There are a number of
characteristics of a bond that you need to be aware of. All
of these factors play a role in determining the value of a
bond and the extent to which it fits in your portfolio.
Face Value/Par Value
The face value (also known as the par value or principal)
is the amount of money a holder will receive back once a bond
matures. A newly issued bond usually sells at the
par value. Corporate bonds normally have a par value of $1,000,
but this amount can be much greater for government bonds.
What confuses many is that the par value is NOT the price
of the bond. A bond's price fluctuates throughout its life
in response to a number of variables (more on this later).
When a bond's price trades above the face value it is said
to be selling at a premium . When a bond sells below face
value, it is said to be selling at a discount .
Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest
payments. It's called a "coupon" because sometimes there are
physical coupons on the bond that you tear off and redeem
for interest. This, however, was more common in the past.
Nowadays records are more likely to be kept electronically.
As previously mentioned, most bonds pay interest every six
months, but it's possible for them to pay monthly, quarterly,
or annually. The coupon is expressed as a percentage of the
par value. If a bond pays a coupon of 10% and its par value
is $1,000, then it'll pay $100 of interest a year. A rate
that stays as a fixed percentage of the par value like this
is a fixed-rate bond.
Bonds may also be issued with a preset schedule of future rates. An example of this is a step-up, which is a type of bond with yields that increase over a set period. After being held for one year, this product can be resold on the secondary market, although the secondary market on such products might be illiquid. It can also be bought back at the issuer's choosing, generally after the first year. A buyback by the issuer is always at par and includes accrued interest. The purchase of a new Step-up issue involves no commission fees. Below you will find an example of a step-up issue that was offered at Disnat.
Example of a STEP-UP Bond
ISSUER: Province of Nova Scotia,
4.35% S/A December 23, 2004, extendible December 23, 2013
RATING: S&P: A-; DBRS: A(low)
FIRST CALL: December 23, 2004
CALLABLE: Semi-annually thereafter
CLIENT PRICE: $100.00
YIELD TO FIRST CALL: 4.35% S/A
YIELD TO MATURITY: 5.23% S/A
December 23, 2003 to December 23, 2004: 4.35%
December 23, 2004 to December 23, 2005: 4.45%
December 23, 2005 to December 23, 2006: 4.55%
December 23, 2006 to December 23, 2007: 4.75%
December 23, 2007 to December 23, 2008: 4.90%
December 23, 2008 to December 23, 2009: 5.10%
December 23, 2009 to December 23, 2010: 5.30%
December 23, 2010 to December 23, 2011: 6.00%
December 23, 2011 to December 23, 2012: 6.75%
December 23, 2012 to December 23, 2013: 7.50%
Another possibility is an adjustable
interest payment, known as a floating-rate bond. In this case
the interest rate is tied to market rates through an index
such as the rate on Treasury bills.
Logically, investors will pay more for a high coupon
than for a low coupon bonds. As well, all things being equal, a lower coupon
means that the price of the bond will fluctuate more.
The maturity date is the future day on which the investor's
principal will be repaid. Maturities can range from as little
as one day to as long as 30 years (though terms of 100 years
have been issued!).
A bond that matures in one year is much more predictable and
thus less risky than a bond that matures in 20 years. Therefore,
in general, the longer the time to maturity, the higher the
interest rate. Also, all things being equal, a longer term
bond will fluctuate more than a shorter term bond.
The issuer is an extremely important factor as their stability
is your main assurance of getting paid back. For example,
the U.S. Government is far more secure than any corporation.
Their default risk --the chance of the debt not being paid
back--is extremely small, so small that the U.S. government
securities are known as risk free assets. The reason behind
this is that a government will always be able to bring in
future revenue through taxation. A company on the other hand
must continue to make profits, which is far from guaranteed.
This means the corporations must offer a higher yield in order
to entice investors--this is the risk/return tradeoff in action.
The bond rating system helps investors distinguish a company's
credit risk. Think of a bond rating as the report card for
a company's credit rating. Blue-chip firms, which are safer
investments, have a high rating while risky companies have
a low rating. The chart below illustrates the different bond
rating scales from the major rating agencies; Moodys, Standard & Poor's ("S&P"), and Dominion Bond Rating Service ("DBRS"):
|| Highest Quality
|| High Quality
|| Medium Grade
| Ba, B
|| BB, B
|| BB, B
|| Speculative ("Junk")
| Caa, Ca, C
|| CCC, CC, C
|| CCC, CC, C
|| Highly Speculative
|| In Default
Notice that if the company falls below
a certain credit rating, its grade changes from investment quality
to junk status. Junk bonds are aptly named: they are the debt
of companies in some sort of financial difficulty. Because they
are so risky they have to offer much higher yields than any
other debt. This brings up an important point: not all bonds
are inherently safer than stocks. Certain types of bonds can
be just as risky, if not more risky, than stocks.