Bonds – Taxable & Tax Free

A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation. This asset is also called collateral on the loan. So if the bond issuer defaults, the asset is then transferred to the investor. A mortgage-backed security (MBS) is one type of secured bond backed by titles to the homes of the borrowers. Unsecured bonds, on the other hand, are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. Also called debentures, these bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.

When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.

The coupon amount represents interest paid to bondholders, normally annually or semiannually. The coupon is also called the coupon rate or nominal yield. To calculate the coupon rate, divide the annual payments by the face value of the bond.

While the majority of corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not subject to taxation.
Tax-exempt bonds normally have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.

Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates.
Risks of Bonds Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments.

Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa. Interest rate risk comes when rates change significantly from what the investor expected. If interest rates decline significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.

Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments—just like any other creditor. When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. Safety usually means the company has greater operating income and cash flow compared to its debt. If the inverse is true and the debt outweighs available cash, the investor may want to stay away.

Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower interest rate environment.

Most bonds come with a rating that outlines their quality of credit. That is, how strong the bond is and its ability to pay its principal and interest. Ratings are published and are used by investors and professionals to judge their worthiness.

The most commonly cited bond rating agencies are Standard & Poor’s, Moody's Investors Service, and Fitch Ratings. They rate a company’s ability to repay its obligations. Ratings range from AAA to Aaa for high-grade issues very likely to be repaid to D for issues that are currently in default.
Bonds rated BBB to Baa or above are called investment grade. This means they are unlikely to default and tend to remain stable investments. Bonds rated BB to Ba or below are called junk bonds—default is more likely, and they are more speculative and subject to price volatility. Firms will not have their bonds rated, in which case it is solely up to the investor to judge a firm’s repayment ability. Because the rating systems differ for each agency and change from time to time, research the rating definition for the bond issue you are considering.

Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.

As noted above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investor’s actual return will differ slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excel’s RATE or YIELDMAT functions (starting with Excel 2007). A simple function is also available on a financial calculator.

The current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bond's annual coupon by the bond’s current price. Keep in mind, this yield incorporates only the income portion of the return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.

The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par or face value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.

A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate the yield to call using Excel’s YIELD or IRR functions, or with a financial calculator.

The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excel’s YIELD or IRR functions, or by using a financial calculator.