• Home
  • Knowledge base
  • Useful Forms
  • FAQ

Bonds

  • A corporate bond I own has just been called by the issuer. How can a company legally take away my bond? How do these call provisions work?
    A:

    Bond issues can contain what is referred to as a call provision, which is a right afforded to the issuing company enabling it to refund the bondholder the par value of his/her bond (perhaps including a small call premium) at the company's discretion. Any and all call provisions applicable to a bond issue will be included in the bond issue's indenture, so be sure you understand the details of the indenture for the bond you are buying.

    Most of today's corporate debentures are callable bonds, and about 70% of municipal bonds are callable too - so if you are interested in trading bonds, you should understand how they work.

    Call provisions contain several specific rules which apply to the issuer and the bondholder. First, there will generally be a waiting period, starting immediately after the bond issue is offered, during which the company cannot call the bond. This provides the bondholder with a guaranteed length of time he/she will be able to hold the bond. Next, call provisions also specify the price at which the company must buy the bonds back from the bondholders, should it choose to call the issue. This price is usually set at the bond's par value plus a small premium.

    Given the structure of call provisions, firms generally call bonds in situations where interest rates have declined since the bonds were first issued. Why? Because they can then buy back their debt at about par value (which will be lower than market value when interest has fallen) and refinance their debt at lower interest rates. Generally, the investor would prefer to hold on to his/her bond, or at least sell it at the higher market price; unfortunately, once a bond issue is called, the investor must accept the call price specified in the bond's indenture. Primarily for this reason, bond investors generally do not like call provisions. However, most bond issues do contain call provisions because most companies receive strong value from them, as they allow a firm to refinance at lower interest rates when they are available.

    Generally, callable bonds offer slightly higher interest rates than non-callable bonds as consideration for this flexibility.

    (For further reading, see Call Features: Don't Get Caught Off Guard.)


  • Are Bid Prices of T-Bills Higher Than the Ask?
    A:

    Typically, the ask price of a security should be higher than the bid price. This can be attributed to the expected behavior that an investor will not sell a security (asking price) for lower than the price they are willing to pay for it (bidding price).

    How Bid/Ask Is Quoted for T-Bills

    Since there is more than one method of quoting the bid and ask prices of T-bills, the quoted ask price may simply be perceived as being lower than the bid.

    For example, one common quote that you may see for a 365-day T-bill is July 12th, bid 2.35 percent, ask 2.25 percent. At first glance, the bid seems higher than the ask, but upon further inspection, you may notice that the ask is actually higher. The reason for this is that a T-bill is a discount bond and these percentages are the quoted yields, not the actual prices.

    If we convert the bid and ask discount yields into the dollar amounts of the prices, we get a bid of $97.65 and an ask of $97.75. Therefore, the bid is actually lower than the ask. Sometimes the quotes on T-bills show the actual prices, in which case you don't have to convert or calculate anything. The same T-bill above, therefore, may be quoted with a bid of 97.65 and an ask of 97.75.

    So, as the dollar amount of the bid should be lower than the ask, the bid's quoted yield percentage should be higher than the ask's quoted yield percentage — the two different kinds of quotes are just different ways of saying the same thing.


  • Are Certificates of Deposit (CDs) a Type of Bond?
    A:

    There is a fair amount of overlap between certificates of deposit (CDs) and bonds — they are both fixed-income securities which you generally hold on to until maturity. Simply put, you put your money into a CD or bond for a set period, and you know exactly what you will receive when that time is up.

    They are both debt-based, meaning that you are the creditor — no different than having a friend ask for 10 dollars today and give you an IOU promising to pay 11 dollars tomorrow. The interest (one dollar) is collected for the same reason that banks charge interest on loans: to compensate for delaying the ability to spend money. Loaning out 10 dollars deprives you of having that 10 dollars to use now for whatever you wish.

    How Bonds and CDs are Different

    We now know why bonds and CDs fit under the same broad category, but here is how they differ:

    1. The Issuer

    In the case of bonds, the issuer is usually a company trying to raise funds for operations, the development of new products or the opportunity to take over another company. Investment-grade bonds have a very low default risk (the chance that your friend will take your 10 dollars and never come back), but it can definitely happen.

    The issuer of CDs is usually a bank because CDs are not issued with the same motives that underlie bonds. CDs are similar to a savings account — basically a place to hold your money until you want to do something else with it. Because bonds issued by a company are riskier, they offer a more favorable return to the people who buy them. The return on CDs, however, is typically less than bonds but a little better than a savings account.

    2. Time to Maturity

    This is the sticky part, but also the most significant point. Bonds are longer-term investments, generally maturing in more than 10 years. By contrast, CDs mature in as little as one month and as much as five years. The complication we run into now is that there are further distinctions or categories within the world of fixed-income debt securities, and they overlap everywhere.

    The loose categorization is as follows (put an imaginary "generally" in front of each description):

    • T-Bills - mature in less than one year
    • Notes - mature between one and 10 years
    • Bonds - mature after a decade or more

    In other words, while a bond is technically a fixed-income security with a maturity of more than 10 years, people often use the term "bond" to refer to fixed-income securities in general — even those securities with a maturity of less than 10 years.

    The difference in time commitment for bonds and CDs is best expressed in terms of the investor's motives. As previously mentioned, CDs are generally considered short-term, low-risk, interest-paying storage for capital until a more profitable investment can be found. Bonds are considered long-term vehicles for guaranteeing a profit and, perhaps, offsetting some of the risk an investor may face in higher-yield investments such as equities.

    (For more on the subtle differences between bonds and CDs, check out our Bond Basics Tutorial.)


  • Are high-yield bonds better investments than low-yield bonds?
    A:

    Most bonds typically make periodic payments, known as coupon payments, to the bondholder. A bond's indenture, revealed when the purchaser buys the bond, will specify the the details of the coupon payments.

    Different companies will issue different bonds to raise financial capital, and the quality of each bond is determined by the quality of the issuer, which depends on its ability to pay all coupon payments and the bond's principal at maturity. The yield offered is used to compensate investors for the risk they incur when purchasing a given company's bond.

    The higher the yield, the more likely it is that the firm issuing the bond is not of high quality – in other words, the more likely the firm is to not make coupon and principal payments. When a firm misses a payment, the bond is said to be in default, and the risk that this will happen is known as default risk.

    Two major credit rating agencies evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. Bonds rated "BB" or lower on the on the Standard & Poor's bond rating scale, or "Ba" or lower according to Moody's, are considered lower-grade (junk or speculative) bonds and carry a larger amount of default risk than bonds that are rated higher. The highest S&P rating a bond can have is "AAA," and the lowest is "CCC"; a rating of "D" indicates the bond is in default. In the case of Moody's, ratings range from "Aaa" to "C,"  with the latter indicating default.

    High-yield bonds tend to be these junk bonds, with lower credit ratings. Since they have lower credit ratings, there is a higher risk of default by the corporate issuers. To entice investors to buy the bonds, the bonds pay a higher rate of interest. In contrast, the better-rated bonds – also known as investment grade – tend to have lower yields. Instead, they're offering greater security and likelihood of reliable payments.

    There is a yield spread between investment grade bonds and high-yield bonds. Generally, the lower the credit rating of the issuer, the higher the amount of interest paid. This yield spread fluctuates depending on economic conditions and interest rates.

    So, which bond is better to purchase? It depends on the amount of default risk you as an investor want to be exposed to. If the issuer does not default, the higher yield bond will give you a higher return, in the form of coupon payments, but the default risk is higher than what you would face with a lower-yield, higher-grade bond. If you purchase a higher-grade, lower-yield bond, you are exposed to less default risk, and you have a higher chance of getting all of the promised coupon payments and the par value if you hold the bond to maturity.

    The Bottom Line

    Investors who are seeking yields greater than those of U.S.Treasury bonds (the gold standard of investment-grade bonds: notoriously low, but famously reliable, payments) may be willing to take on the additional risk in return for greater yield.

    There are highly liquid exchange-traded funds (ETFs) that invest in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of lower-rated bonds. This diversification across companies and sectors can protect against default risk. Still, even with diversification, periods of high market volatility can lead to a much larger number of companies defaulting on their debt obligations.

    For more information on high- and low-yield bonds, see "Are High-Yield Bonds Too Risky?," "The Fundamentals of High Yield Bond Investing" and our Bond Basics Tutorial.


  • Are money market accounts considered checking or savings?
    A:

    A: A money market account (MMA) is neither a checking account nor a savings account, though it does contain elements of both. Like a checking account, an MMA offers check-writing privileges, though they are limited to around three per month. Some MMAs also offer a debit card. Like a savings account, an MMA is an interest-bearing account, though the interest rates on MMAs are generally higher than savings accounts. As with checking and savings accounts, MMAs are deposit accounts insured by the Federal Deposit Insurance Corporation (FDIC). Because it is considered to be a savings-type instrument, withdrawals are limited by federal regulation to six per month. If more than six withdrawals occur within a month, the bank is required to change the account’s status to a non-interest-bearing checking account.

    History

    MMAs were created by banks as an alternative to savings accounts to be able to offer more competitive interest rates. The tradeoff for higher rates is a higher minimum deposit requirement. With many MMAs, in order to receive the highest interest rate available, accounts are required to maintain a minimum daily balance. Many MMAs have tiered savings levels that offer higher interest rates for higher levels of savings.

    MMAs became popular during the 1980s, when interest rates rose to double digits, offering depositors the opportunity to generate high, riskless returns. Between 2010 and 2015, when the Federal Reserve Board cut interest rates to near zero, interest rates on MMAs fell to below 1%, though they were still higher than most savings accounts.


  • Are U.S. banks authorized to issue bank guarantees or medium term notes (MTNs)?
    A:

    Bank guarantees and medium term notes (MTNs) are different types of instruments that serve different purposes for corporations. Bank guarantees are instruments issued by a bank or other lending institutions ensuring that the money owed by a debtor will be paid. In other words, the bank or lending institution is promising to be liable if the customer fails to meet their obligations. On the other hand, MTNs are specific bond-like debt securities with maturity values of nine months to 30 years. Since 1983, companies have used MTNs to raise funds in a way that is similar to debt offering. Most MTNs are non-callable, unsecured and have fixed rates.


    U.S banks generally do not issue bank guarantees, but issue other types of promissory notes that are intended to fulfill the same function. Instead of bank guarantees, U.S banks issue standby letters of credit (SLOC), which are heavily used in international trade. Under section 415 of the Securities Exchange Commission (SEC) rules, approved banks issue MTNs to approved investment banks and brokerage houses. They, in turn, trade the MTNs with institutional investors, who issue them to retail investors. Bank guarantees and letters of credit can also be traded between institutions but the underlying component in their valuation is the creditworthiness of the nonbanking company.

    For a comprehensive review of fixed-income securities, refer to CFA Level 1- Fixed Income Investments.

    This question was answered by Chizoba Morah.


  • Calculate the total return of the municipal bond described below.
    A:

    Jane and Fabbio Salvatore have just discovered that a Fabulous Florence municipal bond will be offered to support a bridge development in Fabbio's hometown in Florence, OH. They want to purchase the bond at $1,000, but end up buying the 10% bond at $1,020. One year later, the Salvatores want to sell and earn a profit when the market value is at $1,000. Calculate the total return of the Fabulous Florence bond.

    A) 12%
    B) 1.96%
    C) 7.84%
    D) 2%





    The correct answer is C.
    The test will try to confuse you by adding extra details to the questions. It doesn't matter that the Salvatores wanted to buy at $1,000 when, in fact, they bought it at $1,020. Furthermore, one year later when the market is at $1,000, their bond has actually depreciated by ($1,020-$1,000 = $20)/$1,020 = 1.96%. Note however that the total return will reflect the interest earned (yield) plus or minus any appreciation or depreciation (growth). While the bond earns 10% interest, it has lost over 1% of its value and delivers a total return of 7.84% = (1.1 x 1000) – 1020/1020


  • Can a bond have a negative yield?
    A:

    The return a bond provides to an investor is measured by its yield, which is quoted as a percentage.

    Current yield is a commonly quoted yield calculation used to evaluate the return on a bond for a one-year period. It only accounts for the interest, or coupon payments, that the bond returns to investors. This yield is calculated as the bond's coupon rate divided by its current market price, but it does not account for any capital gains or losses when the bond is sold. If the bond is not sold within the year, this yield calculation will provide the bondholder with an accurate assessment of his or her return.

    The only way a bond's current yield could be negative, using this basic evaluation, is if the investor were receiving negative interest payments, or if the bond somehow had a market value below $0 – both of which are very unlikely to occur.

