Advanced Bond Concepts

In the Bond Basics Tutorial, we covered introductory concepts. In this tutorial, we’ll review a few ideas and then move onto advanced bond concepts.

A bond is an IOU issued by a corporation or government in order to finance projects or activities. When you buy a bond, you are extending a loan to the bond issuer for a particular period of time. In exchange for the loan, the issuer pays you a specified interest rate (known as the coupon rate) at regular intervals until the bond matures. In general, the higher the interest rate, the higher the risk. When the bond matures, the issuer repays the loan and you receive the full face value (or par value) of the bond.

Here’s an example. Assume you buy a bond when it’s first issued that has a face value of $1,000, a 5% coupon and a maturity of 10 years. You’ll receive a total of $50 of interest each year for the next 10 years ($1,000 * 5%), and when the bond matures in 10 years, you’ll be paid the bond’s face value - $1000 in this example.

Bonds expose investors to several types of risk, including default, prepayment and interest rate risk.

Default Risk

The possibility that a bond issuer will not be able to make interest or principal payments when they are due is known as default risk. While many bonds are considered no- or low-risk (such as short-term U.S. government debt securities), certain bonds, including corporate bonds, are subject to varying degrees of default risk. Bond-rating agencies, including Fitch, Moody’s Investors Service and Standard & Poor’s, publish evaluations of the credit quality and default risk for many corporate bonds.

Prepayment Risk

The possibility that a bond issue will be paid off earlier than expected is known as prepayment risk. This often occurs through a call provision. Many firms embed a call feature that allows them to redeem, or call, the bond before its maturity date at a specified call price. This feature provides flexibility to retire the bond early if, for example, interest rates decline. In general, the higher a bond’s interest rate in relation to current rates, the greater the risk of prepayment. If prepayment occurs, the principal is returned early and any remaining future interest payments will not be made. As a result, investors may be forced to reinvest funds in lower interest rate bonds.

Interest Rate Risk

Interest rate risk is the possibility that interest rates will be different than expected. If interest rates decline significantly, you face the possibility of prepayment as firms exercise call features. If interest rates rise, you risk holding a bond with below-market rates. The longer the time to maturity, the higher the interest rate risk since it is difficult to predict rates farther into the future.

Bonds basics are fairly easy to comprehend – most people understand the concept of borrowing and lending money, after all. Like many securities, however, analyzing and trading bonds can get tricky. In this tutorial, we’ll cover some of the more complex aspects of bonds, including pricing and yield, duration and convexity. If you need a bond refresher before moving on, please see Bond Basics.