Return to:Previous Page
Morningstar.com's Interactive Classroom

Course 409
Bond Basics, Part 1

Introduction

The Investing Classroom spends a lot of time focused on investing in equities, and for good reason: Many of the investors using the Investing Classroom are looking for growth, and in general equities provide more growth over the long term than bonds.

That said, bonds provide much-needed ballast to equity portfolios. They are also key instruments when investing for shorter- and intermediate-term goals. And they are critical in retiree portfolios.

This course and Portfolio 410 provide a brief primer on bonds.

What Is a Bond?

When you buy a stock, you become part owner of the company. When you buy a bond, you are making a loan; you are simply lending money to a company (corporate bonds) or to a government (for U.S. investors, this is most commonly the U.S. government). Because U.S. government bonds (also known as Treasuries) are issued and guaranteed by Uncle Sam, they typically offer a modest return with low risk. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return.

Your loan lasts a certain period of time--until the date that the bond reaches maturity, when the principal of a bond is repaid. In the meantime, you can typically expect income payments (commonly known as coupons) as interest on the loan. Thus, the essential issues for bond investing will be the bond's maturity, how much interest it pays, and how confident you are that the business or government can actually repay the loan.

Because of their fixed interest payments and the promise of repayment at maturity, bonds are considered less risky than stocks, though they historically have also returned less than equities. So if you're buying a bond fund to give your portfolio stability or to help generate income, then your strategy may pay off. But if you think you can't lose money in bonds, guess again.

Bonds and Credit Risk

One of the key risks bond investors face involves the bond's credit quality. Credit quality simply measures the ability of an issuer to repay its debts.

Think of it this way: If your ne'er-do-well brother-in-law who's drowning in credit card debt wants to borrow $50 from you, you would probably wonder if you'd ever see that $50 again. You'd be far more likely to loan money to your super-responsible kid sister who just needs a little emergency cash. The same dynamic occurs between companies and investors. Investors more eagerly loan money to well-established companies that seem likely to repay their debts, but they think twice about loaning to firms without a solid track record or that have fallen on hard times.

Judgments about a firm's ability to pay its debts are encapsulated in a credit rating. Credit-rating firms, such as Moody's, Standard & Poor's, and Morningstar, closely examine a firm's financial statements to get an idea of whether a company is closer to being a no-goodnik or a debt-paying good citizen. They then assign a letter grade to the company's debt: AAA indicates the highest credit quality and D indicates the lowest. (Moody's uses a slightly different ratings scale than S&P and Morningstar, but the basic framework is the same.)

So if you hold a bond rated AAA, odds are very good that you'll collect all of your coupons and principal. Indeed, bonds rated AAA, AA, A, and BBB are considered investment-grade, meaning that it's pretty likely the company that issued the bonds will repay its debts. Bonds rated BB, B, CCC, CC, and C are non-investment-grade, or high-yield, bonds. That means there's a higher chance that the bond issuer will renege on its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default.

Of course, you probably don't want a bond that may not pay its promised coupons and principal. The main purpose in owning a bond, after all, is getting your hands on its income. So if you're bond shopping, you're not going to pick up a lower-rated bond just for the heck of it. You need some sort of incentive. That incentive comes in the form of higher yields. All other things being equal, the lower a bond's credit quality, the higher its yield. That's why you can find a high-yield bond fund with a yield of 5% or much more, while many investment-grade bond funds yield less than half that much. Because investment-grade issuers are more likely to meet their obligations, investors trade higher income for greater certainty.

Credit quality affects more than just a bond's yield, though; it can also affect its value. Specifically, lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession. Recessions usually mean lower corporate profits and thus less money to pay bondholders. If an issuer's ability to repay its debt looks a little shaky in a healthy economy, it will be even more suspect in a recession. High-yield bond funds usually drop in value when investors are worried about the economy.

Bonds and Interest Rates

The other key risk that bond investors face relates to interest rates. Bond prices move in the opposite direction of interest rates. When rates fall, bond prices rise. When rates rise, bond prices fall. Why? Remember that most bonds' interest payments are fixed, but prevailing market interest rates may change. If investors are able to buy a similar bond at a higher interest rate next month, then the market value of the lower-interest bond will decrease (that is, it will need to sell at a discount to its face value in order to attract buyers). When prevailing rates fall, then you could sell a higher-interest bond at a premium to face value.

To determine how dramatic a fund's ups and downs might be in a changing-rate environment, check out its duration. Duration measures a fund's sensitivity to interest rates, factoring in when interest payments are made as well as the final payment. The higher a bond's duration, the more it responds to changes in interest rates. If a bond fund has a duration of five years, you can expect it to gain roughly 5% if interest rates fall by one percentage point, and to lose 5% if interest rates rise by one percentage point. (The manager may be able to offset some of that price depreciation by buying higher-yielding securities, however.) And that bond fund with a duration of 8.5 years? We know it's more volatile, and more vulnerable to interest-rate changes, than the bond fund with a duration of five years.

Quiz 409
There is only one correct answer to each question.

1 When you buy a bond, you are
a. buying ownership in a company
b. lending money to a company or government
c. taking on a lot of risk
2 What does credit quality measure?
a. The ability of the issuer to pay its debt
b. How high the bond’s coupon is
c. When the bond will mature
3 All other things being equal, the lower a bond's credit quality
a. the lower its yield
b. the higher its yield
c. the higher its duration
4 When interest rates fall, what do bond prices do?
a. Fall
b. Rise
c. Nothing – there is no relationship between bond prices and interest rates.
5 What does duration measure?
a. A bond’s credit quality
b. A bond’s sensitivity to inflation
c. A bond’s sensitivity to interest rates
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page