Bonds
StateTrust's fixed income desk deals in all major regions of the world from the developed
markets of the U.S. and Western Europe to emerging markets in Latin America, Eastern
Europe, Middle East, Africa, and Asia.
Our Fixed Income desk can help clients trade more than 25,000 bonds from 90 different
dealers and keeps them up-to-date with events happening in the fast-changing bond markets.
What is a Bond?
A bond is a debt security, in which the authorized issuer ("debtor") owes the holders
("lenders") a debt and, depending on the terms of the bond, is obliged to pay interest (the
coupon) and/or to repay the principal at a later date, termed maturity. A bond is a formal
contract to repay borrowed money with interest at fixed intervals.
Bonds can be issued in foreign currencies. Issuing bonds denominated in foreign currencies
allow issuers to tap into investment capital available in foreign markets. Some foreign issuers
look to diversify* their investor base away from their domestic market.
* Diversification does not guarantee a profit or ensure against loss.
Bond Valuation
The price of a bond is influenced by the following factors:
Interest rate expectations.
Current market interest rates.
Maturity or length of the term.
Creditworthiness of the issuer.
These factors are likely to change over time, so the market price of a bond will vary after it is
issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily
issued at par (100% of face value, corresponding to a price of 100), but bond prices converge
to par when they approach maturity (if the market expects the maturity payment to be made in
full and on time) as this is the price the issuer will pay to redeem the bond.
Features of Bonds
Features
Principal Amount
The amount on which the issuer pays interest, and which,
most commonly, has to be repaid at the end of the term of the
bond.
Coupon
The contractual interest rate that the issuer pays to the bond
holders.
Maturity
The date on which the issuer contractually has to repay the
nominal amount.
Price
The price paid by an investor to buy the bond. Issue Price is
the price paid when the bond is issued.
Interest Structure
The interest rate can be fixed or variable. Variable rates are
typically linked to money market indexes such as LIBOR.
Quality
Credit ratings can provide a quality grading of certain bond
issues. Investment grades bonds will have the best rating and
junk bonds the worst.
CallabilityPutability Some bonds give the issuer the right to repay the bond before
the maturity date on the call date (callability). Other bonds
give the holders the right to force the issuer to repay the bond
before the maturity date on the put dates (putability).
Convertibility
Lets bondholders exchange a bond for a number of shares of
the issuer's common stock.
Coupon Dates
The dates on which the issuer pays the coupon to the bond
holders. In the U.S. and Europe, most bonds are semi-annual,
which means that they pay a coupon every six months.
Indentures and
Covenants
An indenture is a formal debt agreement that establishes the
terms of a bond issue, while covenants are the clauses of such
an agreement. Covenants specify the rights of bondholders
and the duties of issuers, such as actions that the issuer is
obligated to perform or is prohibited from performing.
Types of Bonds
Type
Description
Fixed Rate Bonds
The coupon remains constant throughout the life of the bond.
Floating Rate
Bonds
The coupon is variable and linked to a reference interest rate
such as LIBOR, Euribor or Prime.
Zero-Coupon
Bonds
They pay no regular interest. They are issued at a discount to
par value, so that the interest is effectively rolled up to
maturity permitting the bondholder to receive the full principal
amount on the redemption date.
Inflation Linked
Bonds
The principal amount and the interest payments are indexed to
inflation.
Asset Backed
Securities
The interest and principal payments of these bonds are backed
by underlying cash flows from other assets.
Perpetual Bonds
Also known as Perpetuities, these bonds have no maturity date.
Bearer Bonds
Are bonds represented by an official certificate issued without
a named holder. In other words, the person who has the paper
certificate can claim the value of the bond. Bearer bonds are
very risky because they can be lost or stolen and are seen as an
instrument to conceal income or assets for tax purposes.
Registered Bonds
Are bonds whose initial ownership (and that of any subsequent
purchaser) is recorded by the issuer, or by a transfer agent. It
is the alternative to a Bearer bond. Interest payments and the
principal due upon maturity are sent to the registered owner.
