Different Types For Different Results

Corporate or Government. AAA or Junk. Subordinated or unsubordinated. 30 year or 3 month. The list goes on.

Classifying and tracking the different types of bonds is a full-time job for many. Ok, maybe not everyone's idea of an exciting career, but necessary and extremely helpful to the investor.

ISSUER and RISK

One way to divide bond types is by issuer. The practice isn't trivial, since it guides the investor in making decisions about risk, yield and tax liability.

Bonds range from U.S. Treasury (or Euro) bonds, bills or notes (the terms refer to different maturities - the number of years before the principal is repaid), considered among the lowest risk, down to corporate junk bonds or worse.

Risk and yield (total return over time, in percentage terms) tend to be correlated. That is, a low risk bond tends to yield a low return (say 3%). Junk bonds have some of the highest yields, but are some of the riskiest since the chance of default on the principal is high. If the business fails, even though bondholders get priority on assets, position in line is unimportant if there's nothing to hand out.

When a company does default with salable assets, priority comes into play. When assets are liquidated, unsubordinated (senior) security holders are paid before subordinated, who are paid before shareholders (owners of stock). Hence, bonds carry classifications of Subordinated or Unsubordinated - something to consider when making estimates of risk.

MATURITY and YIELDS

Bonds can be categorized by Maturity - the length of time from issuance to repayment of principal. Periods range from 3-month to 30-year, with 6-month, 2-year, 3-year, 5-year and 10-year also standard. Corporates tend to be on the shorter end of the scale.

The existence of different periods entails the need to consider: (1) How long to invest capital vs the desire or need to sell prior to maturity date - which implies the possiblity of selling at a loss, (2) calculation of total yield vs what could be obtained from another investment.

Calculating yield is a bit complex for the average investor, but fortunately utilities to perform it are readily available on the Internet. For those interested in the mathematics the formula is:

c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-n + B(1 + r)-n = P
where
c = annual coupon payment (in dollars, not a percentage)
n = number of years until maturity
B = par value (original issue price)
P = purchase price

Suppose a bond is selling for $950, and has a coupon rate of 7%, it matures in 4 years, and the par value (original issue price or face value) is $1000. What's the YTM, Yield To Maturity? The coupon payment is $70 (that's 7% of $1000), so the equation is:

70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950.

Using one such caculator: r = 8.53% which is the Yield. You can observe it's higher than the rate.

PREDICTABILITY

The details are complicated, but the lesson is simple and to the investor's advantage. Since bonds have fixed characteristics their risks and returns are much more readily predictable with confidence. No investment is certain, but bonds have attractive features not shared by other choices. Every portfolio should have some.