    Other yield calculations will take into account different factors and can be used to better evaluate the returns an investor may receive, given different events.

    As its name suggests, the yield to maturity (YTM) calculates the return (expressed as an annual percentage) on a bond if the investor were to hold the bond until maturity. This formula takes into account all of the coupon payments and the face – or par – value on the bond (assuming no principal defaults), and it can be seen as a more complete evaluation than current yield. However, calculating a bond's YTM is complex and involves trial and error. It is usually done by using a programmable business calculator, but you can also get an approximate YTM by using a bond yield table.

    Let's consider an example: say an investor pays $800 for a bond that has has exactly two years to maturity, a face value of $1,000 and interest payments of $8 per year. Using a bond table, we could determine that the bond will have a YTM of about 10.86%. If the bond holder paid $1,200 for the bond, the YTM would be about -9.41%. (It is worth noting, however, that a bond will not necessarily have a negative actual yield just because the investor paid more than face value for it.) 

    When using the YTM calculation, it is possible to have a negative yield on a bond, depending largely on how much you initially pay for the bond and the time to maturity.

    Yields can be calculated using different formulas (there are many more than the two mentioned here), and depending on the formula used, you can end up with drastically different yields. To learn more, see our Bond Basics Tutorial, Advanced Bond Concepts and Boost Bond Returns With Laddering.


  • Can a church issue a bond?
    A:

    The North American Securities Administrators Association (NASAA) has acknowledged that "church bonds" are allowed to be issued under certain guidelines. These bonds can be issued only by religious affiliates that are identified as being a "church", "parish", "mosque" or a "synagogue", and can only be used to finance anything related to church property. For instance, the issuing church can use the raised funds to build a church structure, or upgrade church property. The funds only are allowed to better church property, and cannot be used to directly generate revenues.

    These types of bonds are backed by collateral by the issuing church, in the form of church property. This is mandated, under most circumstances, because most churches do not have enough financial capital or cash flow to accommodate a non-secured form of debt. In light of this, the church also must set up a sinking fund, and make large enough payments into the fund - as set out by the minimum standards by the NASAA - that can cover coupon payments and eventually the face value of the bonds.

    Along with the sinking fund payment schedule, the church also must release financial data so bond holders know the financial strength of the church, and can determine if the bond is worth purchasing. These financial statements must include a Cash Flow Statement, Balance Sheet and Income Statement, all of which must be audited. During the holding period, the bond holder may request financial data from the church at any time, and must receive the most recent financial data available.

    It is important to remember that no matter if you are purchasing a church bond, or regular bond, the likelihood of repayment is the most important factor. This will help you determine if the bond will provide you with a high enough return, and will compensate you for the risks you may be taking.

    To learn more about bonds, read Bond & Debt Basics or Advantages Of Bonds.


  • Can Private Corporations Issue Convertible Bonds?
    A:

    A convertible bond is a debt that may be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder.

    The first step to answering this question requires defining the term "private corporation." Many times, the term "private corporation" refers to a privately-held company that is either a sole proprietorship (one owner) or a partnership (multiple owners). Other times, it refers to a business that's actually incorporated under state laws, but not traded on any exchange or by over-the-counter market makers.

    Why Private Companies Cannot Issue Convertible Bonds

    In the instance of a truly private company that is owned by one or multiple people, convertible bonds cannot be issued. The reason has less to do with any laws against privately-held companies issuing bonds and more to do with the fact that no shares of stock exist into which to convert the bonds.

    On the other hand, a closely-held subchapter S or C corporation, which does not trade on any exchange, theoretically may issue convertible bonds if allowed by its corporate charter and state laws. The feasibility of executing a bonds issue of this kind is another matter, however, because many closely-held corporations might have only 100 shares of stock outstanding, if not less.

    It is not unheard of for an owner or local investor to lend smaller corporations money in the form of bonds that come with a convertible feature. However, this usually is carried out as a means of protecting the lender by permitting ownership in the company if it fails to repay the loan.

    (For more on this topic, read Convertible Bonds: An Introduction and Should You Incorporate Your Business?)


  • Collateralized Mortgage Obligation vs. Collateralized Bond Obligation
    A:

    Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors receive payments from a pool of underlying assets. The difference between these securities lies in the type of assets that provide cash flow to investors.

    What Is a Collateralized Mortgage Obligation?

    A CMO is a type of mortgage-backed security (MBS) with separate pools of pass-through security mortgages that contain varying classes of holders and maturities (tranches). When the mortgages underlying a CMO are of poor credit quality, such as subprime loans, over-collateralization will occur.

    In over-collateralization, the issuer will post more collateral than is necessary in an attempt to obtain a better debt rating from a credit rating agency. A better rating is often assigned because investors are cushioned (to some extent) from a certain level of default on mortgages within the pool. The principal repayments from the mortgages are paid to investors at various rates, depending on which tranche the investor buys into.

    (For more on this, see Profit From Mortgage Debt With MBS.)

    What Is a Collateralized Bond Obligation?

    On the other hand, a CBO is an investment-grade bond backed by a pool of low-grade debt securities, such as junk bonds, rather than mortgages. CBOs are separated into tranches based on various levels of credit risk, rather than different maturities.

    Like CMOs, CBOs are also able to increase their credit ratings. However, their credit rating is increased to investment grade through the diversification of various bond qualities, rather than through over-collateralization.


  • Common Examples of Marketable Securities
    A:

    Marketable securities are investments that can easily be bought, sold or traded on public exchanges. The high liquidity of marketable securities makes them very popular among individual and institutional investors. These types of investments can be debt securities or equity securities.

    Types of Marketable Securities

    Though there are numerous types of marketable securities, the most common types of equity and debt securities are, relatively, stocks and bonds.

    Stocks

    Stock represents an equity investment because shareholders maintain partial ownership in the company in which they have invested. The company can use shareholder investment as equity capital to fund the company's operations and expansion.

    In return, the shareholder receives voting rights and periodic dividends based on the company's profitability. The value of a company's stock can fluctuate wildly depending on the industry and the individual business in question, and so investing in the stock market can be a risky move. However, many people make a very good living investing in equities, using short- and long-term strategies.

    Bonds

    Bonds are the most common form of marketable debt security and are a useful source of capital to businesses that are looking to grow. A bond is a security issued by a company or government that allows it to borrow money from investors. Much a like a bank loan, a bond guarantees a fixed rate of return, called the coupon rate, in exchange for use of the invested funds.

    The face value of the bond is its par value. Each issued bond has a specified par value, coupon rate and maturity date. The maturity date is when the issuing entity must repay the full par value of the bond.

    Because bonds are traded on the open market, they can be purchased for less than par (referred to as the discount) or for more than par (also called the premium), depending on their current market values. Coupon payments are based on the par value of the bond rather than its market value or purchase price, and so an investor who can purchase a bond at a discount still enjoys the same interest payments as an investor who purchases the security at par value.

    Interest payments on discounted bonds represent a higher return on investment than the stated coupon rate. Conversely, the return on investment for bonds purchased at a premium is lower than the coupon rate.

    Preference Shares

    There is another type of marketable security that has some of the qualities of both equity and debt. Preference shares, also called preferred shares, have the benefit of a fixed dividend, much like a bond.

    Unlike a bond, however, the shareholder's initial investment is never repaid, making it a hybrid security. In addition to the fixed dividend, preferred shareholders are granted a higher claim on funds than their common counterparts if the issuing company goes bankrupt and must liquidate assets to pay off its liabilities.

    In exchange, preferred shareholders give up the voting rights that ordinary shareholders enjoy. The guaranteed dividend and insolvency safety net make preference shares a more enticing investment to those who find the common stock market too risky but don't want to wait around for bonds to mature.

    Indirect Investments

    Marketable securities can also come in the form of money market instruments, derivatives and indirect investments. Each of these types contains several different specific securities.

    Indirect investments include hedge funds and unit trusts. These instruments represent ownership in investment companies. Most market participants have little or no exposure to these types of instruments, but they are common among accredited or institutional investors.

    Derivatives are investments directly dependent on the value of other securities. In the last quarter of the 20th century, derivatives trading began growing exponentially. Many types of derivatives can be considered marketable, such as futures, options and rights and warrants.

    The most reliable liquid securities fall in the money market category. Most money market securities act as short-term bonds and are purchased in huge quantities by large financial entities. These include Treasury bills (T-bills), banker's acceptances, purchase agreements and commercial paper.

    Common Characteristics of Marketable Securities

    The overriding characteristic of marketable securities is their liquidity, or the ability to convert them into cash and use them as an intermediary in other economic transactions. A security is further made liquid by its relative supply and demand in the market and the volume of its transactions. Because marketable securities have short maturities, and can be sold easily with price quotes available instantly, they typically have a very low rate of return, paying less interest than other instruments. But they are usually perceived as low-risk as well.

    From a liquidity standpoint, investments are marketable when they can be bought and sold easily. If an investor or a business needs some cash in a pinch, it is much easier to enter the market and liquidate common stock than, say, a nonnegotiable certificate of deposit (CD).

    This introduces the element of intent as a characteristic of "marketability." And in fact, many financial experts and accounting courses claim intent as a differentiating feature between marketable securities and other investment securities. Under this classification, the marketable security must satisfy two conditions. The first is ready convertibility into cash; the second condition is that those who purchase marketable securities must intend to convert them when in need of cash. In other words, a note purchased with short-term goals in mind is much more marketable than an identical note bought with long-term goals in mind.

    Marketable Securities and Working Capital

    In accounting terminology, marketable securities are classified as current assets, and, therefore, are often included in the working capital calculations on corporate balance sheets. (It is often noted if they are not; the definition of adjusted working capital, for example, considers only operating assets and liabilities, excluding any financing-related items, such as short-term debt and marketable securities.) Businesses that have conservative cash management policies tend to invest in marketable securities instead of long-term or riskier securities, such as stocks and other fixed-income securities with maturities longer than a year. Marketable securities are typically reported right under the cash and cash equivalents account on a company's balance sheet at the current assets section.

    An investor who analyzes a company may wish to carefully study the company's announcements that make certain cash commitments, such as dividend payments before they are declared. For a company that is low on cash and has all its balance tied in marketable securities, an investor may exclude the cash commitments that management announced from its marketable securities, since this portion of marketable securities is earmarked and spent on something other than paying off current liabilities.

    The Bottom Line

    It's important to note that there are liquid assets that are not securities, and there are securities that are not liquid assets. Every marketable security must still satisfy the requirements of being a financial security: It must represent interest as an owner, creditor or rights to ownership, carry an assigned monetary value, and be able to provide a profit opportunity for the purchaser.


  • Current yield vs yield to maturity
    A:

    Both the current yield and yield to maturity (YTM) formulas are methods of calculating the yield of a bond. However, these two methods of calculation have different applications depending on the goals of the investor.

    Bond Basics

    When a bond is issued, the issuing entity determines its duration, face value (also called its par value) and the rate of interest it pays (also known as its coupon rate). These characteristics remain stable over time and are not affected by any changes in the market value of the bond.

    For example, a bond with a $1,000 par value and a 7% coupon rate pays $70 in interest annually.

    Current Yield of Bonds

    The current yield of a bond is calculated by dividing the annual coupon payment by the current market value of the bond. Because this formula is based on the purchase price rather than the par value of a bond, it is a more accurate reflection of the profitability of a bond relative to other bonds on the market.

    For example, if an investor buys a 6% coupon rate bond (with a par value of $1,000) for a discount of $900, the investor earns annual interest income of ($1,000 X 6%), or $60. The current yield is ($60) / ($900), or 6.67%. The $60 in annual interest is fixed, regardless of the price paid for the bond. If, on the other hand, an investor purchases a bond at a premium of $1,100, the current yield is ($60) / ($1,100), or 5.45%. The investor paid more for the premium bond that pays the same dollar amount of interest, so the current yield is lower.

    Current yield can also be calculated for stocks by taking the dividends received for a stock and dividing the amount by the stock’s current market price.

    The current yield calculation is helpful in determining which of a selection of bonds generates the greatest return on investment each year. This is especially helpful for short-term investments.

    Yield to Maturity of Bonds

    The YTM formula is a more complicated calculation that renders the total amount of return generated by a bond based on its par value, purchase price, duration, coupon rate and the power of compound interest.

    This calculation is useful for investors looking to maximize profits by holding a bond until maturity, because it includes the interest that could be earned if annual coupon payments were reinvested, thereby earning additional interest on investment income.

