Bond Basics

Rising interest rates have caused bond prices to decrease and bond yields to increase. Consequently, investors are faced with the decision of investing in longer dated bonds or shorter dated bonds which will mature soon and can be reinvested at higher rates. The global bond market may appear complex, but it is driven by risk and return trade-offs like the stock market. To navigate this seemingly complex world of bonds, an investor should try to understand the following features before investing. 

The Face Value of a bond, which is also sometimes called the par value, refers to how much a bond will be worth when it matures. It is also the amount which the bond issuer uses when calculating periodic interest payments. It is one of the features you need to know about a bond to understand its value as an investment.

The Coupon Rate is the stated interest rate on the security. This annual rate is paid by the bond issuer and is based on the bond's face value. Interest/coupon payments are generally paid on a semiannual or quarterly basis. Bonds can carry a fixed coupon rate, where interest is paid at the same rate or a floating coupon rate, where the interest rate fluctuates and is based on a specified benchmark. Sometimes a bond can have a fixed coupon rate for a specified period and then transition to a floating rate. The beauty of a bond is that this is known and specified upfront in the terms and conditions of the specific bond you are investing in.

Yield to Maturity is the overall interest rate earned by an investor who buys a bond at the current market price and holds it until maturity. It is quoted as an annual rate and may differ from the bond's coupon rate, as it is a function of the bond's purchase price. 

Callability refers to a bond issuer's right to redeem a bond before it reaches the stated maturity date. A callable bond allows the issuing company to pay off their debt early, especially if interest rates in the market are much lower. This will enable them to re-issue a new bond at a lower coupon rate or seek other cheaper financing options. Call dates and call prices are usually pre-determined and bonds with this feature typically offer higher coupon rates due to their callable nature.

Credit Rating is a letter-based scoring system that helps investors to judge the quality and creditworthiness of a bond. The credit rating is determined by bond rating agencies, most notably Fitch, Moody's and Standard & Poors. The rating scale ranges from investment grade (lowest risk) to junk (highest risk). Generally, bonds with a higher credit rating will carry a lower coupon rate due to the lower credit risk associated with the bond.

Once an investor understands these few basic terms, they can become more confident in investing in bonds, and of course, never be afraid to ask questions. A qualified financial advisor should be able to explain these basic bond terms to you.

Anna-Joy Tibby is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.