Investing 101 – Debt Securities

Bonds are securities, but they are called debt securities or fixed-income securities. In the case of a bond, you are investing your money as a loan to a corporation (or U.S. government or another foreign government) in hopes of receiving regular interest payments, as well as a return to you of the money you put up to buy the security, your “principal.” Bonds are used in investing for regular cash flow where you don’t have an immediate need for the principal. Bonds are issued with “maturity” dates, meaning the date the loan comes due and bond principal is paid back to you.

Debt securities are traded just the same as equity securities on exchanges, and are rated by rating agencies. Moody’s Investor Services and Standard & Poor’s are rating agencies that publish bond ratings. The best quality bond is rated Aaa by Moody’s and AAA by Standard & Poor’s. They are established by looking at the issuer and its ability to repay the principal plus interest. The more creditworthy the corporation, the greater its ability to pay principal and interest, the higher the rating on the bonds it issues. Few bonds are in the triple-A category.

A “high quality” bond is rated Aa by Moody’s and AA by Standard & Poor’s and an upper-medium quality bond is rated A by Moody’s and Standard & Poor’s.

Ratings go down from A to D. The lower the rating, the higher the risk that the issuer of the bond will be unable to repay principal and interest. The D rated bonds are highly “speculative” and are often called “junk” bonds because they are the lowest grade and may default. So who would purchase such a bond and why? The reason is interest rates on these bonds. To compensate for the low rating, the issuer pays a higher rate of interest, because they have a high default risk.
The general categories of bonds are those issued by corporations, the U.S. government, municipal governments and government-sponsored, but private agencies such as Fannie Mae and Freddie Mac that may issue mortgage-backed securities. Bonds are also called fixed-income securities. As the name suggests, when you buy a bond you are expecting regular payments of income on your loan.

What about bond prices? The price of a bond varies inversely with the interest rate on the bond. What does this mean? It means that when the price is up, the interest is down and vice versa. Why? Bonds pay a certain interest rate. If the interest rate on a bond is 7% and a year after you buy it, interest rates on similar bonds go to 9%, your bond will not be in high demand by investors—to sell your bond, you’ll have to discount the price to make the interest payments equivalent to 9%. If you plan to hold the bond until maturity, you don’t have to discount the price.

Prices of corporate and municipal bonds are quoted in points and 8ths of a point and each point is a unit of $10. You can multiply the listed price by 10 to get the actual price. For example, if a bond’s price is quoted at 95 1/2, it’s selling at $950 (95.5 X 10).

Prices of Treasury bills and notes are quoted in units of 100 and 32nds of 100. To get the actual price, you multiply by the number 10. For example, if a T-bond’s price is 100 and 9/32 (100.09), to get the actual price, convert the fraction to a decimal (9/32=9 X 0.3125=2.8125), then attach it to the end of the whole number. So, a bond quoted as 100 and 9/32 is selling for $1,002.85.

A bond trading at 100 is trading at its exact par value ($1,000). A bond quoted over 100 is trading at a “premium.” A bond quoted under 100 is trading at a “discount.”
Bonds that pay no interest while the loan is maturing are called “zero coupon bonds.” Instead of receiving fixed-interest payments, investors holding these receive a lump sum at maturity. Corporate, municipal and Treasury bonds are available as zero coupon bonds. You buy zeros at a deep discount, far lower than the par value. When the zero matures, the accrued interest and the original investment add up to the par value of the bond. Zeros look good to investors with a long time horizon because they are inexpensive. However, keep in mind that unless you purchase tax-exempt municipal zeros or you buy them in a tax-free account (such as through a qualified retirement plan), you will have to pay tax every year on the interest you would have received as if it had been paid to you. Zeros have long times to maturity. Keep in mind that the market for zeros is highly volatile and if you need to sell before the zero reaches maturity, you may lose money.

Another way of looking at bonds and interest rates involves the risk of holding a bond over time. The longer a bond has until it matures, the greater the risk that the issuer of the bond could default and typically longer-term bonds will pay a higher rate of interest to compensate for that default risk.

“Yield” is the amount you actually earn in bond interest expressed as a percentage. So, if you buy a 10-year $1,000 bond paying 6% and hold it to maturity, you’ll earn $60 a year for ten years. This is an annual yield of 6%, the same as the interest rate. But, if you buy in the “secondary market” after the bond is issued, the bond’s yield may not be the same as the interest rate—that’s because the price you pay for the bond affects the yield.

For example, if a bond’s yield is 5%, it means your interest payments will be 5% of what you pay for the bond today. You will get back 5% of your investment annually.

Another way of measuring a bond’s value is called “yield to maturity.” This is a complicated mathematical formula that takes into account the interest rate, price, purchase price in relation to par value and years remaining to maturity. Yield to maturity can be found through brokers or on websites.

Finally, many corporate bonds have “redemption” features. This means that the corporation can redeem or call all the bonds by paying off the principal at any time. Redemption features complicate long-term planning and any bond you purchase should be studied to see if it has redemption features.

About the Author: Lyn Striegel is an attorney in private practice in Chesapeake Beach and Annapolis. Lyn has over thirty years experience in the fields of estate and financial planning and is the author of “Live Secure: Estate and Financial Planning for Women and the Men Who Love Them (2011 ed.).” Nothing in this article constitutes specific legal or financial advice and readers are advised to consult their own counsel.