Categories of Bonds
Bonds can be categorized by Type of Issuer. There are generally two type of issuers:
Corporate Bonds - These are bonds issued by companies. Large corporations have a
lot of flexibility as to how much debt they can issue. Generally, maturities for
short-term corporate bonds are less than five years; for intermediate bonds maturities
range from five to twelve years, and for long term bonds maturities are usually over
twelve years. Corporate bonds are characterized by higher yields because there is
generally a higher risk of a company defaulting than a government.
Government Bonds - These are bonds issued by a sovereign state. Depending on their
maturities they can be classified as: Bills (debt securities maturing in less than a year),
Notes (debt securities maturing in 1 to 10 years) and Bonds (debt securities maturing in
more than 10 years).
Additionally, Bonds can be categorized by the geography or region of the Issuer. For example:
Domestic Bonds
International Bonds
Emerging Market Bonds
Asian Bonds
United States Bonds
US Government
Securities
Treasuries
Description
Treasury Bills - These feature the shortest maturities—13, 26,
and 52 weeks—and are considered as liquid as cash. Along
with minimal credit risk, they also have minimal interest rate
risk because they mature so quickly.
Treasury Notes - These mature between 2 and 10 years, which
means that there is more interest rate risk and that their prices
rise and fall more than Treasury bills.
Treasury Bonds - Government securities with up to 30 year
maturities.
Zero-Coupon Treasuries - Also known as strips, these
securities are the most volatile. Also, even though you do not
get any interest payments, you will pay taxes as though you
do. One way to take advantage of them is to buy them through
tax-deferred accounts like Individual Retirement Accounts
(IRAs).
Treasury Inflation-Protected Securities - Known as TIPS,
these securities are issued by the US Treasury department as a
special kind of security whose principal amount is adjusted for
inflation. The Treasury Department issues TIPS because it
believes their issuance will reduce interest costs to the
Treasury over the long term and will increase the different
types of investors that buy their debt instruments.
Municipal Bonds
Municipal bonds, known as "Munis", are the next progression
in terms of risk. Cities don't go bankrupt that often, but it can
happen. The major advantage to munis is that the returns are
free from federal tax. Furthermore, local governments will
sometimes make their debt non-taxable for residents, thus
making some municipal bonds completely tax free. Because
of these tax savings, the yield on a muni is usually lower than
that of a taxable bond. Depending on your personal situation, a
muni can be a great investment on an after-tax basis.
Federal Agency
Bonds
Federal agencies in the U.S. issue a massive amount of
debt—in the trillions of dollars. Some of these Agency Bonds
are:
Fannie Mae - Bonds issued by the Federal National Mortgage
Association (FNMA).
Freddie Mac - Bonds issued by the Federal Home Loan
Mortgage Corporation (FHLMC).
Ginnie Mae - Bonds issued by the Government National
Mortgage Association (GNMA).
Bonds issued by the Federal Farm Credit Banks Funding
Corporation.
Bonds issued by the Federal Home Loan Banks Office of
Finance (FHLB).
US Series Savings
Bonds
Series EE Bonds - Are offered in 8 denominations ($50, $75,
$100, $200, $500, $1,000, $5,000 and $10,000). They are
purchased at 50% of their face value and are guaranteed to
reach face value in 20 years.
Series I Bonds - Are offered in 7 denominations ($50, $75,
$100, $200, $500, $1,000 and $5,000). They are purchased at
face value.
Bond Market Performance
Bonds historically have provided relatively stable returns. The following image illustrates the
growth of a $1 investment in high-yield corporate bonds, investment grade corporate bonds,
government bonds, municipal bonds, and cash over the period January 1, 1926, through
December 31, 2010:
Source: StateTrust’s analysis of Morningstar data. Performance shown is not indicative of
the performance of any specific investment. An investor cannot invest in an index, such as the
one these graphs are based on. Past returns are no guarantee of future performance. These
returns are based on historical information, from sources believed to be reliable, but accuracy
cannot be guaranteed, and these returns can vary in future time periods.
Adding a Bond Allocation to Diversify*
Historically, adding bonds to a portfolio comprised of stocks and cash equivalents has reduced
portfolio volatility without sacrificing the level of return. This image illustrates the risk and
return profiles of two hypothetical investment portfolios over a 40 year period (1971-2010).
