Bonds are tradeable instruments of debt issued by institutions to finance their activities. Bonds have a face or par value (e.g., $1,000), a fixed interest rate also known as the coupon rate (e.g., 8 percent a year), and a maturity (e.g., 10 years). Bonds are routinely traded, i.e., sold and bought after the initial acquisition from the bond issuer.
When a bond is sold at a rate higher than its face value, it is sold “at a premium”; when sold below face value, it is sold “at a discount.” Trading in bonds is motivated by the coupon value of the bond in comparison with currently prevailing rates of interest, as discussed below.
Bonds are named after the issuing institutions. Best known are “treasuries,” issued by the U.S. Treasury, “municipals,” issued by municipalities and other levels of government, and “corporate bonds,” issued by corporations. Municipals are tax-free; their earnings are not taxed, a special advantage. Other major categories are “mortgage bonds” issued by such agencies as the Government National Mortgage Association and the Federal Home Loan Mortgage Corporation, “federal agency bonds” issued by departments other than Treasury, “money market bonds” such as bankers’ acceptances and commercial paper, and large time deposits, and “asset-backed bonds” where the bonds, issued by either private or public bodies, are tied to a specific object or activity.
Based on data assembled by the Bond Market Association, as of the end of the Third Quarter of 2005, total bonds outstanding amounted to $24.7 trillion. Bond categories in rank order were 1) mortgage bonds: 23.3 percent; 2) corporate bonds: 20.2 percent; 3) U.S. Treasury bonds: 16.4 percent; 4) money market bonds: 13.2 percent; 5) Federal Agency bonds: 10.3 percent; 6) municipal bonds: 8.8 percent; and 7) assetbacked bonds: 7.8 percent. The federal government, Treasury and other agencies combined, represented 26.7 percent; all government (municipals thrown in) 35.5 percent or somewhat over one-third of total.
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Trading In Bonds
Just like stocks, bonds are actively traded. Why would a person holding a bond with a par value of $1,000 sell it for $800? Why would a person purchase a bond, par value $1,000, for $1,200? The determining factors are the components of the bonds (face value, coupon rate, and maturity) and the characteristics of competing securities and their fluctuating values.
To take “maturity” first, a ten-year bond ties up the invested amount for a ten-year period. An individual who, because of changing circumstances, needs to have cash now (“liquidity”) can sell the bond to someone else.
The purchaser will take advantage of the seller’s situation by bidding less than the face value of the bond. The seller realizes cash immediately; the seller has a bond with a higher yield.
The yield of a bond is calculated by dividing its interest rate (which is fixed) by its face value (which can change when it is sold). When initially purchased, a $1,000 bond yielding $80 a year in interest has an 8 percent yield. If the bond is sold for $800, the yield becomes 10 percent ( 80 divided by 800). Conversely, if the bond is sold for $1,200, the yield drops to 6.7 percent (80 divided by 1200). Trading in bonds is based on a more complex formula called “yield to maturity.”
The calculation involves summing up all future yields until maturity, discounting future earnings to current value by using currently achievable interest rates, and deriving a new value. (The calculation is based on the general assumption that future earnings are worth less than cash in hand.) If the resulting “YTM” is higher than the owner of the bond can achieve by other means, he or she holds on to the bond; if not, the bond can be sold at a discount and the money reinvested elsewhere.
Because bonds have a par value and a fixed coupon rate, they are inherently safer than stocks. For this reason, bond prices tend to rise as stock prices drop and vice versa. A downturn in stocks brings money into the bond market; bonds with the most desirable features based on bond ratings, YTM, and tax-exempt status of earnings, tend to go up most. When stock surge, money tends to leave the bond market because greater appreciation is possible holding stocks than is possible to achieve by a combination of bond par values and yields.
Bonds are rated by Moody’s Investor Service, Standard & Poor’s, Fitch Bond Rating Agency, and others. Using Moody’s ratings, similar to S&P/Fitch ratings, Aaa is the highest quality rating, Aa is high quality, A is strong, and Baa is medium grade; all of the above are “investment grade.” Ba, B is a speculative “junk grade” bond, Caa/Ca/C is a highly speculative junk bond, and a rating of C means a junk bond in default. S&P and Fitch use D to indicate a bond in default. The label “junk” in all cases indicates that the bond holder is in some kind of financial difficulty.
The higher a bond’s rating, the lower will be its coupon rate. Junk bond issuers, by contrast, attempt to attract buyers by paying a high rate in compensation for the greater risks.