When you buy a bond, the money you pay is used as a loan by the issuer. Common bond issuers are:
- The federal government (government bonds)
- Municipalities (municipal bonds, called munis)
- Private companies (corporate bonds).
At the end of a given period of time - referred to as the bond's "maturity" - the issuer pays back the amount it borrowed (the "face value" or "par value" of the bond).
The bond's coupon rate
No one would buy a bond if the only incentive were getting back the money after a period of time. The "income" in fixed-income investing is the interest you receive at a fixed rate, called the "coupon rate" or just the "coupon." Generally, the longer the maturity, the higher the coupon, and vice versa:
- Short-maturity bonds, called "short-term" bonds, can be expected to have lower coupons. (Maturity less than 5 years)
- Medium-maturity bonds, called "intermediate-term" bonds, can be expected to offer slightly higher interest rates. (Maturity 5 to 10 years)
- Longer-maturity, or "long-term" bonds, generally have the highest coupon, since the investor's money is tied up for a longer period of time. (Maturity more than 10 years)
Usually, interest on a bond is paid twice a year.
The bond issuer's credit rating
Maturity is just one factor that affects a bond's coupon rate. Another is the issuer's credit rating - a measure of how likely the issuer is to repay the loan:
- The higher the credit rating of the issuer, the lower the interest rate is likely to be.
- The lower the credit rating of the issuer, the higher the coupon is likely to be, since investors need to be rewarded with higher interest payments for loaning money to a less creditworthy company.
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The bond's price
What makes bond investing more tricky than it might appear so far is the fact that a bond's price moves up and down according to market conditions and interest rates. So a $1,000 par-value bond might cost $900 - or $1,100. If the bond sells for less than its face value, it's said to sell at a discount. If it sells for more than the face value, it's said to sell at a premium. Of course, if a bond is held to maturity, an investor is paid the bond's full face value. However, in bond funds, the underlying bonds are rarely held to full maturity, and buying and selling take place all the time.
What causes bond prices to rise and fall? The most influential factor is overall interest rates:
- When interest rates fall, bond prices rise, since the coupon or interest rate paid by existing bonds is higher than those of the new bonds being issued. Therefore, investors are willing to pay a premium for them.
- When interest rates rise, bond prices fall. In this scenario, investors can purchase new bonds at higher interest rates, so the value of existing bonds falls and they are sold at a discount.
Bond fund managers are continually evaluating interest rate environment, creditworthiness, and the discount and premiums offered by different types of bonds to determine what to own in their portfolios.
For example, in a rising-interest-rate environment, mortgage-backed securities may be attractive for their relatively high levels of income. However, as interest rates fall, investing in mortgages may be less attractive, since investors tend to prepay and refinance their mortgages when offered lower rates.
Having an experienced manager at the helm to evaluate all these factors is one of the distinct advantages of bond fund investing.
The bond's yield
Many people are confused about the difference between a bond's yield and its coupon, or interest rate. Yield is defined as its coupon amount - not the coupon rate - divided by its price.
Take, for example, a $1,000 par-value bond with a 6% coupon rate. It pays a coupon amount of $60. So,
| If you buy that bond share |
your yield is: |
Or, the coupon amount divided by the price you pay |
| For $1,000 |
the same as the coupon: 6% |
$60 ./. $1,000 |
| at a discount for $900 |
higher than the coupon, at 6.7% |
$60 ./. $900 |
| at a premium for $1,100 |
lower than the coupon, at 5.5% |
$60 ./. $1,100 |
The rule: when a bond's price rises, its yield drops. When its price falls, its yield rises.
The individual-bond bottom line
Perhaps you begin to see why many investors shy away from individual-bond investing. With creditworthiness of the issuer, maturity, price, face value, coupon rate, and yield to consider, things can get confusing. And many people who want a bond component in their portfolio simply don't have the time to follow the ins and outs of all these factors in the bond market. Ask your financial advisor about the convenience of bond-fund investing with Calvert.
Talk with your financial advisor today about which Calvert fixed-income investments may be best suited to your needs and overall investment profile. If you don't have a financial advisor, use our free Advisor FinderTM Service to locate a qualified investment professional in your area. You can also contact our Sales Department at 800.368.2748.
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