The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (20 page)

The amount of the coupon (fixed-interest rate) depends on a number of factors, such as:

• The current market interest rate at the time the bond was issued.
  
• The creditworthiness of the borrower—typically, higher-grade bonds have lower coupons than lower-grade bonds, which are considered riskier.
  
• The length of time until maturity—generally, the longer the maturity date, the higher the coupon.
  

Except in the case of floating-rate bonds, once the bond is issued, its coupon usually does not change over time, which is why bonds are called “fixed-income” investments.

Turn on the news or read the business section of any newspaper or financial web site, and you will hear a lot about stocks: What’s up, what’s down, and what might go up or down next. Bonds are hardly mentioned. Yet bonds make up a much larger market than stocks.

Bond prices change daily on the bond market depending on several factors, primarily changes in interest rates and any positive or negative news about the creditworthiness of the bond issuer. That means if you buy an already issued bond on the bond market, its value may be greater than it was at the time the bond was first issued. Depending on the market value at any given moment, you may have a potential capital gain or a potential capital loss. This new value of the bond changes the total return you will make on the bond. Why? Because total return is the sum of both the coupon and the capital gain (or loss).

Following are three common measures that combine the coupon and the current market price to help calculate the expected capital gain (or loss) at maturity.

• Current yield
  . Because the latest price of the bond on the bond market also matters to investors, the current yield is the bond’s interest rate as a percentage of the current price of the bond on the bond market.
  
• Yield to maturity
  . This is the total potential income return of both price and coupon of the bond if it is held to its maturity date.
  
• Tax-equivalent yield
  . Only in the case of nontaxable municipal bonds, the interest earned on your bond is based on your tax bracket.
  

In addition to your regular coupon payments, bonds have another nice feature: The bond issuer agrees to repay the principal of the loan at its maturity date, which may range from just a few months to as much as 30 years or longer after the issue date. If you hold a bond until maturity, you get the full coupon. For example, if you purchase a 10-year bond for $1,000 with a 5 percent coupon, you would earn $50 per year (with payments of $25 made twice a year) for 10 years.

On top of earning its fixed-income payment, a bond has another nice feature: The bond issuer
guarantees
to pay back your principal in full. Not too many other investments offer such a reassuring promise. So, going back to the example of a 10-year bond of $1,000 with a 5 percent coupon, you would receive a total of $500 in fixed-income coupon payments ($50/year for 10 years), plus full repayment of your original $1,000 principal, for a total of $1,500!

But the story does not end there. In addition to the potential yield of the bond over time, based on its fixed-interest rate, there is also the option of earning a profit (or a loss) by selling your bond on the
bond market
. Here is where bonds get a bit trickier.

As mentioned before, a bond’s total return is the sum of the capital gain and the coupon. Because bonds are traded on the bond market and their prices continuously change, the bond’s effective or current yield also changes, regardless of its original coupon.

For example, if you buy a 10-year $1,000 bond with a 5 percent coupon for $1,200, you are no longer getting a 5 percent yield from it. You will still get the same fixed 5 percent coupon of $25 twice per year. But because you paid $1,200 for the bond, not $1,000, this coupon
effectively
represents a 4.2 percent annual yield. Therefore, its effective or current yield is 4.2 percent.

But wait a second. You also have to consider that when the bond matures, you will not get your $1,200 back. You will get $1,000, which was the original price of the bond.
That’s a $200 capital loss to take into account, which is why it’s a good idea to calculate a bond’s
yield to maturity
. Yield to maturity spreads the discount or premium paid for a bond across the length of time you own it.

For example, if you bought this 10-year $1,000 bond 2 years after it was issued, spreading that $200 loss over the time you own it gives you a yield to maturity of only 2.25 percent. You may be getting $25 every 6 months, but when the bond matures, you are effectively losing half of that yield (getting 2.1 percent instead of 5 percent) because of that $200 loss on the premium price. Of course, this is the case only if you paid a premium for the bond. If you paid a discount for the bond (meaning you paid less than $1,000 for a $1,000 bond), then the current yield and yield to maturity
add
to the value of your bond.

Your total return (the coupon plus the capital gain) is the
real value
of your bond at any given time, whether you sell it or not. It may be tempting to think that your fixed-rate bond is just plodding along, earning you a steady stream of income, and it is. But bonds are much more than their coupon value. Every minute that the bond market is open, the total return value of your bond is changing. In addition, your options for putting your money into other investments are also changing. All these factors must be considered when you decide if owning bonds is in your best interest. If you look only at the bond’s coupon interest rate, you are missing the bigger picture of the total return. And as we will see shortly, missing the bigger picture can lose you a lot of money very, very quickly.

