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Investing in Bonds

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Investing in Bonds Investing in Bonds Jerry Jevic Senior Director – Investments Oppenheimer & Co. Inc. 1818 Market Street Philadelphia, PA 19103 (800) 247-3243 (215) 656-2866 [email protected] http://fa.opco.com/jerryjevic/ CONTENTS Page Why Invest in Bonds ......................................................................................................................................1 Corporate Bonds ............................................................................................................................................2 High Yield Bonds............................................................................................................................................3 Convertible Securities......................................................................................................................................6 Third Party Trust Preferred Securities ..............................................................................................................9 Municipal Bonds ..........................................................................................................................................10 Pre-Refunded Bonds (Liquid, Tax Advantaged) ............................................................................................13 Conclusion: An Essential Asset Class ............................................................................................................14 Definitions ....................................................................................................................................................15 About Oppenheimer ....................................................................................................................................17 WHY INVEST IN BONDS? Because high-quality bonds such as government securities and investment-grade corporate bonds have tended to preserve capital even in economic downturns, they have traditionally been used to help hedge portfolios against volatility. Their low correlations with stocks serve to help control risk. Prudent investors should understand the risks and rewards of different types of bonds so they can select the types, with the guidance of their Financial Advisor that meet their needs for income, fall within their risk tolerance and have the potential to help achieve their financial goals. Bonds represent contracts between a government or corporate issuer and the investor (or creditor). Creditor status gives an investor rights to repayment when a bond matures (and to pay back principal) and to interest during the bond’s life unless the issuer redeems, or calls it. When a bond is issued, its interest, or coupon rate, is fixed for the life of the bond. Bonds are usually issued at a value of $1,000 on the primary market. This is called “par value” and also referred to as the principal or face value. Bond maturities may range from a few months to as long as 100 years (century bonds). In general, longer-term bonds pay a higher rate of interest than short-term because investors require a premium if they are to lock up their money. In addition, they want to be compensated because longer-term bond prices tend to be more volatile due to fluctuations in the secondary markets and the overall economy during their duration. Although stock dividends may rise or fall, depending on a company’s performance, bonds provide a steady income stream as defined in the bond indenture – the basic document that defines the bond’s terms. Usually, bonds pay interest at six-month intervals based off their maturity date. For example, a bond issued in January would pay interest every July and January until it was called or it matured. This publication is a guide to the bond market for thoughtful investors. In addition to the high-quality government and corporate securities mentioned here, it will also deal with some of the other types of bonds investors are likely to encounter if they and their advisors seek to build a diversified bond portfolio. Among the other types of debt securities touched on here will be high yield (below investment grade) bonds, convertible securities, third party trust preferred securities, municipal bonds and pre-refunded bonds. A glossary is also provided. 1 CORPORATE BONDS Corporate bonds are issued by companies seeking to raise funds. A legal document or security contract (the indenture) defines the terms of the bond and the duties or responsibilities of all related parties. The interest, or coupon, for corporate bonds is stated in the indenture. Except for variable rate bonds, this interest rate does not change. Corporate bonds may be unsecured or secured. Unsecured bonds are backed by the full faith and credit of the issuer, while secured bonds are backed by collateral such as mortgages or equipment. Example: XYZ Corporation issues a 5% bond, due 5/15/2010, in multiples of $1,000. The rate of interest is 5%, or $50 per year for the life, or duration, of the bond. Interest is paid semi-annually on 5/15 and 11/15 in amounts of $25.00 per bond. Interest is paid until 5/15/2010 when the bond matures and the debt is repaid. • Call Feature. Usually, corporate bonds possess a call feature enabling a corporation to redeem them after a pre-set interval, often five years. Bonds are called when the issuer has calculated that redeeming them, even at a premium, is cheaper than continuing to pay interest. Thereafter, bonds may be called at any time until maturity even during a month when interest is not due. Because calling a bond deprives investors of an income stream, the investors must be compensated if they are to buy the bonds. Therefore, if the bonds are called at a time when the bondholder still has considerable interest to receive, the bond will be called at a premium to make up for the lost interest). As the bond approaches maturity (and less interest remains to be paid), its call price will drop toward par. Call schedules indicate what investors will receive as of various pay dates. They are contained in the indenture. • Secondary Market Trading. Bonds are traded day to day on the secondary market, as opposed to when they are issued. This means the price you pay for a bond on the secondary market can vary due to factors such as one bond’s interest rate compared with another; time to maturity; the issuer’s credit quality; the existence of a call feature as well as company news and general economic conditions. Bonds can be sold for more or less than the par value of the bond. • Credit Quality. Bonds come in a variety of credit qualities, as assigned by rating agencies such as Moody’s Investors Service, Standard & Poor’s Ratings Service or Fitch Ratings. These ratings range from investment grade to defaulted bonds. Some bonds carry higher ratings than might be expected because they are guaranteed by another corporation, such as a parent company, to pay interest and principal and thus protect against default. (Please see the chart on page 7.) You should review with your Financial Advisor what these ratings mean and how they correlate to your risk tolerance. • Liquidation Schedule. Corporate bonds are referred to as senior securities, because the corporation must pay bond interest before it pays dividends to stockholders. If the company goes bankrupt, bondholders and other creditors are repaid before equity owners. Who Gets Paid First? 1. Employee Wages 2. Taxes 3. Secured Creditors (including Secured Bonds) 4. General Creditors (including Debentures aka Unsecured Bonds) 5. Subordinated Creditors, including Subordinated Debentures 6. Preferred Stockholders 7. Common Stockholders 2 HIGH YIELD BONDS Until the 1970s, the high yield market was relatively small, consisting primarily of bonds issued by companies whose credit quality had declined below investment grade according to the rating agencies. Most investment portfolios tended to avoid high yield debt, and most dealers did not carry it. Today, however, the market for high yield debt has burgeoned. A report from Moody’s (quoted on April 15, 2009 by Bloomberg) claims that high yield issuers have about $25.7 billion of bonds and loans coming due in 2009, $44.3 billion in 2010 and $119.6 billion in 2011. As the high yield market has grown, it has attracted increasing numbers of investors. Institutional investors such as insurance companies and pension funds are increasingly altering their investment guidelines to purchase high yield debt, either for its higher rate of return or as an alternative to purchasing equities. Individual investors whose capital and risk tolerance enable them to do so purchase high yield bonds as part of their allocation to fixed income assets. Definition of High Yield Bonds High yield bonds are issued by organizations that do not qualify for investment-grade ratings from the major bond rating agencies. In evaluating high yield debt, rating agencies study corporate financial data. They meet with issuers’ management, set the proposed issuance in its economic and industrial context and scrutinize the bond indenture for special provisions that may create additional credit risk. Issuers of high yield bonds can include corporations, certain U.S. banks, various foreign governments and some foreign corporations. In general, high yield bonds tend to be issued in various amounts. The maturities of a high yield bond, like other types of debt, are determined by the issuer to suit their capital needs. Shorter bonds are often called notes, or short term debt. The interest from high yield bonds (but not high yield municipal bonds)
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