    Bond Yield as a Function of Price

    When a bond's market price is above par, called a premium bond, its current yield and YTM are lower than its coupon rate. Conversely, when a bond sells for less than par, called a discount bond, its current yield and YTM are higher than the coupon rate. Only when a bond sells for its exact par value are all three rates identical.


  • Do convertible bonds have voting rights?
    A:

    Convertible bonds usually have no voting rights until they are converted. Even after conversion, they may not be granted voting rights.

    A convertible bond is a form of debt that features an embedded stock option allowing the convertible bondholder to convert his/her bond into a predetermined number of shares in the issuing company at some future date. There are many different kinds of convertible bonds, each with its own conversion features. Usually, convertible bonds are converted when the convertible bondholder chooses to do so - that is, the bondholder has the right, but not the obligation, to convert the bond on or before a set date. The terms of the bond's indenture detail the specific conversion clauses, such as how many and what kind of shares the bonds convert into.

    In most cases, convertible bonds convert to shares of common stock, which usually have voting rights, but not always. Common stock is sometimes divided into different classes; when it's divided into two classes, it's known as dual class stock. Typically, each class will have its own voting rights, and the voting rights of one class will be less effective than the votes of the other class (or classes) when votes are made.

    For example, let's say you have convertible bonds of XYZ Computer Corp. that convert to 100 shares of Class A common stock, but it's the Class B common stock that controls 100% of the voting rights for the corporation (in this example). Class A common stock has no voting rights, which means that even after the convertible bonds are converted, you still don't have the right to vote on those issues that must be brought to shareholders for a vote according to the company's charter.

    The list of different voting rights assigned to different classes of shares is endless. Another example of voting rights that give unequal voting power to different classes of shareholders are those that award a higher number of votes to shareholders that own one class of shares than to shareholders owning another class.

    For more information on convertible bonds, see Convertible Bonds: An Introduction. For more on voting rights, check out The Two Sides of Dual-Class Shares.


  • Do high interest rates hurt the performance of telecommunication stocks? If so, why?
    A:

    Conventional investing wisdom holds that certain types of equities have above-average sensitivity to rising interest rates, not unlike bonds. The common shares of utility companies, established oil companies and telecommunications companies (among others) become more bearish when talk of rate increases begins and investors begin looking for alternatives. Rising interest rates might hurt the performance of telecommunications stocks, but they do not necessarily do so.

    The answer also depends on what is meant by "hurt performance." A stock may still perform well if it drops in price yet continues to pay dividends, or vice versa. It's important to remember the relationship between share price and yield.

    Dividend-yielding Equities As Bond Substitutes

    Times of falling interest rates often compel income investors to dump bonds and begin seeking dividend-yielding equities. Utilities and telecommunications companies have been historically high-yielding. This flight from bonds causes spikes in demand for blue-chip dividend stocks, which could cause share prices to appreciate and potentially reduce yields.

    Rising interest rates could theoretically cause risk-averse income investors to reverse course, dumping their dividend-paying equities for senior debt purchases. In this scenario, the share price could drop, but dividends may be unaffected, increasing yield.

    High Interest Rates and Capital Structure

    The fundamentals of telecommunications companies could also take a hit when interest rates rise. Telecommunications companies can be quite capital-intensive and require high levels of borrowing, especially during expansion. Cash flows tend to be steady, so spikes in revenue would not be likely to offset increased borrowing costs associated with larger rates. Weakened balance sheets could be addressed by raising customer prices or cutting dividends. Companies that do not handle this well could also see their share prices drop.

    However, all equities – even telecom stocks -- correlate with the stock market more closely than with interest rates.


  • Do Preferred Shares Offer Companies a Tax Advantage?
    A:

    A preferred stock is a class of ownership in a corporation that provides a higher claim on its assets and earnings as compared to common stock. There is no direct tax advantage to the issuing of preferred shares when compared to other forms of financing such as common shares or debt.

    Why There Is No Direct Tax Advantage

    The reason for this is that preferred shares, which are a form of equity, are paid fixed dividends with after-tax dollars. This is the same case for common shares. If dividends are paid out, it is in after-tax dollars.

    Preferred shares are considered to be like debt in that they pay a fixed rate like a bond (a debt investment). It is because interest expenses on bonds are tax deductible — while preferred shares pay with after-tax dollars — that preferred shares are considered a more expensive means of financing. Issuing preferred shares does have its benefits over bonds in that a company can stop making payments on preferred shares where they are unable to stop making payments on bonds without going into default.

    Why Issuing Preferred Shares Benefits Companies

    There are a few reasons why issuing preferred shares are a benefit for companies.

    One benefit of issuing preferred shares is that for financing purposes they do not reflect added debt on the company's financial books. This actually can save money for the company in the long run. When the company looks for debt financing in the future, it will receive a lower rate since it will appear the company's debt load is lower — causing the company to in turn pay less on future debt.

    Preferred shares also tend not to have voting rights, so it creates another benefit in that issuing preferred shares does not dilute the voting rights of the company's common shares.

    (For more information on preferred shares, see Introduction to Convertible Preferred Shares.)


  • How a Bond's Face Value Differs from its Price
    A:

    Face value, also known as par value, is equal to a bond's price when it is first issued, but thereafter the price of the bond fluctuates in the market in accordance with changes in interest rates while the face value remains fixed.

    The various terms surrounding bond prices and yields can be confusing to the average investor. A bond represents a loan made by investors to the entity issuing the bond, with the face value being the amount of principal the bond issuer borrows. The principal amount of the loan is paid back at some specified future date, and interest payments are made to the investor at regular, specified intervals during the term of the loan, typically every six months.

    A bond is a fixed-rate security or investment vehicle. The interest rate paid to a bond investor or purchaser is a fixed, stated amount, but the bond's yield, which is the interest amount relative to the bond's current market price, fluctuates along with price. As the bond's price fluctuates, the price is described relative to the original par value, or face value; the bond is referred to as trading either at a premium, synonymous with above par value, or  below par value, often referred to as a discount.

    Three of the factors that influence a bond's current market price are the credit rating of the entity that issued the bond, the market demand for the bond and the time remaining until the bond's maturity date. The maturity date is an important factor because as the bond nears its maturity date, which is the date when the bondholder is paid the full face value of the bond, the bond price naturally tends to move closer to par value.

    An interesting aspect of bond pricing and demand is revealed in the effects of reports issued by bond rating companies such as Moody's or Standard & Poor's. Lower ratings generally cause a bond's price to fall since it is not as attractive to buyers. But when the price falls, that action tends to increase the bond's appeal because lower priced bonds offer a higher yield.


  • How Are Bonds Rated?
    A:

    A bond rating is a grade given to a bond by various rating services that indicates its credit quality. It takes into consideration a bond issuer's financial strength or its ability to pay a bond's principal and interest in a timely fashion.

    Moody's, Standard and Poor's, Fitch Ratings and DBRS are some of the most internationally well-known bond-rating agencies. These organizations operate to provide investors with quantitative and qualitative descriptions of the available fixed income securities. Generally, a "AAA" high-grade rated bond offers more security and a lower profit potential (lower yield) than a "B-" rated speculative bond.

    While this metric provides a sense of the overall characteristics of the security, what sort of underlying analysis goes into differentiating between bond qualities?

    Determining Ratings for Bonds

    For a financial institution, ratings are developed based on specific intrinsic and external influences. Internal factors include such traits as the overall financial strength rating of the bank – a risk measure illustrating the probability that the institution will require external monetary support (Moody's implements a scale where A corresponds with a financially healthy bank, and E resembles a weak one). The rating depends on the financial statements of the firm under analysis and the corresponding financial ratios.

    External influences include networks with other interested parties, such as a parent corporation, local government agencies and systemic federal support commitments. The credit quality of these parties must also be researched. Once these external factors are analyzed, a comprehensive overall external score is given. Essentially, this grade is added to the predetermined "intrinsic score" to obtain the overall grade like BBB.

    The preceding guideline provides a general framework that Moody's uses in its analysis. Specific bonds, such as hybrid securities, require additional complex analysis, such as the underlying terms of the debt.

    Overall, the art of bond rating extends beyond simple ratio analysis and a quick look at a firm's balance sheet. Different measures are used for different industries, and other external influences play a range of roles in the intricate process. A forecasted top-down approach of the overall economic conditions, an in-depth bottom-up procedure of security specifics, along with statistical distribution estimates of the probability of default and loss severity provides investors with a few simple standardized letters to help quantify their investment.

    (Learn about bond investing, read Bond Portfolios Made Easy.)


  • How Are Convertible and Reverse Convertible Bonds Different?
    A:

    Convertible bonds give bondholders the right to convert their bonds into another form of debt or equity at a later date, at a predetermined price and for a set number of shares. Meanwhile, reverse convertible bonds give the issuer the right, but not the obligation, to convert the bond's principal into shares of equity at a set date.

    Convertible Vs. Reverse Convertible Bonds

    For determining the difference between a regular convertible bond and a reverse convertible bond it comes down to the structure of the options attached to the bond.

    Convertible Bonds

    Convertible bondholders are not obligated to convert their bonds to equity, but they may do so if they choose. The conversion feature is analogous to a call option that has been attached to the bond.

    If the equity or debt underlying the conversion feature increases in market price, convertible bonds tend to trade at a premium. If the underlying debt or equity decreases in price, the conversion feature will lose value. But even if the convertible option comes to be of little value, the convertible holder still holds a bond that will typically pay coupons and the face value at maturity. The yield on this type of bond is lower than a similar bond without the convertible option because this option gives the bondholder additional upside.

    Convertible bonds are a flexible financing option for companies and tend to be quite useful for companies with high risk/reward profiles.

    Reverse Convertible Bonds

    Reverse convertible bonds are a similar vehicle to convertible bonds as both contain embedded derivatives. In the case of reverse convertible bonds, the embedded option is a put option that is held by the bond's issuer on a company's shares. This option is exercised if the shares underlying the option have fallen below a set price, in which case the bondholders will receive the equity rather than the principal and any additional coupons. The yield on this type of bond is higher than a similar bond without the reverse option.

    An example of a reverse convertible bond is a bond issued by a bank on the bank's own debt with a built-in put option on the shares of, say, a blue chip company. The bond may have a stated yield of ten to 20 percent, but if the shares in the blue chip company decrease substantially in value, the bank holds the right to issue the blue chip shares to the bondholder, instead of paying cash at the bond's maturity.

    (To learn more about convertible bonds, see Convertible Bonds: An Introduction.)


  • How Are Day-Count Conventions Used in Bond Markets?
    A:

    A day-count convention is a system used in the bond markets to determine the number of days between two coupon dates. This system is important to traders of various bonds because it affects how the accrued interest and present value of future coupons is calculated.

    The notation used for day-count conventions shows the number of days in any given month divided by the number of days in a year. The result represents the fraction of the year remaining that will be used to calculate the amount of future interest owed.

    Here are the most common day counts used in bond markets and the securities to which they typically apply:

    30/360

    This is the easiest convention to use because it assumes that there are 30 days in every month, even though some months actually have 31 days. For example, the period from May 1, 2018 to August 1, 2018 would be considered to be 90 days apart.

    Given the simplicity of this day-count convention, it is often used in calculations of accrued interest for corporate, agency and municipal bonds. It is also commonly used by investors of mortgage-backed securities.

    Actual/360

    This convention is most commonly used when calculating the accrued interest for commercial paper, T-bills and other short-term debt instruments that have less than one year to expiration. It is calculated by using the actual number of days between the two periods, divided by 360.

    Actual/365

    This convention is the same as the actual/360, except that it uses 365 as the denominator. This is used when pricing U.S. government Treasury bonds.

    Actual/Actual

    This convention uses the actual number of days between two periods and divides the result by the actual number of days in the year, rather than assuming that each year is made up of 360 or 365 days.

    Of course, we know that in reality there are always 365 days in a year (with the exception of leap years), but these conventions are standards that have developed over time and help to ensure that everyone is on an even playing field when a bond is sold between coupon dates.

    (To learn more, see our tutorials on Bond Basics and Advanced Bond Concepts.)


  • How are municipal bonds taxed?
    A:

    Municipal bonds are commonly tax-free at the federal level, but can be taxable at state or local income tax levels or under certain circumstances.

    An Overview of Municipal Bonds

    A municipal bond, also known as a muni, is a debt security used to fund capital expenditures for a county, municipality or state. One of the major advantages of munis is that they are typically exempt from federal income tax. They are often excused from local and state tax as well, particularly when the bond’s investor lives in the state in which the bond was issued.

    Essentially, when investors buy a municipal bond, they loan money to the bond’s issuer in exchange for a specified number of interest payments over a set period of time. The end of this time period is referred to as the bond’s maturity date, defined as when the investor’s full investment principal is returned. Municipal bonds, because they are tax-exempt, are popular among individuals in higher income tax brackets.