Bonds may be less risky than stocks because, unlike stocks, they pay interest and also guarantee the return of principal, but they are not risk free. The level of perceived risk affects how much interest bond issuers are willing to pay when a bond is first issued. After a bond is issued, any changes in the level of risk will impact how much investors are willing to pay for that bond on the bond market. These risk factors include changes in interest rates, changes in creditworthiness, and the passage of time.

The bond market is ultra-sensitive to changes, even very small changes, in interest rates. Depending on current interest rates, bonds may trade at a premium or at a discount to their par or face value (i.e., the principal for which it was originally purchased and will be paid at maturity). If interest rates have gone up since a bond has been issued, the bond will trade at a discount to make up for the lower coupon payments, compared to the currently higher rates one can get on newly issued bonds. However, if interest rates have gone down since the bond was issued, that bond will trade at a premium because of its higher coupon, compared to current interest rates.

In general, the longer the bond has to maturity or the lower the coupon, the more price sensitivity that bond has to yield changes. The degree of this price sensitivity is measured in terms of something called
duration
. The greater a bond’s duration, the more sensitive the price of the bond is to interest rate changes. For example, a bond with a duration of two will move 2 percent in price for every 1 percent change in yield. A bond with a duration of four will move 4 percent for every 1 percent in price change in yield, and so on. Clearly, when interest rates rise, the prices of bonds with the highest duration will fall the fastest.

As in all markets, what investors believe may happen in the future affects how they value or discount any asset. In the case of bonds, if investors foresee a decline in interest rates in the future, they will want to buy bonds now in order to sell them at a profit later. However, if investors believe that interest rates may rise in the future, they will not be too eager to buy lower interest rate bonds now unless they can get them cheaply. When interest rates rise more and more, demand for already existing bonds will decline more and more, and bond prices will fall more and more.

This is why investor beliefs about the future direction of interest rate changes make a difference in the current market value of bonds. Just as we discussed in the previous chapter on stocks,
investor psychology matters
.

In addition to being ultra-sensitive to interest rate changes, bond values are also responsive to changes in perceived credit risk. As with any loan, higher perceived risk of the creditor comes with higher rewards to the lender (meaning higher interest rates), while lower perceived risk loans come with smaller rewards (lower interest rates). Thus, the safest bonds tend to have the lowest yields, and riskier bonds from the least creditworthy companies, or junk bonds, come with the highest yields.

Under normal conditions, credit risk typically does not radically change from the time a bond is issued until the time of its maturity, but that is not always the case. A once creditworthy bond issuer can become not so creditworthy over time. That is the credit risk. Even without a big change in creditworthiness, this risk does change somewhat over time.

If investors feel that the creditworthiness of the bond issuer has gone down since the bond was first issued—meaning the borrower has for some reason become less likely to pay the coupon or return the principal—then bondholders are more likely to want to get rid of these bonds, and their market prices will decline.

However, when investors feel confident in the bond issuer, they are willing to pay more for a bond that appears to be a lower risk than for a bond that seems to be at higher risk. Of course, the lower risk also means a lower coupon.

The degree of credit risk is not a permanent feature of a bond. Just like interest rates, creditworthiness changes over time and investor psychology plays an important role. Because the coupon is higher for the higher-risk bond, investors may want to take a bet on them, hoping the bond issuer’s poor public image may improve down the road. When investors feel less confident about the future, they may feel less eager to own even currently high-rated bonds if investors become concerned about future credit risk.

All risk, including interest rate risk and credit risk, increases over time. The longer the maturity date, the greater the odds of either interest rates going up or the bond issuer’s creditworthiness going down. So the greater the amount of time to maturity, the greater the risk, and therefore the higher the interest rate paid. By tying up your principal for a longer time, you are making a bigger sacrifice by not having your money available for other purposes (the time value of money), and you are taking on greater interest rate and credit risk. So, generally speaking, long-term bonds come with higher coupons than medium-term bonds, which come with higher coupons than short-term bonds.

But it doesn’t always work that way, particularly if interest rates are expected to go down, not up. In that case, long-term bonds may come with lower coupons than short-term bonds. A long-term bond that does not come with a higher yield than a short-term bond can be a losing proposition for the bondholder unless you feel confident that interest rates will fall.

However, if interest rates rise—as we know they will when inflation increases—then long-term bonds are a very bad bet because the future interest rates will likely be much higher than what these long-term bonds currently pay, making the market value of the long-term bonds fall.

In general, investors have considered bonds to be among the safest of all investments. The reasons for this are rock solid: