How to Evaluate Bond Issues and Interest Rates
When simplified, investment markets can be divided into two types: stocks and debt. Equity investments are purchases of shares in a company and represent a portion of the ownership of the business. Shareholders may or may not receive annual dividends. Debt investments, on the other hand, represent a loan to the business with the corresponding return plus expected interest. A bondholder is entitled to regularly scheduled interest payments. Debt investments are considered a bit safer than stocks, but there is risk associated with any investment.
Debt investments are commonly known as bonds. Bonds can be issued by federal, state, and local governments, as well as corporations. There are advantages and disadvantages with either. For example, if you invest in a federal bond issue, the interest income you receive on this investment is generally not subject to state and local tax. Similarly, interest income from state and local bond issues is generally not subject to federal tax. Interest income from corporate bonds is taxed everywhere.
It’s a good idea to get educated about interest rates before investing in debt instruments. In the United States, the Federal Reserve Bank (or the “Fed”) sets interest rates. They do it in a meeting that takes place every six or eight weeks in which the national economy is evaluated. Then they decide what to do with the interest rates. This decision is based on many factors, but mainly on the rate of inflation that is being experienced.
If inflation is rising, the Fed may raise interest rates. This makes the money supply (in the form of loans) a bit tighter and harder to come by, which in turn slows down inflation. If there is little or no inflation, interest rates will probably stay as they are. If there is deflation, or a slowing economy, the Fed may try to stimulate it by lowering interest rates, allowing more people to borrow and thus stimulating the economy.
The reason you need to know what’s going on with interest rates before investing in bond issues is because bond prices are directly related to currently available interest rates. In general, if interest rates go up, the price of bonds goes down and vice versa. Of course, this means next to nothing if you intend to hold the bond to maturity. This is noticeable only if you, like most bond investors, tend to hold the bond for less time, selling it before maturity. Therefore, if you sell a bond before maturity during a period of rising interest rates, the value of the bond may be less than when you bought it.
The main characteristics of a bond issue that you should know are:
Coupon Rate – This is the interest rate that you will be paid on this loan. You should also know when it is paid. Usually this is once or twice a year on specific dates.
Maturity Date – This is the date the loan matures and is payable. On this date, the company will return the capital it lent you.
Purchase clauses: Some bonds include the right of the borrower to repay the loan proceeds early. Some are not required. Those that are callable are generally returned at a higher price than what you originally paid when the early option is exercised. Keep in mind that when a bond issue is callable and interest rates are falling, it will often be financially advisable for the company to buy back your bond with the proceeds of a new bond issue at the new lower rates.
The biggest risk in investing in bonds is that the issuer goes out of business. That’s why federal bonds are so popular; there is virtually no chance of the federal government going bankrupt! Federal Treasury bonds are among the safest investments you can make. Corporate bonds, however, are a different story. Any company can go out of business for any number of reasons. If you have an investment in a company’s bonds when this happens, your investment is almost worthless almost immediately. However, bondholders DO have priority over shareholders and will be paid first. Senior bondholders can even claim physical assets upon company liquidation.
Bonds are a good, fairly safe investment as long as you keep these risk factors in mind. A good mix of corporate, federal and local government bonds is recommended. Even throwing in some high interest rate junk bonds could be profitable. Diversification reduces risk, even in the bond market.