This lesson was written by Stockpickr member Ira Krakow.
fixed-income investments like bonds can be an effective way to balance your overall portfolio. But where do you start?
The first lesson of bond-picking: Understanding the terms that are fundamental to how bonds are price and quoted.
is a good place to find bond quotes.
Bond Breakdown: A Typical Bond Quote
Let's look at a recent quote page for the
General Electric Capital Internotes
, a 10-year corporate bond:
Coupon (%): 5.25%
Maturity Date: April 15, 2018
Yield to Maturity: 5.502%
Current Yield: 5.359%
Fitch Rating: AAA
Coupon Frequency: Semi-Annual
First Coupon Date: October 15, 2003
If you have never seen a bond quote before, this must seem very confusing. You're probably wondering: How much does this bond cost? How much interest do I get, and when? How can I be sure that I'll get my money back? Do I have to wait until April 15, 2018 (the bond's maturity date) to sell? If not, will I get back all of my money?
Determining the Price
Bonds are sold in units of $1,000. However, the price is based on a value of 100, called "par." Until you get used to the terminology, bond prices can be confusing. If you had bought this GE bond when it was issued on April 15, 2003, you would have paid $1,000. For investors new to bonds, the price quote at that instant would have been 100.
Remember this: when looking at bond prices, to find out what your bond is actually worth, multiply the price quote you see by 10. When the price quote is 100, even though this is not golf, the bond is trading "at par," which means, when you sell it, you get your entire $1,000 back (
any transaction commission).
If you hold the bond until its maturity date of April 15, 2018, you would get your original investment (the principal) of $1,000 back, and you would have collected, for nearly 10 years, interest payments of 5.25% (the coupon percentage) per year. Since the coupon frequency is semi-snnual, you would get two interest checks, of $262.50 (half of the 5.25% interest), on April 15 and October 15, each year.
Suppose you need the money now. In that case, you may or may not get your entire principal back. That's because, like in golf, a bond may trade over par (at more than 100, called a "premium"), or under par (at less than 100, called a "discount").
The bond's price fluctuates according to the market's perception of interest rates. When interest rates fall, bond prices rise because the coupon interest payments on your bond are higher than the current market interest rates.
Unfortunately, this GE bond trades at a discount. In other words, the bond is on sale. If you were to sell this bond right now, you would receive only $979.60 (the price of 97.96 multiplied by 10) -- a loss of $20.40 (less any commissions).
Looking Beyond the Interest Payments
Before buying a bond just for its interest payments, consider the quality of the issuer. It's probably a good bet that General Electric will be able to meet its interest obligations and return your principal 10 years from now. Do you have the same faith in a company like
,, which lost $1.39 per share in its most recent quarter and has been trading around $2.00 (and less)? If you believe in Six Flags, then there's a bond issued by the company that pays 10.5% interest until June 2014. Your risk, of course, is the state of Six Flags' financial health over the next few years. For example, if Six Flags goes bankrupt before June 2014, you might lose most, and possibly all, of your principal.
To evaluate this risk, look at the ratings by the three major bond rating agencies --
Standard and Poor's
and privately held
Just like your teachers in school, these three agencies issue grades for bonds, from AAA ("triple-A") for the highest quality "investment grade" bond to D for defaulted. There
subtle variations among the grading systems. However, in general, you should be more confident with the A rated bonds than with the B, C or D rated ones.
The GE bond, backed by one of the world's largest and most profitable companies, has the AAA rating (the highest) from Fitch. The Six Flags bond, on the other hand, is graded CCC, which Fitch says means "currently vulnerable and dependent on favorable economic conditions to meet its commitments." In other words, the reason you're getting 10.5% (reward) is that perhaps Six Flags won't be able to pay back your principal in 2014 (risk). So before you buy a bond, make sure you understand the three agencies' ratings and that you're comfortable taking on the issuer risk.
Should You Hold a Bond Until Maturity?
The yield to maturity (sometimes called YTM) is an important part of your decision to buy (or not to buy) a bond. The YTM is the interest rate you would receive if you bought the bond at its current price and held it until its Maturity Date. The GE bond was issued on April 15, 2003 because its first coupon date is October 15, 2003 and GE thus issued it six months earlier. If you had bought it then and will hold the bond to maturity (April 15, 2018), you would receive 5.25% interest. However, the bond is now "on sale." If you buy it now for $979.60 and hold until maturity, your yield is actually better: 5.502%.
Interest rates -- just like stock prices -- fluctuate, which means that there are opportunities to either make
lose money in the bond market. In other words, the bond market is not a risk-free bet. It's just that the risks are a bit different from the ones you encounter with stocks.
Ready to do some bond-picking homework?
Here is a four-step assignment for comparing different types of bonds. The focus: Bonds with a maturity date of 10 years or more.
First, look at corporate bonds. Go to the
. Once you're there, check the "Corporate" box, and select a "Maturity Range (min)" of 10 years to view the corporate bonds that mature in 10 years or more. Then click the "Find Bonds" button.
Compare the "Yield to Maturity" column with the "Fitch Ratings" column. Note that as the Fitch Rating descends from AAA, to AA, to BBB, to BB, and so on, that the Yield to Maturity increases. In other words, bonds from such AAA rated companies as
Federal National Mortgage Association
( FNM) or
United Parcel Service
have a lower yield to maturity than CCC rated companies, such as
What is the yield on AAA bonds? What is the yield on CCC bonds? How much more is the yield on the lower rated bonds?
Return to the Bond Screener. Uncheck the "Corporate" box and check the "Treasury" box instead. Select a "Maturity Range (min)" of 10 years to view the Treasury bonds that mature in 10 years or more. Then click the "Find Bonds" button.
Treasuries are the safest bonds because the U.S. government, unlike any corporation, can essentially print money, thus guaranteeing that your principal will be returned. What is the YTM on typical 10 year Treasuries? How much less are you being paid for this margin of safety than an AAA rated corporate bond?
Knowing the basics of how bonds are priced and quoted should give you a better understanding of the bond market. In subsequent lessons and assignments, we'll examine the topics of safety, yield and return.
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