    While munis are generally assumed to be tax-free, investors should determine a bond's tax consequences before investing. If an individual invests in a bond issued by an agency of their home state, there is rarely state tax charged. However, if they buy the bonds of another state, their home state may tax their interest income from the bond. While interest income is usually tax-exempt for municipal bonds, capital gains realized from selling a bond are subject to federal and state taxes. The short- or long-term capital gain, or loss, on a bond sale is simply the difference between the selling price of the bond and the original purchase price of the bond.

    Municipal Bonds and Capital Gains Tax

    When buying munis on the secondary market, investors must be aware that bonds purchased at a discount (less than par value) will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to coupon payments, only the principal of the bond.

    For example, the table below shows three different bonds, all maturing in two years and all of which give the buyer a return of 4% if purchased at their net present value price:

    Bond
    Required Rate of Return
    Coupon Rate
    Cash Flow at End of Year 1 (Coupon)
    Cash Flow at End of Year 2 (Coupon+ Principal)
    Net Present Value
    Par
    4%
    4%
    $4
    $104
    $100
    Premium
    4%
    6%
    $6
    $106
    $103.77
    Discount
    4%
    2%
    $2
    $102
    $96.22

    The difference between the net present value and the principal payment at maturity is taxed at a capital gains rate of 15%. In this case, the discount bond (from above) will be worth less to the buyer, as shown below.

    Bond
    Required Rate of Return
    Coupon Rate
    Cash Flow at End of Year 1 (Coupon)
    Cash Flow at End of Year 2 (Coupon + Principal - Tax)
    Net Present Value
    Discount (Not Taxed)
    4%
    2%
    $2
    $102
    $96.22
    Discount (Capital Gains Tax of 15%)
    4%
    2%
    $2
    $101.34 (Tax=$100 - $95.62 x 0.15)
    $95.62

    An investor could end up paying $96.22 for a bond that is only worth $95.62 without knowing that the gain is subject to capital gains tax. So, when looking at a muni bond offered for sale on the secondary market, the investor must look at the price of the bond, not just the yield to maturity, to determine whether tax consequences will affect the return. (To learn more, see Where can I get bond market quotes?)

    The bad news is that while discount bonds are taxed, bonds purchased at a premium do not work in a similar manner; they cannot offset capital gains by providing capital losses. This tax rule runs contrary to that of most investments, including other types of bonds, because the Internal Revenue Service treats tax-free instruments differently than their taxable counterparts. Therefore, when analyzing yields for muni bonds offered on the secondary market, the yield-to-maturity figure is usually sufficient to determine an expected return. For discount bonds, one must also factor in the negative tax implications that can arise from capital gains.

    Municipal Bonds and the "De Minimis" Rule

    One of the most confusing concepts related to muni bonds is the de minimis tax rule. This nugget of tax law states that if you purchase a bond at a discount and the discount is equal to or greater than a quarter point per year until maturity, then the gain you realize at redemption of the bond (par value minus purchase price) will be taxed as ordinary income, not as capital gains. For those in the top tax bracket this could mean the difference between paying 15% and 35% on the gain.

    For example, let's take the discount bond from the previous example. Because it is a two-year bond, we can calculate that purchasing it for $99.50 or less will mean falling into the de minimis rule and being taxed at the ordinary income tax rate:

    Par Value
    -
    (Amount Allowable * Years to Maturity)
    =
    De Minimis Cutoff
    $100
    -
    (0.25 * 2)
    =
    $99.50

    Since the net present value for this bond is well below $99.50, we need to calculate the tax consequences when the gain on principal is taxed as ordinary income, as indicated here:

    Bond
    Required Rate of Return
    Coupon Rate
    Cash Flow at End of Year 1 (Coupon)
    Cash Flow at End of Year 2 (Coupon + Principal - Tax)
    Net Present Value
    Cap. Gains Tax (15%)
    4%
    2%
    $2
    $101.34
    $95.62
    Ordinary Income Tax (35%)
    4%
    2%
    $2
    $100.47 (Tax = $100 - $95.62 x 0.35)
    $94.42

    While an investor might pay $95.62 if only accounting for capital gains tax, the true value is much lower – only $94.42. At the time of purchase, the buyer must recognize whether the bond is subject to de minimis because the after-tax return could be substantially less than expected.

    Municipal Bonds and Federal Taxes

    The federal government does not tax most activities of states and municipalities, thereby giving most muni bonds tax-exempt status. However, some activities do not fall under this tax exemption. For instance, coupon payments for muni bonds sold to fund those activities are federally taxed, with one common example is a bond issued to fund a state's pension plan obligation. When this type of bond is for sale, brokers selling the bond should readily know whether it is taxable.

    Another more harrowing example of taxable munis are those that are issued as tax free, then later become taxable if and when the IRS determines the proceeds are being used for purposes that do not fall under tax-exempt status. This is very rare, but when it happens, it leaves a lot of very unhappy investors; their coupon payments are taxed as ordinary income and, if they choose to sell the bond, the price they receive will be reduced because buyers would require a higher yield on a taxable bond.

    Generally, taxable munis are still exempt from state and local taxes, so investors in states with high income taxes may find that they get a better after-tax return than with other fixed income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposit.

    Municipal Bonds and the Alternative Minimum Tax

    Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax (AMT). If you are unsure of whether a specific muni is subject to AMT, be sure to consult the broker before purchase. For example, a bond that is used for a particular municipal improvement that is not backed by the credit of a state or municipality, but rather that of a corporation (such as an airline backing an airport improvement bond), would be subject to AMT.

    Zero-Coupon Municipal Bonds and Taxes

    Zero-coupon municipal bonds don’t have to be taxed. In fact, most aren't. As long as you’re investing in a local municipal bond, taxes won’t be a concern. This provides a big advantage over taxable bonds, even with lower interest. To determine whether or not a tax-free bond is a better option than a taxable bond, simply apply the Tax Equivalent Yield (TEY) formula. (For more, see: Risk and Return Measures: Taxable Equivalent Yield.)

    Another important note here is that if you sell the bond before it matures, you will likely be subject to a capital gain or loss. If you sell higher than the adjusted issue price, then it will be a capital gain. If you sell for less than the adjusted issue price you will have a capital loss, which can be utilized to reduce your overall tax bill.

    The biggest and most obvious benefit is that you’re buying the bond at a big discount to its face value. This is also known as the original issue discount or OID. For example, you can buy a $1,000 bond for $500. However, most zero-coupon municipal bonds are sold in denominations of $5,000. Either way, you’re receiving a tremendous discount. This, in turn, allows you to buy more bonds if you so desire. The longer the bond has to mature, the bigger the discount you will receive. (For more, see: All About Zero Coupon Bonds.)

    Of course, you have to hold up your end of the bargain in order to see the greatest benefits. And that simply means that you must remain patient until the bond matures. By doing so, you will see a substantial return that’s also tax free. And if you’re the type of person who does not like guesswork or worrying about economic conditions, it is worth considering a zero-coupon municipal bond because you will receive one payment at maturity, which is based on the principal invested plus the interest earned (compounded semi annually) at a predetermined yield.

    Most zero-coupon municipal bonds mature between eight and 20 years. If you’re risk averse and you’re looking towards retirement, then it’s highly recommended that you discuss zero-coupon municipal bonds with your financial advisor. Municipal bonds are one of the safest investments you will find with an average default rate of 0.07% between 1970 and 2016, according to an annual study by the Moody's credit agency.

    Most zero-coupon municipal bonds are rated A or higher by the rating agencies, but it’s still important to check the quality of the issuer. If you’re uncertain or questioning whether or not you made a good decision, you can ease your mind by purchasing insurance for the bond. (For more, see: When to Trust Bond Rating Agencies.)

    The Bottom Line

    While traditional and zero-coupon municipal bonds are an attractive investment for many due to the tax savings, it is vital that you understand the potential tax liabilities prior to making a purchase. In the absence of proper due diligence, you may be surprised by an unexpected tax bill. To learn more, read The Basics Of Municipal Bonds and Weighing The Tax Benefits Of Municipal Securities.


  • How Are Savings Bonds Taxed?
    A:

    According to Treasury Direct, interest from EE U.S. savings bonds is taxed at the federal level but not at the state or local levels for income. This interest is also taxed through federal and state estate, gift and excise taxes. The interest is the amount that a bond can be redeemed for above the face value of the bond, which is its original purchase price.

    The ownership of the bond governs who is responsible for paying tax on the interest. If one person purchases the bond and is the sole owner for the life of the bond, that person owes the taxes on the interest. If a child is the sole owner, a parent may report the interest on the bond and pay the taxes on the parent's tax return.

    Extenuating circumstances

    If one person purchases the bond and adds another person to the bond as co-owner and that person remains as such for the life of the bond, however, the purchaser is responsible for the taxes. If one person purchases the bond and lists another person as the sole owner of the bond, the person listed as owner is responsible for the interest.

    If two people split the purchase price of the bond, each person is responsible for the proportion of the taxes that represents the proportion of the ownership stake in the bond. For instance, if Jim and Bill purchase a $1,000 bond with Jim paying $400 and Bill paying $600, Jim is responsible for 40% of the taxes, and Bill is responsible for 60% of the taxes.

    The Exception to the Proportional Rule

    The exception to the proportional rule is for spouses who live in community property states and who are each responsible for half of the taxes if they file their taxes separately. Taxes may also be split if there is a succession of ownership. When a bond changes hands, the owners are each responsible only for the taxes on the portion of the interest that accrued during each period of ownership.

    So, if Jill owned a bond from 2003 to 2007 before relinquishing it to Amy, who has owned it since, Jill must pay the taxes on the interest accrued between 2003 and 2007, and Amy must pay the taxes on interest earned after 2007.

    Owners can wait to pay the taxes when they cash in the bond, when the bond matures or when they relinquish the bond to another owner. Alternatively, they may pay the taxes yearly as interest accrues. Most owners choose to defer the taxes until they redeem the bond. A bond that has reached maturity and stopped earning interest is automatically considered redeemed and the interest amount is reported to the Internal Revenue Service. The income is interest income and is reported on a 1099-INT, and the owner includes it on the yearly tax return.

    If an owner decides to report the interest income yearly, the income from that bond and all other savings bonds for the same owner must continue to be reported yearly. The interest still accrues, in this case, and is not received. Once the bond reaches maturity, the owner must let the IRS know that the interest has been paid yearly.


  • How are the Equity Market and Fixed-Income Market Different?
    A:

    The major differences between equity and fixed income markets are the way they make profits for investors, the manner in which they are traded, their representation of financial interest and their levels of risk.

    Equity Markets

    Equity markets involve the purchase and sales of stocks, conducted on regular trading exchanges. All stock markets, no matter the type, can be volatile and experience significant highs and lows in regard to share values.

    Operating in equity markets involves taking on substantial amounts of risk in the belief that much greater returns will be obtained. Success with equity investing involves greater amounts of research and follow-up on investments than is required with fixed income investments. Compared with bond portfolios, the holdings of equity portfolios have a substantially higher turnover rate.

    Equity investments symbolize interest of ownership in a corporation, while bonds are solely a financial, interest-earning investments.

    Fixed-Income Markets

    The fixed-income market, more commonly referred to as the debt securities market or the bond market, consists of bond securities issued by the federal government, corporate bonds, municipal bonds and mortgage debt instruments. The bond market is referred to as a capital market since it provides the capital financing for long-term investments.

    Debt security investments are generally seen as less risky than equity investments. As such, they typically offer lower potential returns. Debt security investments are traded over the counter (OTC) instead of being centrally traded on exchanges.

    Bonds are the most common form of debt security. Mortgage instruments are also part of this category.

    (For further background on fixed income security risk, check out Six Biggest Bond Risks).


  • How are Treasury bill interest rates determined?
    A:

    U.S. Treasury bills (T-bills) are typically sold at a discount from their par value. The level of discount is determined during Treasury auctions.

    Unlike other U.S. Treasury securities such as Treasury notes (T-notes) and Treasury bonds (T-bonds), T-bills do not pay periodic interest at six-month intervals. The interest rate for Treasuries is therefore determined through a combination of the total discounted value and the maturity length.

    Auctions and Bidders

    The Treasury holds auctions for different maturities at separate, reoccurring intervals. Auctions for the 13-week and 26-week T-bills happen every Monday, as long as the financial markets are open during the day. Fifty-two-week T-bills are auctioned every fourth Tuesday. Each Thursday, announcements are made about how many new T-bills will be issued and their face values. This allows potential buyers to plan their purchases.

