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If you’re looking for investments that can provide a steady income stream, bonds and CDs are two strong choices. While both are likely to underperform riskier investments like dividend stocks or real estate in the long term, they also generally offer more safety and stability.
Bonds and CDs have a lot in common. But there are times when one may be a better choice than the other….Continue reading….
By: Clint Proctor
Source: CDs Vs. Bonds: Which Is the Smarter Investment Choice for You?
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Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process for issuing bonds is through underwriting. When a bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the entire issue of bonds from the issuer and resell them to investors.
The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The bookrunner is listed first among all underwriters participating in the issuance in the tombstone ads commonly used to announce bonds to the public.
The bookrunners’ willingness to underwrite must be discussed prior to any decision on the terms of the bond issue as there may be limited demand for the bonds. In contrast, government bonds are usually issued in an auction. In some cases, both members of the public and banks may bid for bonds. In other cases, only market makers may bid for bonds. The overall rate of return on the bond depends on both the terms of the bond and the price paid.
The terms of the bond, such as the coupon, are fixed in advance and the price is determined by the market. In the case of an underwritten bond, the underwriters will charge a fee for underwriting. An alternative process for bond issuance, which is commonly used for smaller issues and avoids this cost, is the private placement bond. Bonds sold directly to buyers may not be tradeable in the bond market.
Historically, an alternative practice of issuance was for the borrowing government authority to issue bonds over a period of time, usually at a fixed price, with volumes sold on a particular day dependent on market conditions. This was called a tap issue or bond tap. Nominal, principal, par, or face amount is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term.
Some structured bonds can have a redemption amount which is different from the face amount and can be linked to the performance of particular assets. The issuer is obligated to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond.
The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term shorter than 30 years. Some bonds have been issued with terms of 50 years or more, and historically there have been some issues with no maturity date (irredeemable). In the market for United States Treasury securities, there are four categories of bond maturities:
The coupon is the interest rate that the issuer pays to the holder. For fixed rate bonds, the coupon is fixed throughout the life of the bond. For floating rate notes, the coupon varies throughout the life of the bond and is based on the movement of a money market reference rate (historically this was generally LIBOR, but with its discontinuation the market reference rate has transitioned to SOFR).
Historically, coupons were physical attachments to the paper bond certificates, with each coupon representing an interest payment. On the interest due date, the bondholder would hand in the coupon to a bank in exchange for the interest payment. Today, interest payments are almost always paid electronically. Interest can be paid at different frequencies: generally semi-annual (every six months) or annual.
The yield is the rate of return received from investing in the bond. It usually refers to one of the following: The current yield, or running yield: the annual interest payment divided by the current market price of the bond (often the clean price). The yield to maturity (or redemption yield, as it is termed in the United Kingdom) is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the capital redemption on schedule.
It is a more useful measure of the return on a bond than current yield because it takes into account the present value of future interest payments and principal repaid at maturity. The yield to maturity or redemption yield calculated at the time of purchase is not necessarily the return the investor will actually earn, as finance scholars Dr. Annette Thau and Dr. Frank Fabozzi have noted. The yield to maturity will be realized only under certain conditions, including:
All interest payments are reinvested rather than spent, and all interest payments are reinvested at the yield to maturity calculated at the time the bond is purchased.This distinction may not be a concern to bond buyers who intend to spend rather than reinvest the coupon payments, such as those practicing asset/liability matching strategies.
The quality of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. In other words, credit quality tells investors how likely the borrower is going to default. This will depend on a wide range of factors. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.
The market price of a tradable bond will be influenced, among other factors, by the amounts, currency and timing of the interest payments and capital repayment due, the quality of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets. The price can be quoted as clean or dirty. “Dirty” includes the present value of all future cash flows, including accrued interest, and is most often used in Europe. “Clean” does not include accrued interest, and is most often used in the U.S.
The issue price at which investors buy the bonds when they are first issued will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. The market price of the bond will vary over its life: it may trade at a premium (above par, usually because market interest rates have fallen since issue), or at a discount (price below par, if market rates have risen or there is a high probability of default on the bond).
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. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders.
The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders.
Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer: Callability—Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option.
These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so-called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
Puttability—Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. These are referred to as retractable or putable bonds. Call dates and put dates—the dates on which callable and putable bonds can be redeemed early. There are four main categories: A Bermudan callable has several call dates, usually coinciding with coupon dates. A European callable has only one call date. This is a special case of a Bermudan callable.
An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of a deceased bondholder to put (sell) the bond back to the issuer at face value in the event of the bondholder’s death or legal incapacitation. This is also known as a “survivor’s option”. Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically.
The entire bond issue can be liquidated by the maturity date; if not, the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in the open market, then return them to trustees.
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