Research a Bond’s Ratings, Maturity, and Callability - dummies

Research a Bond’s Ratings, Maturity, and Callability

By Russell Wild

After you have done basic research on a bond and know the face value, coupon rate, and sale price (discount or premium), you are ready to start a little digging. Here’s what you want to know next about the bond:

  • Is the bond issuer capable of repaying you your money? Or could the issuer go belly-up and default on (fail to repay) all or part of your loan?

  • When will you see your principal returned?

  • Is there a chance that the bond will be called?

Bond ratings: Separating quality from junk

Not all bonds pay the same coupon rates. In fact, some bonds pay way more than others. One of the major determinants of a bond’s coupon rate is the financial standing of the issuer.

The U.S. Treasury, a major issuer of bonds, pays modest rates of return on its bonds (generally a full percentage point less than similar bonds issued by corporations). The reason? Uncle Sam doesn’t have to pay more. People assume that the U.S. government isn’t going to welsh on its debts, so they are willing to lend the government money without demanding a high return.

Shakier entities, such as a new company, a city in financial trouble, or the Russian government (which has a history of defaulting) would have to offer higher rates of return to find any creditors. So they must, and so they do.

An entire industry of bond-rating companies, such as Moody’s, Standard and Poor’s (S&P), and Fitch Ratings, exists to help bond investors figure their odds of getting paid back from a company or municipality to which they lend money. These firms dig into a bond issuer’s financial books to see how solvent the entity is.

Theoretically, the higher the rating, the safer your investment; the lower the rating, the more risk you take. In addition, other resources can tell you how much extra interest you should expect for taking on the added risk of lending to a shaky company.

Know this: Ratings are very helpful — it’s hard to imagine markets working without them — but neither the ratings nor the raters are infallible. In the case of Enron, the major ratings firms — S&P and Moody’s — had the company’s bonds rated as investment-grade until four days prior to the company declaring bankruptcy.

Investment-grade means that the risk of loss is very low and the odds of getting repaid very high. Weren’t Enron bondholders surprised!

That was 2002. Six years later came the subprime mortgage crisis, in which investors in certain mortgage bonds lost a bundle. Just about the time that everyone thought the ratings agencies had learned something since the Enron debacle and reestablished the public’s trust, they once again failed investors quite miserably.

They apparently failed to see — or perhaps they did see but failed to report — the impending collapse of these mortgage bonds.

Bond insurance

Some bonds come insured and are advertised as such. This is most common in the municipal bond market, although less common than it was years ago. Even though default rates are very low among municipalities, cities know that people buy their bonds expecting safety. So they sometimes insure.

If a municipality goes to the trouble of having an insurance company back its bonds, you know that you are getting a safer investment, but you shouldn’t expect an especially high rate of interest. (No, you can’t decline the insurance on an insured bond. It doesn’t work like auto-rental insurance.)

Know this: Some proponents of holding individual bonds say that you should delve not only into the financial health of the bond issuer but also, in the case of an insured bond, the financial health of the insurance company standing behind the issuer. That’s a fair amount of work, which is one reason many advisors tend to favor bond funds for most middle-class family portfolios.

Bond maturity

Generally, the longer the maturity of the bond, the higher the interest rate paid. The reason is simple enough: Borrowers generally want your money for longer periods of time and are willing to pay accordingly. Lenders generally don’t want their money tied up for long periods and require extra incentive to make such a commitment.

And finally, the longer you invest your money in a bond, the greater the risk you are taking — both that the issuer could default and that interest rates could pop, lessening the value of your bond.

Know this: it doesn’t matter who the issuer is, when you buy a 20-year bond, you are taking a risk. Anything can happen in 20 years. Who would have thought 20 years ago that General Motors could find itself on the verge of bankruptcy? Or that Eastman Kodak would be in bankruptcy, its bonds selling for pennies to the dollar?

Bond callability

A bond that is callable is a bond that can be retired by the company or municipality on a certain date prior to the bond’s maturity. Because bonds tend to be retired when interest rates fall, you don’t want your bond to be retired; you generally aren’t going to be able to replace it with anything paying as much.

Because of the added risk, callable bonds tend to carry higher coupon rates to compensate bond buyers.

Know this: Please be careful when buying any individual callable bond. Much of the real pain seen in the bond market has occurred over calls. There have been cases where a bond buyer will pay a broker a hefty sum to buy a bond callable in, say, six months.

The bond, sure enough, gets called, and the bondholder suddenly realizes that he paid the broker a fat fee and made nothing — perhaps got a negative return — on his investment. Of course, the broker never bothered to point out this potentially ugly scenario.

Bond taxes

Back in the early days of the bond market in the United States, the federal government made a deal with the cities and states: You don’t tax our bonds, and we won’t tax yours.

And, so far, all parties have kept their word. When you invest in Treasury bonds, you pay no state or local tax on the interest. And when you invest in municipal bonds, you pay no federal tax on the interest. Accordingly, muni bonds pay a lower rate of interest than equivalent corporate bonds. But you may still wind up ahead on an after-tax basis.

Know this: the simple taxable versus tax-free calculators you find online don’t always steer you in the best direction.