    There are two types of bidders for Treasury bills: competitive and noncompetitive. Competitive bidders are the only ones who actually influence the discount rate. Each competitive bidder declares the price they are willing to pay, which the Treasury accepts in descending order of price until the total face value of any particular maturity is sold out. Noncompetitive bidders agree to buy at the average price of all accepted competitive bids.

    Face Value and Interest Rate

    Buyers who hold T-bills until maturity always receive face value for their investments. The interest rate comes from the spread between the discounted purchase price and the face value redemption price.

    For example, suppose an investor purchases a 52-week T-bill with a face value of $1,000. The investor paid $975 up front. The discount spread is $25. After the investor receives the $1,000 at the end of the 52 weeks, the interest rate earned is 2.56%, or 25 / 975 = 0.0256.

    The interest rate earned on a T-bill is not necessarily equal to its discount yield, which is the annualized rate of return the investor realizes on an investment. Discount yields also change over the course of the life of the security. The discount yield is sometimes referred to as the discount rate, which should not be confused with the interest rate.

    Treasury Bill Pricing and Market Impact

    Several external factors can influence the discount price paid on T-bills, such as changes in the federal funds rate, which impacts T-bills more than other types of government securities. This is because T-bills directly compete with the federal funds rate in the market for low-risk, short-term debt instruments. Institutional investors are particularly interested in the difference between the federal funds rate and T-bill yields.

    The prices for Treasury bills (T-bills) can have a significant impact on the risk premium charged by investors across the entire market. T-bills, are priced like bonds; when prices rise, yields drop and the opposite is also true. In the world of debt securities T-bills represent the greatest liquidity and the lowest risk of principal. They act as the closest thing to a risk-free return in the market; all other investments must offer a risk premium in the form of higher returns to entice money away from Treasuries.

    There are other drivers of T-bill prices. During times of high economic growth, investors are less risk-averse and the demand for bills tends to drop. As T-bill yields rise, other interest rates rise as well. Other bond rates climb, the required rate of return on equities tends to rise, mortgage rates tend to rise and the demand for other "safe" commodities tends to drop.

    Similarly, when the economy is sluggish and investors are leaving riskier investments, T-bill prices tend to rise and yields drop. The lower T-bill interest rates and yields drop, the more investors are encouraged to look for riskier returns elsewhere in the market. This is particularly true during times when inflation rates are higher than the returns on T-bills, essentially making the real rate of return on T-bills negative.

    Inflation also affects T-bill rates. This is because investors are reluctant to purchase Treasuries when the yield on their investments does not keep up with inflation, making the investment a net loss in terms of real purchasing power. High inflation can lead to lower Treasury prices and higher yields. Conversely, prices tend to be high when inflation is low. The second reason inflation affects T-bill rates is because of how the Federal Reserve targets the money supply.

    The Bottom Line

    T-bill prices have a large influence on the relative levels of risk investors are comfortable taking. High T-bill prices drive investors into longer-term bonds, lower-grade bonds, equities or derivatives. This is true of institutional investors and individual investors. In effect, the price and yield of T-bills and other Treasuries helps inform the fundamentals of nearly every other investment class on the market.


  • How are treasury bills (T-bills) taxed?
    A:

    Interest earned on all U.S. Treasury securities, including treasury bills, is exempt from taxation at the state and local level but is fully taxable at the federal level. At the end of each year, owners of treasury bills should be sent a 1099-INT form by the Treasury. This form details how much interest was earned on government securities.

    Understanding Treasury Bills (T-bills)

    Treasury bills – often referred to as T-bills – are short-term debt obligations that are fully backed by the faith and credit of the U.S. government. They are sold in denominations that range between $1,000 and $5 million. T-bill maturity durations are all less than one calendar year. Common maturity durations are one month, three months (13 weeks) or six months (26 weeks).

    Like all Treasury securities, T-bills are considered to be risk-free investments. The likelihood of the federal government defaulting on debt obligations is incredibly low, since the government has the ability to tax and print money.

    For instance, during the 2007-08 financial crisis, investors flocked to Treasury securities to safeguard assets as losses in stocks and other areas of their portfolios mounted, while those that had already placed assets in Treasury securities prior to the crisis were largely spared.

    Taxation of Treasury Bills

    Even if states require that earned interest on government securities is reported as income, that income is never taxable at anything below the federal level. The federal tax burden can be eased through tax withholding.

    Those who hold Treasury bills can withhold up to 50% of their interest earnings. Any percentage below 50% is acceptable, and it can be specified through any retail securities site. The Treasury automatically transfers the withholdings to the U.S. Internal Revenue Service (IRS) and reports the amount that is withheld on the 1099-INT form.


  • How can bond yield influence the stock market?
    A:

    Bond yields influence the stock market in different ways at different times. Investors and traders need to be aware of economic and market conditions to understand the constantly evolving relationship between bond yields and the stock market.

    Changes in the Economy

    When the economy is healthy, rising interest rates and bond yields are bullish for stocks, as it implies an increase in the return that investors are seeking for their money. When the economy is not healthy, falling interest rates are bullish for stocks as it is stimulative for assets. Interest rates are the largest variable in determining bond yields.

    During periods of economic expansion, bonds and the stock market trade inversely as they are competing for capital. Selling in the stock market leads to lower yields as money moves into the bond market. Stock market rallies lead to rising yields as money moves from the safety of the bond market to riskier stocks. Under these circumstances, when optimism about the economy grows, money moves into the stock market as it is more leveraged to economic growth. Additionally, economic growth also carries with it inflation risk, which erodes the value of bonds.

    However, there are periods in time when bonds and stocks move together. This tends to happen early in economic recoveries when inflationary pressures are weak and central banks are committed to low interest rates to stimulate the economy. Until the economy begins to grow without the aid of monetary policy or capacity utilization reaches maximum levels where inflation becomes a threat, bonds and stocks move together in response to the combination of mild economic growth and low interest rates.


  • How can I calculate a bond's coupon rate in Excel?
    A:

    A bond's coupon rate is simply the rate of interest it pays each year, expressed as a percentage of the bond's par value. The par value is the bond's face value, or the amount the issuing entity must pay the bondholder once the bond matures. Most bonds have a clearly stated coupon rate percentage. However, calculating the coupon rate using Microsoft Excel is simple if all you have is the coupon payment amount and the par value of the bond.

    The formula for the coupon rate is the total annual coupon payment divided by the par value. Some bonds pay interest semi-annually or quarterly, so it is important to know how many coupon payments per year your bond generates.

    In Excel, enter the coupon payment in cell A1. In cell A2, enter the number of coupon payments you receive each year. If the bond pays interest once a year, enter 1. If you receive payments semi-annually, enter 2. Enter 4 for a bond that pays quarterly. In cell A3, enter the formula =A1*A2 to yield the total annual coupon payment.

    Moving down the spreadsheet, enter the par value of your bond in cell B1. Most bonds have par values of $100 or $1,000, though some municipal bonds have pars of $5,000. In cell B2, enter the formula "=A3/B1" to yield the annual coupon rate of your bond in decimal form.

    Finally, select cell B2 and hit CTRL+SHIFT+% to apply percentage formatting.

    For example, if a bond has a par value of $1,000 and generates two $30 coupon payments each year, the coupon rate is ($30 * 2) / $1,000, or 0.06. Once the cell format is adjusted, the formula yields a return rate of 6%.


  • How can I calculate convexity in Excel?
    A:

    In the bond market, convexity refers to the relationship between price and yield; when graphed, this relationship in non-linear and forms a long-sloping U-shaped curve. A bond with a high degree of convexity will experience relatively dramatic fluctuations when interest rates move. There is no bond convexity function in Microsoft Excel, but it can be approximated through a multi-variable formula.

    Simplifying Convexity Formulas

    The standard convexity formula involves a time series of cash flows and rather complicated calculus. This cannot be easily replicated in Excel, so a simpler formula is necessary:

    Convexity = ((P+) + (P-) - (2Po)) / (2 x ((Po)(change in Y)²)))

    Where (P+) is the bond price when the interest rate is decremented, (P-) is the bond price when the interest rate is incremented, (Po) is the current bond price and the change in Y is the change in interest rate and is represented in decimal form. "Change in Y" can also be described as the bond's effective duration.

    This may not seem simple on the surface, but this is the easiest formula to use in Excel.

    Calculating Convexity in Excel

    Designate a different pair of cells for each of the variables identified in the formula. The first cell acts as the title (P+, P-, Po and Effective Duration), and the second carries the price, which is information you have to gather or calculate from another source.

    Suppose that (Po) value is in cell C2, (P+) is in C3 and (P-) is in C4. The effective duration is in cell B5. In a separate cell, enter the following formula:

    =(C3 + C4 - 2*C2)/(2*C2*(B5^2))

    This should provide the effective convexity for the bond. A higher result means that the price is more sensitive to changes in interest rates.


  • How can I calculate the carrying value of a bond?
    A:

    The carrying value of a bond is the net amount between the bond’s face value and any un-amortized premiums or minus any amortized discounts. The carrying value is also commonly referred to as the carrying amount or the book value of the bond.

    Because interest rates continually fluctuate, bonds are rarely sold at their face values. Instead, they sell at a premium or discount to par value depending on the difference between current interest rates and the stated interest rate for the bond on the issue date. Premiums and discounts are amortized over the life of the bond, so book value equals par value at maturity.

    Calculating Carrying Value

    The first step in calculating carrying value is to determine the terms of the bond. There are three characteristics of any bond that are needed: the bond’s par value, the interest rate and the time to maturity.

    Then, it must be determined whether the bond is sold at face value, at a premium or at a discount. A bond with an interest rate that is equal to current market rates sells at par. If a bond's interest rate is above current market rates, the bond sells at a premium. If the interest rate of the bond is lower than the current market rate, it sells at a discount. The amount of time that has passed since the bond’s issuance must also be determined, as any premium or discount has to be amortized over the life of the bond.

    It is necessary to know how much of the premium or discount has amortized to calculate the carrying value. Typically, amortization is on a straight-line basis; for each reported period, the same amount is amortized.

    Calculating the carrying value of the bond, after gathering the aforementioned information, is a simple step of either addition or subtraction. The un-amortized portion of the bond's discount or premium is either subtracted from or added to the bond's face value to arrive at carrying value.


  • How Can I Check If an Old Railroad Bond Has Value?
    A:


    Finding out whether an old railroad bond from 1938 still has any value is a tough question to answer. The short answer is that it will require a person to do some homework or spend money on a search service.

    Getting Started With Your Research

    The first step would be to contact your broker to see whether they can obtain more information about the company that issued the bond. Keep in mind that brokers typically have access to tools that most of us do not, including Standard & Poor's corporation records, and similar types of resources.

    At the same time, consider doing an online search of your own. Try search engines such as Google. Was the company taken over? Did it go bankrupt? If you're lucky, the search will provide the new company's name, address and contact information.

    Beyond that, your local library and/or the state in which the corporation operated may yield additional information. Try contacting the Department of Commerce or the corporation commission in the state that is listed on the bond. If nothing else, these organizations should be able to point you in the right direction.

    Use a Stock Search/Collectibles Service

    If all else fails, there are services out there such as Arizona-based Stock Search International that charge between $40 and $85 for access to their corporate databases, and/or to initiate new research about a company on your behalf.

    Also keep in mind that the bond may be a collectible and have value even if it can't be redeemed. To that end, check out Scripophily.com to see whether the security has some collectible value. You might be surprised!

    With all of this in mind, remember that spending money involves risk because you may discover that your bond is worth little more than the paper it's printed on.

    (Take a look at Old Stock Certificates: Lost Treasure or Wallpaper?)


  • How can I create a yield curve in Excel?
    A:

    You can create a yield curve in Microsoft Excel if you are given the time to maturities of bonds and their respective yields to maturity. The yield curve depicts the term structures of interest rates for bonds and the term structures could be normal, inverted or flat.

    The shape of a yield curve indicates where future interest rates are headed. The x-axis of the graph of a yield curve is reserved for the time to maturity, while the yield to maturities are located on the y-axis.

    Assume you want to plot the yield curve for the two-, five-, 10-, 20- and 30-year U.S. Treasury bonds (T-bonds). The respective yield to maturities of the U.S.T-bonds are 2.5%, 2.9%, 3.3%, 3.60% and 3.9%.

