MonthlyPassiveIncome: March 2019

Recently, I found some old notes that I have summarized from various sources I have read on bond investment 6-7 years ago. These notes are more detail than the earlier articles that I have written on US Corporate Bonds Investment in my blog and I found these notes helpful for better understanding on some of terms used for bonds trade . These notes are applicable for all types of bonds investment. I will be sharing these notes in the next few articles on bonds investment.

WHAT ARE BONDS?
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it “matures,” or comes due.
Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds.

WHY INVEST IN BONDS?

Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages,depending upon individual circumstances and objectives. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income.That’s especially true for retirement planning. The diversity of fixed-income securities presents investors with a wide variety of choices to tailor investments to their individual financial objectives. Whatever your goals, your investment advisor can help explain the numerous investment options available to help you reach them, taking into account your income needs and tolerance for risk.

KEY BOND INVESTMENT CONSIDERATIONS
There are number of key variables to look at when investing in bonds: the bond’s maturity, redemption features, credit quality, interest rate, price, yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.

1)Interest Rate
Bonds pay interest that can be fixed,floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Typically,investors receive interest payments semiannually. For example, a $1,000 bond with an 8% interest rate will pay investors $80 a year, in payments of $40 every six months. When the bond matures, investors receive the full face amount of the bond—$1,000.

But some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index, such as the rate on Treasury bills. Some bonds have no periodic interest payments. Instead, the investor receives one payment—at maturity—that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the (original) interest rate. Known as zero-coupon bonds, they are sold at a substantial discount from their face amount. For example,a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures. If the bond is taxable,the interest is taxed as it accrues, even though it is not paid to the investor before maturity or redemption.

2)Maturity
A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years. Maturity ranges are often categorized as follows:
Short-term notes: maturities of up to five years;
Intermediate notes/bonds: maturities of five to 12 years;
Long-term bonds: maturities of 12 or more years.

3)Redemption Features
While the maturity period is a good guide as to how long the bond will be outstanding,certain bonds have structures that can substantially change the expected life of the investment.

4)CALL PROVISIONS For example, some bonds have redemption, or “call” provisions that allow or require the issuer to repay the investors’ principal at a specified date before maturity. Bonds are commonly “called” when prevailing interest rates have dropped significantly since the time the bonds were issued. Before you buy a bond,always ask if there is a call provision and, if there is, be sure to obtain the “yield to call” as well as the “yield to maturity.” Bonds with a redemption provision usually have a higher annual return to compensate for the risk that the bonds might be called early.

5)PUTS Conversely, some bonds have “puts,” which allow the investor the option of requiring the issuer to repurchase the bonds at specified times prior to maturity. Investors typically exercise this option when they need cash for some purpose or when interest rates have risen since the bonds were issued. They can then reinvest the proceeds at a higher interest rate.

6)PRINCIPAL PAYMENTS AND AVERAGE LIFE
In addition, mortgage-backed securities are typically priced and traded on the basis of their “average life” rather than their stated maturity. When mortgage rates decline, homeowners often prepay mortgages, which may result in an earlier-than-expected return of principal to an investor. This may reduce the average life of the investment. If mortgage rates rise, the reverse may be true—homeowners will be slow to prepay and investors may find their principal committed longer than expected. Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment you are seeking within your risk tolerance. Some individuals might choose short-term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long-term securities. Alternatively, investors seeking greater overall returns might be more interested in long-term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks as well as credit risk.

7)Credit Quality
Bond choices range from the highest credit quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment-grade and considered speculative. Since a bond may not be redeemed, or reach maturity, for years—even decades—credit quality is another important consideration when you’re evaluating a fixed-income investment. When a bond is issued, the issuer is responsible for providing details as to its financial soundness and creditworthiness. This information is contained in a document known as an offering document, prospectus or official statement, which will be provided to you by your investment advisor. But how can you know whether the company or government entity whose bond you’re buying will be able to make its regularly scheduled interest payments in five, 10, 20 or 30 years from the day you invest? Rating agencies assign ratings to many bonds when they are issued and monitor developments during the bond’s lifetime. Securities firms and banks also maintain research staffs which monitor the ability and willingness of the various companies, governments and other issuers to make their interest and principal payments when due.Your investment advisor or the issuer of the bond can supply you with current research on the issuer and on the characteristics of the specific bond you are considering.

