Bonds (and fixed-income investments in general) are too often overlooked by most investors as viable alternatives to stocks . Why is that the case?

Here are a few reasons that I think generate a general disdain for this asset class :

  • Bonds offer little instant gratification to investors.
  • Bonds are seen as "boring." In other words, there is no "story" to tell. It is more sexy to discuss your purchase of Baidu (BIDU) than the "5.25% General Electric (GE) of 2010" (a GE bond paying a 5.25% annual interest rate that will mature in 2010) in your portfolio .
  • Bonds are traded in dealer markets and as such receive little or no media attention.
  • Bond pricing (see valuation ) is far less transparent that stock pricing.
Individual investors can overcome this last reason with some basic terminology and a calculator. This installment of The Finance Professor will look at the five things you need to know about how bonds are priced.

1. What Bonds Are

Bonds are created when a corporation or government borrows money today in exchange for the promise to repay the money, with interest, in the future. These bonds represent an obligation on the part of the borrower ( debtor ) to that of the lender ( creditor ). Thus, bonds have a series of future cash flows that must be priced to arrive at a total price for the bond.

2. Types of Bond Issuers

Bonds are issued by a multitude of borrowers ( issuers ). Before you can price a bond it is important to understand the category of bond that you are looking at. The following is a list of the most common types of bonds that you might encounter.

  • Corporate : Simply put, these are bonds issued by a corporation (see "Corporate Bonds" ).
  • Municipal (or "Muni"): This category of bonds is issued by a state, city, county or other municipality (see "Municipal Bonds" ).
  • U.S. Government (or Treasury): Bonds issued by the U.S. Treasury on the full faith and credit of the United States of America (see "Treasury Bonds" ).
  • Sovereign:These are bonds issued by foreign nations.
  • Agency: Bonds issued by agencies of the U.S. Government or pseudo-governmental entities. An example of such bonds are those issued by Fannie Mae (FNM).
  • Asset-backed securities (or asset-backed bonds): These are the "bad boys" of the credit markets at the heart of the current mortgage and credit crisis. Asset-backed securities take many forms, such as pools of mortgages or auto loans (see "Mortgage-Backed Securities 101" ).

So why is it important to know the class of bond you are trying to price? There are two main reasons:
1. Some bonds, such as corporate bonds, are taxable. Other bonds, such as municipals, may be "triple tax exempt ," free from federal, state and local taxes. U.S. Government bonds are taxable by the IRS (U.S. Internal Revenue Service) but not by state or local governments.

2.Not all bonds are alike. There can be differences between bond classes and within bond classes (see subclass ). This is due to the credit worthiness (see credit rating ) of the issuer. I will tackle that in the next section.

3. Credit Ratings and Spreads

Not all borrowers are alike. Let's look at two extremes. On one end, you have a borrower who is so credit worthy that they will almost certainly repay their debt. Let's call this debtor the "Omnipotent Borrower." On the other end, you have a borrower whose ability to repay their obligations is far less certain. Let's call this one the "Deadbeat."

If interest rates were the same for all borrowers, as a lender, you would still be more likely to lend money to the Omnipotent Borrower rather than the Deadbeat. So in order to entice lenders to extend credit to the Deadbeats, these higher- risk borrowers have to agree to pay lenders a higher rate of interest than the Omnipotent Borrowers have to pay.

Thus, to differentiate the riskiness of borrowers, the markets have established a rating system. Bond issuers are evaluated for their ability to repay based upon a review process. The most influential rating agencies are Moody's , Standard & Poor's and Fitch.

These agencies will express their ratings in some sort of gradation, with the highest credit rating assigned to the U.S. Government. After the U.S. Government, the highest credits are then typically assigned an AAA rating, followed by AA, A, BBB, BB, B, CCC and so on. Some rating agencies also add a plus (+) or minus (-) designation.

With the ratings in hand, the markets will then be able to ascertain the rates of interest that all borrowers will be required to pay. U.S. Government bonds, being the least risky and most liquid debt securities, are the base (see benchmark ) on which other rates are established (see "Bond Ratings" ).

A credit "spread" is then established by the marketplace. This spread represents the difference in interest rates between U.S. Government securities and other debt instruments that are identical in all respects except for credit rating (see yield spread ).

4. Yield Curve

While one facet of bond risk is the credit rating, there is another element of risk to consider, the dimension of time. Holding credit ratings constant, the interest rate demanded by lenders will vary according to time to maturity. The relationship between time and interest rates is referred to as the yield curve .

Normally, as time increases, the yield on bonds will increase. This is referred to as a normal yield curve. On some occasions, yields will be less for longer maturities than short maturities. This is referred to as an inverted yield curve. Inverted yield curves are the result of supply-demand conditions or, in some investors' opinions, an inverted yield curve is a signal of an impending financial crisis or imminent recession .

5. Forms of Bonds

There are several different forms of bonds. Before pricing a bond, one must understand its investment characteristics. Here are some of the most common forms and their unique characteristics:

  • Coupon Bonds: These are bonds that have periodic interest payments. There are two types of coupon rates : fixed and floating. With a fixed coupon rate (similar to a fixed-rate mortgage ), the interest rate remains the same throughout the life of the bond. On the other hand, with a floating rate coupon bond, the interest rate will vary according to some predetermined formula on a periodic basis.
  • Zero-Coupon Bonds : Sometimes referred to as "zeros" or discount bonds, these bonds will not pay periodic interest payments to bond holders. Instead, the borrower will receive an amount less than its maturity value on issuance of the bond in return for payment of the full face value at maturity.
  • Convertible Bonds : These are bonds that can be exchanged for shares of stock in the issuer's company. Some convertible securities are mandatory convertibles, while others are convertible at the option of the holder (see "Convertible Bonds" ).
  • Equity - Indexed Linked Bonds: These are notes that have a debt component and a contingent payment based on the performance of a particular stock or stock index.

Homework Time

  • 1. Identify several bonds that you would be interested in buying. Then determine what the credit spread is and compare those spreads against the issuers' credit ratings .
  • 2. For one bond issuer, identify different forms of bonds (such as fixed, floating and convertible) and compare the yields for each form.
  • 3. For the same maturity date , compare the yields for different type of issuers (such as U.S. Government, corporate, agency and municipal).

To learn more about bond investing, check out these tutorials on

  • Getting Started With Bonds
  • Bond Mutual Funds
  • Building a Do-It-Yourself Bond Portfolio
  • Booyah Breakdown: Bonding With Bonds, Part 1 , Part 2 and Part 3
At the time of publication, Rothbort had no positions in the stocks mentioned, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at Scott appreciates your feedback; click here to send him an email.

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