Corporate bonds? Government bonds? Junk Bonds? AAA Bonds ... ARGGGGHH!
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 fulltime job for many. Ok, maybe not everyone's idea of an exciting career, but
necessary and extremely helpful to the investor.
BOND TYPES BY 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.
BOND TYPES BY MATURITY and YIELDS
Bonds can be categorized by Maturity  the length of time from issuance to repayment of principal. Periods range from 3month to 30year, with
6month, 2year, 3year, 5year and 10year 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.