Although both portfolios had the same level of return, the portfolio containing bonds assumed
Although both portfolios had the same level of return, the portfolio containing bonds assumed
less risk—meaning it experienced less volatility. The graph below illustrates that by
diversifying* the original portfolio the overall risk of the portfolio was reduced without
having to sacrifice the 9.8% return.
Return* 9.8%
Risk
12.8%
Return* 9.8%
Risk
9.9%
Source: StateTrust’s analysis of Morningstar data. Performance shown is not indicative of
the performance of any specific investment. An investor cannot invest in an index, such as the
one these graphs are based on. Past returns are no guarantee of future performance. These
returns are based on historical information, from sources believed to be reliable, but accuracy
cannot be guaranteed, and these returns can vary in future time periods.
* Diversification does not guarantee a profit or ensure against loss.
When developing a portfolio asset-allocation policy, it is important to understand the
risk/return relationship of the assets being considered. The following image illustrates the
risk/return relationship of five traditional asset classes over the period 1926 - 2010:
Source: StateTrust’s analysis of Morningstar data. Performance shown is not indicative of
the performance of any specific investment. An investor cannot invest in an index, such as the
one these graphs are based on. Past returns are no guarantee of future performance. These
returns are based on historical information, from sources believed to be reliable, but accuracy
cannot be guaranteed, and these returns can vary in future time periods.
Credit Rating Agencies
Rating agencies are private companies that measure the financial status and repayment
capability of bond issuers. Ratings, quite simply, evaluate the probability that bond issuers
will repay the principal and interest of bonds in full and on time. They are not
recommendations on which bonds to buy and sell.
In the United States all of the ratings agencies are supervised by the Securities and Exchange
Commission (SEC) which does not allow for conflicts of interest between rating agencies and
the groups that they are rating.
Some of the top global Bond rating agencies are:
Standard and Poor's Ratings Services.
Moody's Investor Service.
Fitch/IBCA Ratings.
Duff & Phelps.
Rating agencies use four different elements to provide bond ratings:
Capacity - The bond issuer's ability to repay the interest and principal on time.
Character - Explores management's history, success with business plans, honesty, and
operations.
Collaterals - Assets used to back contractual debt.
Covenants - Conditions the bonds were issued under—decide who gets paid back first
in the event of a default and if the bonds can be called back.
Factors Affecting Bond Ratings
The quality of a Bond is influenced by a variety of factors. Some factors are directly
dependent to the issuer's ability to meet its financial obligations and other factors are
dependent on the issuers environment such as country regulations, currency and political
environment. All these factors can cause a change in the bond's rating.
Important factors that are considered by rating agencies are:
Economic fluctuations.
Business climate.
Company reorganization.
Management restructuring.
Tax increases/decreases.
Revenue increases/decreases.
Changes in the regulatory environment affecting the issuer.
Net income changes
Bond Credit Rating System
Moody's
S
Fitch
&P
Best Quality
Aaa
AAAAAA
High Quality
Aa
Risk Grade
Bond
Grade
Investment
High-Medium Grade
A
Bonds
Quality
Medium
Quality
Speculative
Very
Speculative
Baa
Speculative Ba
Grade
Bonds
B
Caa
Poor Quality
Highly
Speculative
Junk
Bonds
Ca
Meaning
Issuers exceptionally stable and
dependable.
High quality, with slightly higher
AA AA
degree of long-term risk.
High-medium quality, with many
strong attributes but somewhat
A A
vulnerable to changing economic
conditions.
Medium quality, currently
BBBBBB adequate but perhaps unreliable
over long-term.
Some speculative element, with
BB BB moderate security but not well
safeguarded.
Able to pay now but at risk of
B B
default in the future.
Poor quality, clear danger of
CCCCCC
default.
Highly speculative quality, often
CC CC
in default.
Bonds
Lowest Rated
C
C
C
In Default
-
D
D
Poor prospects of repayment
though may still be paying.
In default.
Bonds' credit rating movements are highly correlated with price movements in the same
direction. That is, as credit ratings go down, they will pressure bond prices downward.
Likewise, if credit ratings go up, they will push the prices upward.