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FIXED-INCOME INVESTMENTS
Characteristics: A bond represents a debt, or an IOU,
from the issuing entity to the bondholder. Both governments and corporations
borrow billions of dollars from individual investors. The amount of the loan is
known as the principal, and the compensation given to lenders for making such
funds available is typically in the form of interest payments. As with stocks,
there are essentially two ways to make money from bonds: (1) capital gains,
which are achieved by selling a bond for more than it cost to buy, and (2) the
receipt of periodic interest payments.
Corporate bonds historically have been viewed as safer than
stocks. At least in part, this is because bonds have a claim on earnings and
assets that ranks ahead of all equity securities in a corporation's capital
structure. A bondholder is a creditor of the issuing corporation. A
shareholder, on the other hand, is a part owner and is entitled only to a
proportionate share of residual assets and earnings, if any. Thus, if financial
problems result in the liquidation of a company, bondholders have greater
protection in getting at least some return on their investment.
That doesn't mean all corporate bonds are safe. The risk level
of bonds in general has heightened during the past several decades, because of
wide swings in the interest rates and the sizable amount of so-called junk
bonds issued during the 1980s. Corporate junk bonds are issued with
significantly above average interest rates, which are typically required to
compensate investors for a greater amount of uncertainty about the issuing
corporation's ability to meet its scheduled interest and principal payments.
Junk bonds were popularized in the 1980s, when many were issued to finance big
corporate takeovers. Some junk bonds have provided regular streams of interest
payments and have risen in price, but there have also been some sizable
defaults on junk bond obligations. Junk bonds are considered noninvestment
grade securities, a speculative category that precludes many money managers
from owning them.
U.S. government securities include Treasury bills, notes, and
bonds. Treasury bills are short-term obligations (mostly with 13-, 26-, and
52-week maturities) sold by the federal government through competitive bidding.
Bills are generally issued in $10,000 minimum denominations, then in $5,000
increments above $10,000. These bills are sold for less than their face value,
the discount representing the interest. In this respect, these bills are
similar to the Series EE Savings Bonds, which are also sold at a discount but
are paid off at full face value at maturity. Treasury notes may run up to 7
years, while Treasury bonds typically have maturities ranging from 5 years to
30 years. Interest income on debt obligations of the federal government is
typically exempt from state and local income taxes, but is subject to federal
taxes. The relatively low credit risk of government securities, plus their
favorable tax treatment, causes them to generally provide a lower pretax yield
than that of corporate fixed-income securities with similar maturities.
Newly-issued bills, notes and bonds can be bought directly from
the Federal Reserve, an approach which provides savings in transaction costs.
Also, investors can make individual purchases through a bank or brokerage firm.
However, most individual investors typically own such securities through their
participation in a mutual fund.
Municipal bonds are issued by towns, cities, and regional and
local agencies. They are favored by investors in high tax brackets because
interest income is generally exempt from both federal income taxes and those,
if any, of the state and locality where the bond was issued. Capital gains on
all such bonds are treated as normal taxable income, however. The minimum
principal amount of a municipal bond is typically $5,000, although they are
sometimes issued at a discount. Growing financial problems facing some
municipalities have caused the risk level of certain municipal bonds to
increase.
The tax-exempt feature of municipal bonds allows municipalities
to borrow money at lower interest rates. These bonds can provide investors with
opportunities, on an after-tax basis, to achieve a greater return, for a given
amount of risk, than would otherwise be available. To compare the after-tax
yields of a taxable bond and a tax-free bond, divide the tax-free rate by the
reciprocal of your tax bracket. For example, for an investor in a hypothetical
31% tax bracket, a 6% tax-free bond is the same as an 8.70% taxable yield:
computed as 0.06/(1 - 0.31) (see Table 5). Such comparisons should be made
among bonds of similar credit quality and maturity dates.
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Credit Ratings: A major concern to
prospective bond owners is the ability of a borrower to meet its debt
obligations. Typically, the interest level of the debt has a close relationship
to the borrower's perceived creditworthiness.
The interest rate on U.S. government securities is sometimes
called the risk-free rate of return, because the chance that the federal
treasury will default on its obligations is slight. Since corporations are
viewed as riskier borrowers, they must typically pay a higher interest rate
than the U.S. government when they borrow. Lenders want a greater return to
compensate them for holding riskier bonds.
Standard & Poor's assigns credit ratings to corporate and
municipal bonds. AAA (Triple A) is the highest rating assigned by Standard
& Poor's to a debt obligation. It indicates an extremely strong capacity to
pay principal and interest. Bonds rated AA are just a notch below, then single
A, then BBB, and so on. Some ratings show a + or - sign to further
differentiate creditworthiness. A BBB rating means that the issuer has an
adequate capacity to pay principal and interest, but less so than an issuer
with an A rating under adverse economic conditions or changing circumstances.
Bonds rated BBB- and above are referred to as investment grade,
a category to which certain investors, including many pension funds, confine
their bond holdings. Bonds rated BB, B, CCC, CC, and C are regarded, on
balance, as predominantly speculative. A bond rating of D indicates payment
default, or the filing of a bankruptcy petition. (Other firms also assign
credit ratings to bonds, and their opinions and terminology may differ from
those of Standard & Poor's.)
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