called the
par value, is returned at maturity; therefore, the maturity date
is when you get your principal investment back. The term of maturity
is the time between when the bond is issued, to when the principal is
repaid. Most bonds have terms ranging from 1 to 30 years. Duration is
a weighted average term that is used by institutional investors. The
coupon payment frequency is typically twice a year (semi-annually).
Interest is usually a fixed coupon rate; however, floating (variable)
interest rate bonds are also available.
The rate of interest
paid on the par value is called the coupon rate. The price of bonds
will fluctuate on the open market with changes in the interest rates. Bond
prices are quoted as a percentage of par value, which is 100. When the
market rate is less than the coupon rate, the bond sells at a bond
premium and the price trades over 100. When the market rate is
greater then the coupon rate, the bond sells at a bond discount;
the bond’s price will be under 100.
Clipping Coupons - In my parents’ days, interest payments were called coupons. A bond
would have interest coupons attached. Holders would cut out the coupons and
redeem them at their local banks. These are the bearer bonds which,
if not registered, could be used as a way to keep one’s money out of public
view. Today, as the world becomes digital, bearer bonds are being phased
out; most US banks no longer cash the
coupons. The paying agent, however, normally a bank or broker, will honor
the coupons, usually by mail. Bearer bonds are, however, still popular
overseas. The expression “clipping coupons” was not originally about grocery
store sales, but about how rich people earned a living.
bonds are classified into the following categories:
||One to five years
|Medium term notes/bonds
||Five to twelve years
||Greater than twelve years
In a normal rate environment (when the yield curve slopes upward to the
right) the longer the maturity (term), the higher the yield; the lower the
credit rating, the higher the yield. Conversely, short-term bonds with high
credit ratings return the least.
Analysis for Selective Fixed Income Securities:
Below is a comparative analysis of interest rates on high quality, 30 year,
debt instruments as of October 12, 2005. The list is designed to demonstrate
how corporate rates compare with similar debt instruments. Keep in mind that
rates are fluid and are constantly changing.
Corporate AAA 5.59%
Agency AAA 5.00%
Treasury AAA 4.66%
Municipal AAA 4.48%
Bond Rate Trends: Corporate bonds
are attractive because they return a higher yield than government
securities. Normally, the longer the maturity, the higher the yield.
Additionally, bond prices fluctuate inversely with the change in interest
rates. As interest rates decline, bond prices increase, and vice versa.
there has been a gradual decline in long-term Aaa corporate bond yields,
from approximately 15% in 1981 to 5% in June 2005. Recently, rates have
ticked up, in response to inflation concerns and an overheated housing
Corporate bonds are
liquid investments, in that they trade on the exchanges. It is difficult to
know, however, if you are realizing fair value.
Corporate bond interest
and capital gains/ (losses) are subject to federal and state income taxes.
Bonds also have various
distinctions; the most common are: call, convertible, and estate put
- The call
(redemption) provision allows
the issuing company to repurchase the bonds before their scheduled
maturities. There is usually a call schedule, with call dates and prices,
issued with these bonds. Usually, if interest rates decline, the company
will reissue lower yielding bonds to reduce their interest payments.
Investors can protect themselves from the call risk by purchasing
non-callable bonds. Most corporate bonds have some sort of protection from
- Convertible bonds
allow the holders to participate in the upside capital appreciation
potential of the common shares. These bonds can convert into a set number
of company shares. Convertibles are of interest to investors who need a
predictable cash flow and would appreciate some juice on the bond price
Convertible bonds are really fixed-income
debt instruments with attached embedded warrants. Convertibles are priced
less than regular bonds because of the value of the attached warrants. In
practice, when the stock trades above the bond’s conversion price, both
instruments trade lock step in parity. When the stock drops below the
conversion price, the floor of the bond’s price will be cushioned by the
In recent years, investment bankers created
the synthetic convertible bond. The bond of one company is combined
with a warrant of another company. This creates a fixed-income product,
with the return potential of a convertible security. This can get wild,
because the combinations are limitless.
- Estate put feature
allows the estate of the bondholder to sell back the bond to the issuer at
par value, in the event of the bondholder’s death.
bonds is weighing safety versus yield. Preservation of capital should always
win over yield trade-off decisions.