8)Credit Ratings
In the United States, major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on in-depth analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB category or higher are considered investmentgrade; securities with ratings in the BB category and below are considered “high yield,” or below investmentgrade. While experience has shown that a diversified portfolio of high-yield bonds will, over the long run, have only a modest risk of default, it is extremely important to understand that, for any single bond, the high interest rate that generally accompanies a lower rating is a signal or warning of higher risk.

How can you find out if the credit factors affecting your bond investment have changed? Usually, rating agencies will signal they are considering a rating change by placing the security on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings). The rating agencies make their ratings available to the public through their ratings information desks. In addition, their published reports and ratings are available in many local libraries. Many also provide online ratings information that can be accessed through the Internet.

9)Bond Insurance
Credit quality can also be enhanced by bond insurance. Specialized insurance firms serving the fixed-income market guarantee the timely payment of principal and interest on bonds they have insured. In the United States, major bond insurers include MBIA,AMBAC, FGIC and FSA. (See glossary for list.) Most bond insurers have at least one triple-A rating from a nationally recognized rating agency attesting to their financial soundness; and insured bonds, in turn, receive the same rating based on the insurer’s capital and claims-paying resources. While the focus of their underwriting activities has historically been in municipal bonds, bond insurers also provide guarantees in the mortgage and asset-backed securities markets and are moving into other types of securities as well. An investor may also buy bond insurance on a bond purchased in the secondary market.

10)Price
The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value,it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.

11)Yield
Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at $1,000 and the interest rate is 8% ($80), the current yield is 8% ($80 ÷ $1,000). If you bought at $900 and the interest rate is 8% ($80), the current yield is 8.89% ($80 ÷ $900).

12)Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date. You should ask your investment advisor for the yield to maturity or yield to call on any bond you are considering purchasing. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond’s real value to your portfolio.

13)Market Fluctuations: The Link Between Price and Yield
From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds—and true of the entire bond market—with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.
When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues.
When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.
Because of these fluctuations, you should be aware that the value of a bond will likely be higher or lower than its original face value if you sell it before it matures.

14)The Link Between Interest Rates and Maturity
Changes in interest rates don’t affect all bonds equally. The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way and that the fluctuations will be greater—and the more the investors will expect to be compensated for taking the extra risk.There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest
to longest. Such a line is called a yield curve.
A yield curve could be drawn for any bond market but it is most commonly drawn for the U.S. Treasury market, which offers securities of every maturity, and where all issues bear the same top credit quality.
By watching the yield curve, as reported in the daily financial press, you can gain a sense of where the market perceives interest rates to be headed—one of the important factors that could affect your bonds’ prices.
A normal yield curve would show a fairly steep rise in yields between short- and intermediate-term issues and a less pronounced rise between intermediate and long-term issues. That is as it should be, since the longer the investor’s money is at risk, the more the investor should expect to earn.
If the yield curve is said to be “steep,” it means the yields on short-term securities are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a short one, and you may wish to modify your choice of bond accordingly. On the other hand, if the yield curve is “flat,” it means the difference between short- and long-term rates is relatively small. This means that the reward for extending maturities is relatively small, and many investors will choose to stay in the short end of the maturity range. When yields on short-term issues are higher than those on longer-term issues, the yield curve is said to be “inverted.” This suggests that investors expect interest rates to decline. An inverted yield curve is sometimes considered to be a harbinger of recession.

As an investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation. You may have wondered why press reports say the bond market fell after the government released positive economic news about job growth or housing starts. As a general rule, the bond market, and the overall economy, benefit from steady, sustainable growth rates. Moderate economic growth also benefits the financial strength of the municipal and corporate issuers whose bonds you may hold, making them a stronger credit. But steep rises in economic growth can lead to inflation, which raises the costs of goods and services for everyone, leads to higher interest rates and erodes a bond’s value. Ultimately, persistent and rapid economic growth will lead to rising interest rates, either through actions taken by the Federal Reserve to slow the expansion, or through market forces acting in anticipation of interest rate moves. Since rising interest rates push bond prices down, the bond market tends to react negatively to reports about strong economic growth.

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