Bonds are basically loans; however, since the total issue is normally for quite large amounts, they involve more of a legal structure. A multitude of different entities can issue bonds, such as: sovereign governments, like the U. S. Treasury; state and local governments, which are referred to as tax-free municipal bonds (or “munis”) in the U.S; “Agencies” ( originally formed by the federal government, and are no longer a part of it, such as FNMA (“Fannie Mae”) and FHLMC (“Freddie Mac”)); corporations (both foreign and domestic); etc.
Bonds have three common characteristics: a “face” (or payment) amount; a “coupon” (rate of interest) and a maturity date. Some issues have call dates or other differentiating characteristics; but, let’s just stick to the main three characteristics. Since bonds are loans, the face amount denotes what the repayment amount will be (for the portion of the total issue that a particular bondholder owns). The coupon, describes the annual interest rate (generally divided over semi-annual payments), which will be paid during the life of the bond. And the maturity date is when the bond will be paid-off. Those three characteristics generally never change, as long as the bond issue is in existence.
Unlike mortgages, bonds are not always something that a person keeps for long periods of time, that is, right up until the maturity date, which might be some ten or twenty years from when they were purchased. An investor’s personal plans, their financial picture or the markets might change, along the way. Accordingly, as investments, bonds are often bought or sold part at various times throughout their existence. Thus, the concept of “Yield” is extremely vital to the bond markets. Here’s why!
Trading bonds–buying and selling them in the secondary market–can be confusing. But, with a short explanation, I believe that it can be better understood. Let’s consider a ten-year bond, with a face amount of $10,000, that was issued in 2010, and a coupon (or interest) rate of four percent. As noted earlier, the coupon and maturity date (in 2020) will never change. When someone wishes to sell a bond, the maturity date and the coupon rate–in essence the cash flow–remains fixed, as it was on the date it was first issued. So, how do you sell it?
Regardless of the 2010 issue date, if the bond pays four percent per annum, and is due in (now) five years, it would trade based on how bonds of similar quality (i.e. credit rating) and maturity are trading. For instance, if you sell your house today, what you paid for it, sometime back in the past, is irrelevant. Therefore the hypothetical bonds’ market value would now be based on the coupon and the maturity date, five years hence. Also, the markets would factor-in a subtle differences between, let’s say, four and a half years, five years and three months, etc.
Let’s go back to the four percent bond that now has five years until maturity. The key point now is what five (not ten) year bonds (of a similar creditworthiness) are trading for at this time. If today’s going rate is three and a half percent, no one would expect to sell it at face (maturity) value. For instance, if the bond you have pays one-half percent extra, for five years, you would expect to sell it for approximately 102 1/2. So, you might sell a $10,000 face amount bond for $10,250. The extra principal amount would pay you for the additional (market) value that your bond pays the owner annually–for the remaining life of the bond.
Likewise, if the current interest rate for five year bonds is five percent, you might find that your $10,000 (face amount) bond would only sell for $9,500 in the current market. That shortfall (just like a house in a depressed market) would compensate the buyer for buying a bond that would pay a one percent lower cash flow for the remaining life of the bond. These numbers are approximate since there are various technical factors that would come into play, as well.
As I noted in a prior IBC blog post, most people invest in bonds through mutual funds. Generally, individual bonds with a face amount of less that $25,000 have a somewhat impaired marketability, and the actual value would be proportionately lower, depending upon how much lower the face amount is. That would mean that an investor would need at least $200,000 to $250,000 in order to create a diversified portfolio of, say, eight-to-ten different bonds, respectively.