    Now Follow These Five Steps:

    1. Using Microsoft Excel, enter "U.S. Treasury Bonds' Times to Maturity" in cell A1 and "U.S. Treasury Bond's Yields to Maturity" in cell B1.
    2. Next, enter "2" into cell A2, "5" into cell A3, "10" into cell A4, "20" into cell A5, and "30" into cell A6.
    3. Then, enter "2.5%" into cell B2, "2.9%" into cell B3, "3.3%" into cell A4, "3.6%" into cell A5, and "3.9%" into cell A6.
    4. Select cells A2 through A6 and B2 through B6 together and click on Insert. Under the Charts tab, select Scatter and click on Scatter with Smooth Lines and Markers.
    5. Next, click on the chart, select Chart Elements and click on Axis Titles. For the horizontal axis, enter "Time to Maturity (In Years)" and "Yields" into the vertical axis title. Enter "U.S. Treasury Bonds Yield Curve" into the Chart Title.

    The resulting yield curve for these U.S. T-bonds is considered normal because it is concave down (increasing), and the rates are increasing as the times to maturity are further out.


  • How Central Banks Influence Money Supply
    A:

    Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board (the Fed) could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used.

    Below are three methods the Fed uses in order to inject (or withdraw) money from the economy.

    Modifying Reserve Requirements

    The Fed can influence the money supply by modifying reserve requirements, which generally refer to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.

    Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.

    Changing Short-Term Interest Rates

    The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money.

    Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, and so the Fed must be careful not to lower interest rates too much for too long.

    Conducting Open Market Operations

    Lastly, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.

    Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system.

    To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy. For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.


  • How do companies like Moody's rate bonds?
    A:

    Rating the creditworthiness of a bond issuer, despite the number crunching, is as much an art form as it is a science. While companies like Moody's and A.M. Best gather and analyze mountains of data, the rating itself comes down to the informed opinion of an analyst or a rating committee.

    Not unlike your individual credit score, the organizations that rate bonds look at an issuer's assets, debts, income, expenses and broad financial history. In addition, special attention is given to the trustworthiness of a company to repay previous bond issues on time and in full.

    The major bond rating agencies each use a form of scholastic grading scale, with some variation of an "A+" denoting the best rating. In the case of Moody's, ratings range from "Aaa" to "C". Typically, only bonds issued with a "Baa" rating or above are considered "investment grade", or appropriate for more conservative accounts and investors.

    Bond ratings are reviewed every six to 12 months. However, a bond may be reviewed at any time the agency deems necessary for reasons including: missed or delayed payments to investors, issuance of new bonds, changes to an issuer's underlying financial fundamentals, or other broad economic developments.

    For more on this subject, read The Debt Ratings Debate.

    This question was answered by Ken Clark.


  • How do hurdle rate MARR and internal rate of return IRR relate?
    A:

    In capital budgeting, projects are often evaluated by comparing the internal rate of return (IRR) on a project to the hurdle rate, or minimum acceptable rate of return (MARR). Under this approach, if the IRR is equal to or greater than the hurdle rate, the project is likely to be approved. If it is not, the project is typically rejected.

    The hurdle rate is the minimum rate that the company or manager expects to earn when investing in a project. The IRR, on the other hand, is the interest rate at which the net present value (NPV) of all cash flows, both positive and negative, from a project is equal to zero.

    Projects are also evaluated by discounting future cash flows to the present by the hurdle rate in order to calculate the NPV, which represents the difference between the present value of cash inflows and the present value of cash outflows.

    Generally, the hurdle rate is equal to the company's costs of capital, which is a combination of the cost of equity and the cost of debt. Managers typically raise the hurdle rate for riskier projects or when the company is comparing multiple investment opportunities.

    IRR is also used by financial professionals to compute the expected returns on stocks or other investments, such as the yield to maturity on bonds.

    While it is relatively straightforward to evaluate projects by comparing the IRR to the MARR, this approach has certain limitations as an investing strategy. For example, it looks only at the rate of return, as opposed to the size of the return. A $2 investment returning $20 would have a much higher rate of return than a $2 million investment returning $4 million to a company.

    IRR can only be used when looking at projects and investments that have an initial cash outflow followed by one or more inflows. Also, this method does not consider the possibility that various projects might have different durations.


  • How do I calculate a discount rate over time, using Excel?
    A:

    The discount rate is the interest rate used when calculating the net present value (NPV) of something. NPV is a core component of corporate budgeting and is a comprehensive way to calculate whether a proposed project will add value or not.

    For this article, when we look at the discount rate, we will be solving for the rate such that the NPV equals zero. Doing so allows us to determine the internal rate of return (IRR) of a project or asset.

    Discount Rate Defined

    First, let's examine each step of NPV in order. The formula is:

    NPV = ∑ {After-Tax Cash Flow / (1+r)^t} - Initial Investment

    Broken down, each period's after-tax cash flow at time t is discounted by some rate, shown as r. The sum of all these discounted cash flows is then offset by the initial investment, which equals the current NPV. Any NPV greater than $0 is a value-added project, and in the decision-making process among competing projects, having the highest NPV should go a long way toward being chosen.

    The NPV, IRR and discount rate are all connected concepts. With an NPV, you know the amount and timing of cash flows, and you know the weighted average cost of capital (WACC), which is designated as r when solving for the NPV. With an IRR, you know the same details, and you can solve for the NPV expressed as a percentage return. 

    The big question is - what is the discount rate that sets the IRR to zero? This is the same rate that will cause the NPV to be zero. As you will see below, if the discount rate equals the IRR, then the NPV is zero. Or to put it another way, if the cost of capital equals the return of capital, then the project will break even and have a NPV of 0. 

    Calculating the Discount Rate in Excel

    In Excel, you can solve for the discount rate a few ways:

    • You can find the IRR, and use that as the discount rate, which causes NPV to equal zero.  
    • You can use What-If analysis, a built-in calculator in Excel, to solve for the discount rate that equals zero.

    To illustrate the first method, we will take our NPV / IRR example. Using a hypothetical outlay, our WACC risk-free rate, and expected after-tax cash flows, we've calculated a NPV of $472,169 with an IRR of 57%. (Note: If table is hard to read, right-click and hit "view" for a bigger image.)


    Since we already defined the discount rate as a WACC that causes the IRR to equal 0, we can just take our calculated IRR and put it in place of WACC to see the NPV of 0. That replacement is shown below:


    Let's now look at the second method, using Excel's What-If calculator.  This assumes we did not calculate the IRR of 57%, as we did above, and have no idea what the correct discount rate is.

    To get to the What-If solver, go to the Data Tab --> What-If Analysis Menu --> Goal Seek. Then simply plug in the numbers, and Excel will solve for the correct value. When you hit "OK," Excel will recalculate WACC to equal to discount rate that makes the NPV zero (57%).



  • How do I calculate the expected return of my portfolio in Excel?
    A:

    The expected return of your portfolio can be calculated using Microsoft Excel if you know the expected return rates of all the investments in the portfolio. Using the total value of your portfolio, the value of each individual investment, and its respective return rate, your total expected return can be calculated quite simply.

    You can also calculate the expected return of a portfolio outside of Excel by using a basic formula.

    Calculating Total Expected Return in Excel

    First, enter the following data labels into cells A1 through F1: Portfolio Value, Investment Name, Investment Value, Investment Return Rate, Investment Weight, and Total Expected Return.

    In cell A2, enter the value of your portfolio. In column B, list the names of each investment in your portfolio. In column C, enter the total current value of each of your respective investments. In column D, enter the expected return rates of each investment.

    In cell E2, enter the formula = (C2 / A2) to render the weight of the first investment. Enter this same formula in subsequent cells to calculate the portfolio weight of each investment, always dividing by the value in cell A2. In cell F2, enter the formula = ([D2*E2] + [D3*E3] + ...) to render the total expected return.

    Example

    In the example above, assume that the three investments are government-issued bonds that carry annual coupon rates of 3.5%, 4.6%, and 7%, respectively.

    After labeling all your data in the first row, enter the total portfolio value of $100,000 into cell A2. Then, enter the names of the three investments in cells B2 through B4. In cells C2 through C4, enter the values $45,000, $30,000, and $25,000, respectively. In cells D2 through D4, enter the respective coupon rates referenced above.

    Next, in cells E2 through E4, enter the formulas = (C2 / A2), = (C3 / A2) and = (C4 / A2) to render the investment weights of 0.45, 0.3, and 0.25, respectively.

    Finally, in cell F2, enter the formula = ([D2*E2] + [D3*E3] + [D4*E4]) to find the annual expected return of your portfolio. In this example, the expected return is:

    = ([0.45 * 0.035] + [0.3 * 0.046] + [0.25 * 0.07])
    = 0.01575 + 0.0138 + 0.0175
    = .04705, or 4.7%


  • How do I calculate the Macaulay duration of a zero-coupon bond in Excel?
    A:

    The resulting Macaulay duration of a zero-coupon bond is equal to the time to maturity of the bond. A zero-coupon bond is a type of fixed-income security that does not pay interest on the principal amount. However, to compensate for the lack of coupon payment, a zero-coupon bond typically trades at a discount, and traders and investors can profit at its maturity date, when the bond is redeemed at its face value.

    The Macaulay duration is calculated by adding up the coupon payment per period multiplied by the time to maturity divided by 1 plus the yield per period raised to the time to maturity. Then, the resulting value is added to the total number of periods multiplied by the bond's par value divided by 1 plus the yield per period raised to the total number of periods. The resulting value is divided by the current bond price.

    For example, assume you hold a two-year zero-coupon bond with a par value of $10,000 and a yield of 5%, and you want to calculate the duration on Excel. In column A and B, right-click on the columns and select Column Width... and change the value to 30 for both columns. Next, enter "Par Value", "Yield", "Coupon Rate", "Time to Maturity" and "Macaulay Duration" into cells A2 through A6.

    In cells B2 through B5, enter "=10000", "=0.05", "=0" and "=2", respectively. In cell B6, enter the formula "=(B4 + (B5*B2)/(1+B3)^1) / ((B4 + B2)/(1+B3)^1)". Since a zero-coupon bond only has one cash flow and does not pay any coupons, the resulting Macaulay duration is 2.


  • How do I calculate yield in Excel?
    A:

    When assessing the profitability of bonds, analysts use a concept called yield to determine the amount of income that a given investment can be expected to generate each year. Yield is prospective and should not be confused with rate of return, which refers to gains that have already been realized.

    To calculate the current yield of a bond in Microsoft Excel, enter the bond value, the coupon rate and the bond price into adjacent cells, say A1 through A3. In cell A4, enter the formula "= A1 * A2 / A3" to render the current yield of the bond. However, as a bond's price changes over time, its current yield varies. Analysts often use a much more complex calculation called yield to maturity (YTM) to determine the bonds' total anticipated yield, including any capital gains or losses due to price fluctuation.

    (see also Guide To Excel For Finance)

    To calculate the YTM of a bond in Excel, you need the following information:

    • Settlement Date: The date when you purchased the security. All dates should be entered using the DATE function in Excel rather than as text.
    • Maturity Date: This is the date when the security will expire.
    • Coupon Rate: This is the fixed rate of payment guaranteed annually.
    • Price: This is the security's price per $100 of face value.
    • Redemption Value: This is the redemption value of the bond per $100 of face value.
    • Frequency: This is the number of coupon payments per year. Generally, payments are made annually, semi-annually or quarterly.
    • Basis: This is the annual day-count basis to use for calculation. This entry is optional; if omitted, it will revert to the Nasdaq 360-day standard count.

    Enter all of the information into cells A1 through A7. If the day-count basis is omitted, there will be data only in cells A1 through A6. In the next available cell, enter the formula =YIELD (A1, A2, A3, A4, A5, A6, A7) to render the YTM of the bond. A formula omitting the day-count basis will not include the A7 entry.


  • How do I calculate yield of an inflation adjusted bond?
    A:

    Standard yield calculation methods still apply to inflation-adjusted bonds, only investors are more likely to pay attention to real yield with an inflation-adjusted bond. Inflation-adjusted bonds have yields that appear to be lower than non-adjusted (nominal) bonds. The bond yields for inflation-adjusted bonds are specified as a percentage rate in excess of measured inflation.

    To find the real (rather than nominal) yield of any bond, calculate the annual growth and subtract the rate of inflation. This is easier for inflation-adjusted bonds than it is for non-adjusted bonds, which are only quoted in nominal changes.

    Consider the difference between a U.S. Treasury bond (T-bond) and a Treasury inflation-protected security (TIPS). A standard T-bond with a par value of $1,000 and a coupon rate of 7% will always return $70. A TIPS, on the other hand, adjusts its par value according to inflation. If inflation is 5% during the course of a year, a $1,000 par value TIPS would turn into a $1,050 par value even if the secondary market price of the TIPS declined over the same time.

