A bond is nothing more than a loan to an entity. There are many types of bonds available such as cooperate bonds, government bonds, treasury bills or convertible bonds. As and investor, there is one reason to invest in a bond and that is to get interest payments. As a trader, you can also make money in this market. The interest rate fluctuations make the principle of the bonds change and you can make short term profits.
Growing up I had family that would swear by purchasing bonds and would only invest in interest bearing securities. I will tell you these investments aren’t completely risk-free and I will go over the fundamentals of bonds. Everything affects the price of a bond from the firm’s ability to pay back the principal and make interest payments to the economic conditions on many levels. The bond market is very complex and is something that the average person should learn about to make wise investment decisions. I will try to lay a foundation for you in this article on how to analyze a bond.
The bond rating system is part of Standard & Poor’s which gives the bond investor a general rating on how risky the bond is that they are purchasing. The rating mostly tells the person how creditworthy the business is sort of like we each have our own personal FICO score telling leaders what our credit history looks like.
The first class is investment grade bonds which are considered to be creditworthy. If you were to analyse the financial statements of these entities they would have clean looking balance sheets meaning they could pay you back your principle with interest. There are some exceptions to this rule. As an example, the United States is in extreme amounts of debt. Still a US T-bill has an investment grade rating of AA.
Non-Investment Grade are bonds that are high risk to the creditors. These are called “speculative bonds” or even “junk bonds” because there is a high risk of default. One thing that is important to understand is these bonds will pay more interest kind of like the individual that has a bad credit score.
|Investment Grade Bonds||This means that the entity carries a relatively low risk of default.|
|AAA||This rating is the highest on the S&P ratings. This entity is extremely credit worthy.|
|AA||Only a small degree of risk compared to AAA Rating.|
|A||Changes in economic circumstances could stop the bond holders from getting paid.|
|BBB||A little more susceptible to economic changes than A rating.|
|Speculitive||Bonds Below this row are considered higher risk|
|BB||An obligor rated ‘BB’ is less vulnerable in the near term than other lower-rated obligors.|
|B||An obligor rated ‘B’ is more vulnerable than the obligors rated ‘BB’, but the obligor currently has the capacity to meet its financial commitments.|
|CCC||An obligor rated ‘CCC’ is currently vulnerable and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.|
|CC||An obligor rated ‘CC’ is currently highly vulnerable.|
|C||highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations|
|R||An obligor rated ‘R’ is under regulatory supervision owing to its financial condition. During the pendency of the regulatory supervision, the regulators may have the power to favor one class of obligations over others or pay some obligations and not others.|
|SD||This entity has selectively defaulted on some obligations|
Bond pricing isn’t as straightforward as other types of investments and you will want to understand what will affect the valuation of bonds. Below I explain some of these factors that cause bonds to increase and decrease in value.
Interest Rate Price Increase and Decrease
The first thing that you should understand before you invest in bonds is that they have an inverse effect on the overall interest rate. If the market interest rate goes up then your bond will actually gain value and if the market rate goes down you will lose money on the principle value of your bond. There is a risk involved with purchasing bonds low-interests rate periods because at any moment the value of these securities can go down. There is more risk associated with these securities if they are part of a larger fund that is leveraged.
There is a risk involved with purchasing bonds low-interests rate periods because at any moment the value of these securities can go down. An important note to make about these types of investments when they are part of an ETF or Mutual fund is that these funds can be leveraged. This means the fund has borrowed funds to purchase these securities and the rate changes will affect them more.
Bond Par Value
There is a par value or face value of every bond. The majority of them have a face value of $1000 wich means at the end of the period that is the value that you get back on these bonds. Like I said before these are changing value at all times so bonds sell at either a premium or discount depending on certain factors.
Long Term Outlook
The greatest risk to any bond is the fact that they are long term if you purchase them directly from a company during the IPO. (Initial Public Offering) Some of these bonds don’t mature for 10 to 20 years so think about all the different things that could happen during this time. There have been whole industries or fortune 500 companies that have defaulted, so you don’t know if you will get your interest payments over this 20 year period of time.