Posted by Gail | Filed under Investing
There are a whack of investments that fall into the fixed-income category: from the lowly savings account, to the not-much-more-esteemed GIC, to bond and mortgage mutual funds to extremely liquid treasury bills, to mortgages and their derivatives, such as mortgage-backed securities, to what may be the most popular of all fixed income investments: bonds, both of the corporate and government variety.
Bonds are a way for an entity – be it the federal, provincial/state or municipal governments, or a corporation – to raise money to do the things they want to do. In essence, they are borrowing money from you and paying you interest.
Most bonds pay a set rate of interest semiannually for the life of the bond, with the principal due at maturity. However some bonds pay a floating rate of interest that adjusts to more accurately reflect prevailing market rates. This rate is periodically reset in line with a base interest-rate index such as the rate paid on treasury bills.
Large corporations have found many ways of designing bonds to attract investors while keeping costs in line. These range from mortgage bonds, which corporations issue when they have adequate fixed assets to be pledged, through to debentures, which companies can issue if their financial rating is high enough to allow them to borrow without pledging any assets. When a company does not possess fixed assets or does not wish to pledge against those assets, but is prepared to pledge securities, collateral trust bonds are issued.
A bond’s maturity refers to the specific future date on which your principal will be repaid. Maturities can 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 short-term (up to 4 years) medium-term (5 to 12 years) and long-term (12 years or more). 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. With a “call” provision, the issuer may choose to repay the principal at a specified date before maturity. Not a great feature during periods of falling rates since the issuer may call the bonds and you’ll get stuck reinvesting your money at a lower rate. Conversely, the bond may have a “put” feature that would allow bondholders to demand the issuer repurchase the bond prior to maturity. Great feature if you think you might need the money at a moment’s notice.
Since many bonds do not reach maturity for years, or even decades, credit quality is a very important consideration when choosing a bond. 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.
Rating agencies assign ratings to bonds when they are issued and monitor developments during the bond’s lifetime. Bonds are rated based on the quality of the bond itself and the credit worthiness of the issuer. Usually the lower the bond’s rating the higher its yield. To attract investors, issuers have to pay a higher rate of interest to compensate for the higher risk.
Bond ratings fall into two main categories and are graded on a scale: investment and high-yield or junk bonds. While not all bonds are rated, you might want to think twice about investing in a bond that hasn’t been. Two of the largest rating agencies are Standard & Poor’s and Moody’s and they rate bonds from Highest Quality to Default.
Next Week: More About Bonds
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