    A $1,000 par value TIPS with a 4% coupon would initially generate a return of $40. If inflation adjusted the par value to $1,050, the coupon payment would instead be $42 ($40 * 1.05). Suppose the TIPS were trading at $925 on the secondary market. The real yield calculation would use the secondary market price (like any other bond) of $925, but use the inflation adjusted coupon payment of $42. The real yield would be 4.54% (42 / 925).

    Bonds that are linked to the consumer price index (CPI(, for example, generate yields that have an embedded inflation assumption. If nominal government bonds are yielding 5% and TIPS are yielding 3% for the same maturity, then the assumption is that the annualized CPI will be 2%. If actual inflation over the course of the year exceeds 2%, the TIPS bondholders receive a higher real return than nominal bondholders. That 2% threshold is referred to as the inflation break-even point, beyond which the TIPS becomes a better value than the nominal bond.


  • How do I calculate yield to maturity of a zero-coupon bond?
    A:

    Zero-coupon bonds do not have re-occurring interest payments, which makes their yield to maturity calculations different from bonds with a coupon rate.

    Most time value of money formulas require some interest rate figures for each point in time. This makes the yield to maturity easier to calculate for zero coupon bonds, because there are no coupon payments to reinvest, making it equivalent to the normal rate of return on the bond.

    The Formula

    The formula for calculating the yield to maturity on a zero coupon bond is:

    Yield to Maturity = (Face Value / Current Price of Bond) ^ (1 / Years to Maturity) - 1

    For example, consider a $1,000 zero coupon bond that has two years until maturity. The bond is currently valued at $925 (the price it could be purchased at today). The formula would look like: (1000 / 925) ^ (1 / 2) - 1. When solved, this equation produces a value of 0.03975, which would be rounded and listed as a yield of 3.98%.

    Potential Changes

    The yield to maturity may change from year to year for any bond, depending on changes in the overall demand for bonds in the market. Consider what would happen if investors become more willing to hold bonds due to economic uncertainty. Bond prices would probably rise, which would increase the denominator in the yield to maturity formula, thereby reducing the yield.

    Yield to maturity is a basic investing concept that is used to compare bonds of different coupons and time until maturity. Without accounting for any interest payments, zero coupon bonds always have a yield to maturity equal to their normal rate of return. The yield to maturity for zero coupon bonds is sometimes referred to as the spot rate.


  • How do I use the holding period return yield to evaluate my bond portfolio?
    A:

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given period. This method of yield comparison enables investors to determine which bonds are generating the largest profit. In addition, this formula can help determine when it is more advantageous to sell a bond at a premium or hold it until maturity.

    What Is the Holding Period Return Yield Formula?

    Depending on the type of asset involved, different holding period return yield formulas can be applied to account for the compounding of interest and varying return rates. However, bonds generate a fixed amount of income each year. This rate of return, known as the coupon rate, is set at issuance and remains unchanged for the life of the bond.

    The formula for the holding period return yield of bonds, therefore, is quite simple:

    HPRY = ((Selling Price - Purchase Price) + Total Coupon Payments) / Purchase Price

    If you still own the bond, use the current market price of the bond instead of the selling price to determine the current holding period return yield of your bond.

    Example

    Assume you purchased a 10-year, $5,000 bond with a 5% coupon rate. You purchased the bond five years ago at par value. This means the bond has paid $1,250, or 5 * $5,000 * 5%, in coupon payments over the past five years.

    Assume the bond has a current market value of $5,500.

    If you sold your bond today, the holding period return yield of the bond is:

    = (($5,500 - $5,000) + $1,250) / $5,000
    = ($500 + $1,250) / $5,000
    = $1,750 / $5,000
    = 0.35, or 35%

    However, like all bonds, the repayment of your initial investment is guaranteed by the issuing entity once the bond matures. If you hold the bond until maturity, it generates a total of $2,500 in coupon payments, or 10 * $5,000 * 5%, and the holding period return yield is:

    = (($5,000 - $5,000) + $2,500 / $5,000
    = $2,500 / $5,000
    = 0.5 or 50%


  • How Do Low Rates Affect the Demand for Bonds?
    A:

    The lower interest rates that are found on bonds, especially government-backed bonds, are often not seen as enough by investors. This is the main driving force behind certain investors not wanting to invest in bonds. 

    The Impact of Low Rates on Bond Investing

    Many investors are more attracted to the potential double-digit returns that the stock market can produce, which are not seen as often in the debt market.

    Despite the perception, the bond market can be very profitable for investors, as investing in bonds is considerably safer than investments in the equities market. It is often not until after an investment in the stock market goes wrong that investors realize how risky stocks can be. The underlying concept of this idea is the willingness of an investor to take on risk to reap a potentially greater reward.

    This is one of the most basic tenets of the financial markets — the more risk you take on, the greater the compensation you need to receive. Investing in the stock market is considered to carry more risk than the bond market and, therefore, it generally provides greater returns for investors in the long run.

    (To learn more, read Determining Risk and the Risk Pyramid.)

    Risk vs. Return

    It is the impact of these greater returns on a person's investments that affects the investment that person will choose. For example, imagine that you were able to invest in the bond market and earn five percent on your initial investment of $10,000 every year for 30 years. In this case, your investment would grow to $43,219. On the other hand, if you were to invest in the stock market, which provides a higher return of, say, 10 percent, that initial $10,000 would grow to $174,494 or just over four times as much (20 percent would get you $2.3 million).

    The possibility of earning a significantly higher amount of money certainly influences investors to place their money in the stock market. It is important to note, however, that a 10 percent return on stocks is far from guaranteed and there remains a potential for loss. Nevertheless, it is the prospect of huge gains over time that draws some people away from the bond market and more towards the stock market.

    (For more information, review Financial Concepts: The Risk/Return Tradeoff.)


  • How do open market operations (OMOs) affect bond prices?
    A:

    Open market operations (OMOs) directly influence the money supply, which in turn impacts interest rates. Interest rates are negatively correlated with bond prices due to opportunity cost. Thus, central banks can indirectly affect bond prices through the purchase or sale of debt securities on the open market.

    OMOs are a tool used by central banks such as the Federal Reserve to implement monetary policy. OMOs involve the purchase or sale of securities, typically government debt securities, on the open market. Banks must often borrow reserves from one another to meet overnight reserve requirements, and these funds are loaned at an interest rate called the federal funds rate.

    By affecting money supply through OMOs, the Fed can influence the federal funds rate. Low reserve borrowing rates make it relatively easy for banks to procure money, leading to lower borrowing rates for businesses and consumers. Bond prices are negatively correlated to interest rates due to opportunity cost. When interest rates go up, existing bonds bearing the old coupon rates are no longer as valuable as new bonds with the higher coupon rate. On the open market, the price of lower-interest bonds must fall so that expected return is equal for all comparable bonds.

    From 2008 to 2014, the Federal Open Market Committee targeted very low interest rates in an effort to stimulate economic activities and keep financial institutions functioning normally. As part of this expansionary policy, the Fed purchased $600 billion of Treasuries and $600 billion of mortgage-backed securities. This increased the money supply, drove down interest rates and sent bond prices higher.


  • How does a bond's coupon interest rate affect its price?
    A:

    All bonds have a coupon interest rate, sometimes referred to as a coupon rate (or simply a coupon), that denotes the fixed annual interest paid by the issuer to the bondholder. Coupon interest rates are determined as a percentage of the bond's par value, also known as face value, but differ from interest rates on other financial products because it is the dollar amount, not the percentage, that is fixed over time.

    Why National Interest Rates Matter

    Coupon rates are largely influenced by the national interest rates controlled by the government. This means that if the minimum interest rate is set at 5%, no new bonds may be issued with coupon rates below this level. However, pre-existing bonds with coupon rates higher or lower than 5% can still be bought and sold on the secondary market.

    Most bonds have fixed coupon rates, meaning that no matter what the national interest rate may be or how much the bond's market price fluctuates, the annual coupon payments remain stable. When new bonds are issued with higher interest rates, they are automatically more valuable to investors because they pay more interest per year compared to pre-existing bonds. Given the choice between two $1,000 bonds selling at the same price, one that pays 5% and one that pays 4%, the former is clearly the wiser option.

    Coupon Interest Rate versus Yield

    For instance, a bond with a $1,000 face value and a 5% coupon rate is going to pay $50 in interest even if the bond price climbs to $2,000 or drops to $500. It is crucial to understand the difference between a bond's coupon interest rate and its yield. The yield represents the effective interest rate on the bond, determined by the relationship between the coupon rate and the current price. Coupon rates are fixed, but yields are not.

    Another example would be that a $1,000 face value bond has a coupon interest rate of 5%. No matter what happens to the bond's price, the bondholder receives $50 that year from the issuer. However, if the bond price climbs from $1,000 to $1,500, the effective yield on that bond changes from 5% to 3.33%. If the bond price falls to $750, the effective yield is 6.67%.

    General interest rates have a huge impact on investing, and this is also true with bonds. When the prevailing market rate of interest is higher than the coupon rate, such as interest rates may be at 7% but a bond's coupon is only 5% of face value, the tendency is for the price of the bond to drop on the open market. This is because investors do not want to purchase a bond at face value and receive a 5% yield when they could find 7% elsewhere.

    This drop in demand pushes down the price of the bond towards an equilibrium 7% yield, which is roughly $715 in the case of a $1,000 face value bond. At $715, the bond's yield is competitive.

    Higher Coupon Rates

    Conversely, a bond with a higher coupon rate than the market rate of interest tends to raise in price. If the general interest rate is 3% but the coupon is 5%, investors rush to purchase the bond to achieve a higher return on their investment. This increased demand causes bond prices to rise until, other things being equal, the $1,000 face value bond sells for $1,666.

    In reality, bondholders are just as concerned, if not more so, with the bond yield to maturity than with current yield, as bonds with a shorter maturity tend to have smaller discounts or premiums.

    The credit rating given to bonds also has a large influence on price. It could be very possible that the bond's price does not accurately reflect the relationship between the coupon rate and other interest rates.

    Things get even more complicated when you start adding in call options. All things being equal, however, the coupon rate affects the price of bonds until the current yield equals prevailing interest rates.

    Because each bond returns its full par value to the bondholder upon maturity, investors can increase bonds' total yield by purchasing them at below-par prices, referred to as a discount. A $1,000 bond purchased for $800 generates coupon payments each year but also yields a $200 profit upon maturity, unlike a bond purchased at par.


  • How does a bull market in stocks affect the bond market?
    A:

    Bonds and stocks compete for investment money at a fundamental level, which suggests that a strengthening equity market would attract funds away from bonds. This would tend to lower the demand for bonds; sellers would have to lower prices to attract buyers. Theoretically, the price of bonds would gravitate south until bond yields rose to a level that was competitive with the risk-adjusted returns found in the stock market. Even though the actual relationship between bonds and stocks often doesn't fit this simple theory perfectly, it does help to describe the dynamic nature of these investment alternatives.

    In the short run, rising equity values would tend to drive bond prices lower and bond yields higher than they otherwise might have been. However, there are many other variables at play in any given investment market, such as interest rates, inflation, monetary policy, government regulation and overall investor sentiments.

    Bull markets tend to be characterized by investor optimism and expectations of future stock price appreciation. This adjusts the risk/return dynamic in the marketplace and often leads to investors and traders becoming relatively less risk-averse. Most bonds (not junk bonds) represent a less risky investment than most stocks, which means that stocks have to offer a higher return as a premium for increased risk. This is why money leaves equities and goes into the bond market during times of uncertainty. The opposite would tend to be true during a bull market; stocks would begin to receive funds at the expense of bonds.

    Whether declining bond prices are a positive effect depends on the type of bond investor. Current bondholders with fixed coupons become increasingly harmed by dropping bond prices as their securities approach maturity. Those who are purchasing bonds like dropping bond prices because it means that they can get higher yields.

    The interest rate policy of the Federal Reserve (and other central banks for markets outside of the U.S.) must also be considered. The Fed manipulates short-term interest rates in an effort to affect economic conditions. If the economy is perceived to be struggling, the Fed may try to force interest rates lower to spur consumption and lending. This causes bond prices to rise. If the strong bull market develops concurrent with strong economic data, however, the Fed may decide to let interest rates rise. This should drive bond prices even lower as yields rise to match interest rates. Fed intervention has a large impact on both stocks and bonds.

    Economists and market analysts have ideas about certain causal effects in the economy, but the entire system is too interrelated and complicated to predict with certainty. It may be possible for bond prices to rise while stocks are enjoying a bull market. Investor confidence is never fixed, and the purported outcomes of government or central bank policy may create results that were not anticipated. This is part of why it is difficult to develop effective trading strategies based on macroeconomic phenomena.


