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 Desjardins Online Brokerage.
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") NOTE - This link will open in a new tab.:
|Ba, B||BB, B||BB, B||Speculative ("Junk")|
|Caa, Ca, C||CCC, CC, C||CCC, CC, C||Highly Speculative|
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.