Bonds with high credit ratings and returns
In some ways, bond issuers are just like regular people who need to borrow money: those with the highest credit rating get to pay the lowest interest rate. However, once issued, most bonds are bought and sold through brokerage firms on the secondary market. A bond issued at one rate may pay a higher or lower rate to investors who buy them after the initial offering.
The basic factors that determine what bonds and other credit securities pay are: the creditworthiness of the borrower, the terms of the loan (how much time the loan will be outstanding before the lender gets paid back), prevailing interest rates and their direction (up or down), and other risk factors.
What is a bond?
When a company, a government or federal agency or other organization issues a bond, they enter into a legal agreement with the purchaser (the lender) to make payments over a specified period of time – days, months or years – until the bond reaches maturity. When the bond matures the issuer must pay back the face value of the loan – called its par value. In addition to the creditworthiness of the issuer, the time until maturity influences the interest rate. If you pay back a loan within a relatively short period, you’ll usually pay a lower rate.
What do you call a bond?
Of course, as with most legal agreements, things can get complicated. Many bonds include a “call” provision allowing the bond issuer to pay back the principal before the maturity date. If interest rates are falling, bond issuers are more inclined to issue bonds that can be called early because they hope to be able to re-issue new debt at lower rates. The opposite holds true if interest rates are rising; issuers stand to benefit if current interest rates rise. Bond buyers want to enjoy as high a stream of income for as long a time as possible. That’s why when interest rates rise bond prices fall because investors prefer to buy newer bonds that pay higher rates.
How to buy at a discount
On the other hand, investors who buy older issues may get them at a discount. A newly issued $1,000 bond paying $65 a year has a current yield of 6.5 percent. Someone who buys that bond after the price has dropped to (say) $950, would have an effective yield of 6.84 percent.
Who rates bonds?
Bond rating organizations like Moody’s Investors Service or the Standard & Poor’s Corporation are the most frequently cited sources of bond ratings. The highest rating is AAA and they slide down the alphabet to D, the worst. Bonds receiving a rating of Baa or better by Moody’s (BBB or better by Standard & Poor’s) are considered “investment grade.” Bonds with below investment-grade ratings are often referred to as junk bonds, but they are popular among investors who feel they can afford to accept greater risk return for higher yields.
To get as high a yield as possible from a bond with a high credit rating as you can, first look for borrowers like the U.S. government that are regarded as top rated, primarily because they are backed by the ability of the government to raise taxes to repay the debt. Bonds issued by foreign governments (sovereign bonds) reflect the perceived creditworthiness of the issuing governments.
The maturity benefit
Once you have selected the type of issuer that fits your risk tolerance level, look for bonds issued with as long a maturity as possible within your individual comfort zone. Short-term bonds are typically defined as maturing in one to three years. Intermediate-term bonds generally mature in four to ten years. Bonds with 30 years to maturity are regarded as long-term, and the prospect of receiving a steady stream of income for that long can be attractive until you remember that interest rates rise and fall over time, along with the cost of living. Many investors chose to invest in mutual funds that invest in bonds because the professionals who manage the funds can buy and sell bonds and adjust their strategies to suit changes in the markets.
In addition to major news organizations like The Wall Street Journal, many resources are available on the internet, including www.BondsOnline.com, which offers newsletters and information on securities covering major and emerging markets across the globe. Another site, www.investinginbonds.com, produced by the Securities Industry and Financial Markets Association, includes information on current yields on Treasury bonds with different maturities, as well as articles and other information of interest to bond investors.