  • How Does a Person Gain From an Investment?
    A:

    There are two main ways in which a person gains from an investment. The first is by capital gains, which is the difference between the purchase price and the sale price of an investment. The second is investment income, defined as the money paid to the holder of an investment by the issuer of the investment. Depending on the type of investment, the source or mix of the total gain will differ. And in some cases, these different sources are taxed at different rates, so it is important to be aware of each.

    How Gains in Stocks are Determined

    All stocks can generate a capital gain as the price of a stock is constantly changing in the market. This allows you to potentially sell for a higher price than what you bought the stock for originally. Some stocks also generate income gain through the payment of dividends paid out by a company from its earnings.

    For example, say that you bought a stock for $10 and the company pays off an annual dividend of $.50, and after two years of holding the stock you sell it for $15. Your capital gain is 50 percent ($5/$10) and your income gain is ten percent ($1/$10) for a total gain of 60 percent (or $6/$10).

    (For more, check out How Stocks Trade in our Stocks tutorial.)

    How Gains in Bonds Are Determined

    Bonds are typically known for their payment of coupons, which is an income source of gain. However, a person also can generate a capital gain from a bond by selling the bond before maturity into the secondary market.

    For example, if you bought a bond for $1,000 and sold it for $1,100, you would realize a capital gain along with any income gain from coupons paid out to you. There is an inverse relationship between bonds and interest rates, the price of a bond will change in the opposite direction of the prevailing interest rates in the market. If interest rates fall, your bond will become more attractive in the market and an upwards bid should be expected.

    (For more information on gains, see our Investing 101 tutorial.)


  • How does an investor make money on bonds?
    A:

    Bonds are part of the family of investments known as fixed-income securities. These securities are debt obligations, meaning one party is borrowing money from another party who expects to be paid back the principal (the initial amount borrowed) plus interest.

    How an Investor Makes Money From a Coupon-Paying Bond

    Investors (the holders of the bond) can make money on bonds in two ways.

    First, as we already mentioned, the holder receives interest payments – known as the coupon – throughout the life of a bond. For instance, if you bought a 10-year bond with a coupon rate of 8%, the issuer would send you a coupon (interest) payment of $80 every year. Most bonds pay twice a year, and so, technically, you would receive two checks for $40 each.

    Second, bonds fluctuate in price similar to any other security. This price fluctuation depends on a number of factors, the most important of which is the interest rate in the market. Some investors attempt to make money from the changing price of a bond by guessing where interest rates will go.

    How an Investor Makes Money From a Zero-Coupon Bond

    An investor makes money on a zero-coupon bond by being paid interest upon maturity. Also known as a discount bond, a zero-coupon bond is a type of bond purchased for an amount lower than its face value, which means that the full face value of the bond is repaid when the bond reaches maturity.

    The party who issues the bond does not make interest payments (coupon), but pays the full value once the maturation process is complete. U.S. Treasury bills (T-bills) and savings bonds are two examples of zero-coupon bonds. Though most zero-coupon bonds pay a set amount of money (giving them a set face value), some bonds are inflation-indexed, in which case the amount paid back to the bondholder is determined to have a specified amount of purchasing power instead of a specific dollar amount.

    Reaching Maturity

    The amount of time involved for a zero-coupon bond to reach maturity depends on whether the bond is a short-term or long-term investment. A zero-coupon bond that is a long-term investment generally has a maturity date that starts around 10 to 15 years.

    Zero-coupon bonds that are considered short-term investments typically have a maturity that is no more than one year. These short-term bonds are usually called bills.

    Because zero-coupon bonds return no interest payments throughout the maturation process, if there is a case where a bond does not reach maturity for 17 years, investors in the bond do not see any profit for nearly two decades. A retired investor, for example, seeking to maintain a steady flow of income would likely see little use for zero-coupon bonds.

    However, a family saving to buy a vacation retirement home could benefit significantly from a zero-coupon bond with a 15- or 20-year maturity. A zero-coupon bond may also appeal to an investor seeking to pass on wealth to his heirs. If a $2,000 bond is given as a gift, the giver uses only $2,000 of his yearly gift tax exclusion, and the recipient receives more than $2,000 once the bond reaches maturity.

    Tax Reasons

    Zero-coupon bonds issued in the U.S. retain an original issue discount (OID) for tax reasons. Zero-coupon bonds often input receipt of interest payment, or phantom income, despite the fact the bonds do not pay periodic interest. For this reason, zero-coupon bonds subjected to taxation in the U.S. can be held in a tax-deferred retirement account, allowing investors to avoid paying tax on future income.

    As an alternative to this process, if a zero-coupon bond is issued by a U.S. local or state government entity such as in the case of a municipal bond, any imputed interest is free from U.S. federal tax and typically state and local tax as well.

    (For further reading, see the Bond Basics Tutorial).


  • How does chapter 11 bankruptcy affect a company's stocks and bonds?
    A:

    Filing for chapter 11 bankruptcy protection simply means that a company is on the verge of bankruptcy but believes that it can once again become successful if it is given an opportunity to reorganize its assets, debts and business affairs. Although the chapter 11 reorganization process is complex and expensive, most companies, if given the choice, prefer chapter 11 to other bankruptcy provisions such as chapter 7 and chapter 13, which cease company operations and lead to the total liquidation of assets to creditors. Filing for chapter 11 gives companies one last opportunity to be successful.

    Understanding Chapter 11 Bankruptcy

    While chapter 11 can spare a company from declaring total bankruptcy, the company's bondholders and shareholders are usually in for a rough ride. When a company files for chapter 11 protection, its share value typically drops significantly as investors sell their positions. Furthermore, filing for bankruptcy protection means that the company is in such rough shape that it would probably be de-listed from the major exchanges such as the Nasdaq or the New York Stock Exchange and relisted on the pink sheets or the Over-The-Counter Bulletin Board (OTCBB).

    When a company going through bankruptcy proceedings is listed on the pink sheets or OTCBB, the letter "Q" is added to the end of the company's ticker symbol to differentiate it from other companies. For example, if a company with the ticker symbol ABC was placed on the OTCBB due to chapter 11, its new ticker symbol would be ABCQ.

    Under Chapter 11, corporations are allowed to continue business operations, but the bankruptcy court retains control over significant business decisions. Corporations may also continue to trade company bonds and stocks throughout the bankruptcy process but are required to report the filing with the Securities and Exchange Commission within 15 days. Once Chapter 11 bankruptcy is filed, the federal court appoints one or more committees that are tasked with representing and working with creditors and shareholders of the corporation to develop a fair reorganization. The corporation, along with committee members, creates a reorganization plan that must be confirmed by the bankruptcy court and agreed upon by all creditors, bondholders and stockholders.

    Sometimes after a reorganization, a company will issue new stock that is considered different from the pre-reorganization stock. If this occurs, investors will need to know whether the company has given its shareholders the opportunity to exchange the old stock for new stock, because the old stock will usually be considered useless when the new stock is issued.

    Throughout the duration of the reorganization, bondholders will stop receiving coupon payments and/or principal repayments. Furthermore, the company's bonds will also be downgraded to speculative-grade bonds, otherwise known as junk bonds. Since most investors are wary of buying junk bonds, investors that want to sell their bonds will need to do so at a substantial discount.

    After the reorganization process and depending on the terms dictated by the debt restructuring plan, the company may require investors to exchange their old bonds for shares and/or new bonds. These new issues of stocks and bonds represent the company's attempt to create a more manageable level of debt.

    (For more on this, see What Is A Corporate Credit Rating? and Junk Bonds: Everything You Need To Know.)

    If the plan for reorganization fails and the company’s liabilities start to exceed its assets, then the bankruptcy is converted into a chapter 7 bankruptcy.

    How Division of Assets Differs Under Chapter 7 Bankruptcy

    Under a chapter 7 bankruptcy, all assets are sold for cash. That cash is then used to pay off legal and administrative expenses that were incurred during the bankruptcy process. After that, the cash is distributed first to senior debt-holders and then unsecured debtholders, including owners of bonds. In the extremely rare event that there is still cash left over, the rest is divided among the shareholders.

    On the other hand, if the reorganization plan ends up being successful and the company returns to a state of profitability, then multiple things could happen to investors’ pre-reorganization bonds or stock. In the case of bonds, investors may be obligated to exchange their old bonds for a combination of new bonds or stock, depending on the conditions required by the debt restructuring plan. In addition, the coupon and principal repayments on the new debt instruments would resume.

    Stockholders, however, tend not to be so lucky. After restructuring, the company usually issues new stock, making the pre-reorganization stock worthless. In some cases, holders of the old stock are allowed to exchange their securities for a discounted amount of the new stock, which is dictated by the plan of reorganization.

    For further reading on this topic, see An Overview of Corporate Bankruptcy.


  • How does inflation affect fixed-income investments?
    A:

    Inflation is typically defined as a sustained increase in the price level of goods and services. There is no widespread consensus on the primary cause of inflation, but most economists agree that certain mechanisms in the economy, mainly commodity price increases and currency depreciation, contribute strongly to it. Inflation has the potential to significantly reduce the return on fixed-income investments, and investors should monitor its effect on their assets.

    The real interest rate incorporates the effect inflation has on an investment. For example, a bond’s nominal interest rate does not take inflation into account, and an investor will only earn that amount in accumulated value when inflation is zero. A bond’s real interest rate, which indicates the investor's actual gain or loss, is calculated by subtracting inflation from the nominal interest rate. For example, if the nominal interest rate is 4% and inflation is 3%, the real interest rate is 1%. If inflation is higher than the nominal interest rate, the bondholder will take a loss. As many investors rely on bonds as a predictable source of income, they can take significant losses during periods of high inflation.

    One of the most problematic aspects of inflation is that its impact on investments is not stated explicitly, so the investor must monitor it him/herself. There are two main inflation indicators: the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI consists of prices of consumer goods and capital goods paid to producers (mostly by retailers), and inflationary trends are reflected earlier than they are in the CPI, so the PPI can be useful to investors as an early signal. The CPI solely includes retail prices, though it is much more widely followed than the PPI. When economists talk about rising inflation, they are usually referring to a rise in the CPI.


  • How does preferred stock differ from company issued bonds?
    A:

    Preferred stock is a special kind of equity ownership, while bonds are a common form of debt issue. Many consider preferred stock an investment that lands in between common shares and bonds. Despite many similarities, preferred stock is generally riskier than a bond and tends to have higher yields to compensate for that. In the event of corporate bankruptcy proceedings and liquidation, bonds take preference over preferred stock when receiving payments.

    Preferred Stock

    Preferred stockholders have a claim to ownership of a corporation just like common stockholders. The structure and rights granted by preferred stock varies from company to company. Unlike common shares, preferred shares do not come with voting rights.

    Preferred stock carries characteristics of fixed, dividend-paying securities such as bonds and offers appreciation and possible capital gains such as regular stock. In terms of the distribution of profits, preferred stock dividends are paid before common stock dividends. Additionally, most preferred shares have regularly occurring interest payments. These features make them a more attractive income investment than common shares.

    Like bonds, preferred stock is generally callable at the company's option. This gives the issuer the right to call back the security during times of falling interest rates. Typically, the calling of preferred stock is followed by a reissuing of additional lower-yielding preferred stock. Most preferred stock is convertible into common shares.

    Bonds

    Corporate bonds are debt instruments, or loans made to the company, which pay interest to the holder until the loan matures, at which point the face value of the bond is repaid. Bondholders do not enjoy voting rights like common shareholders, and they are also not entitled to any dividend payments. They are not owners and do not share in profits.

    Bonds are issued at a certain face value, but their actual price in the market fluctuates based on a number of factors, including interest rates and the overall demand for loanable funds. In the event a corporation suffers financial hardship and is forced to declare bankruptcy, bondholders are paid back before any of the company's assets are distributed to shareholders. This feature makes bonds less vulnerable to default risk than other types of securities.

    Bonds Vs. Preferred Stock

    All bonds have a set maturity date, but this is not necessarily the case for preferred shares, although there are callable redemption dates. Preferred shares can theoretically last forever. However, the interest payments to bondholders are more secure than the dividend payments to preferred shareholders. A company may determine to suspend dividends during times of hardship or capital expansion, while bond payments must be made regardless of financial circumstance.

    From an investor's perspective, bonds are safer but offer less upside than preferred stock. Preferred stock tends to have a lower par value and higher yields. It also tends to experience greater price volatility and be less secure than a bond.