Want to improve your portfolio's risk/return profile?

Adding bonds creates a more

balanced portfolio, strengthening diversification and calming volatility. You can
get your start in bond investing by learning a few basic bond market terms.
On the surface, the bond market may seem unfamiliar, even to experienced stock
investors. Many investors make only passing ventures into bonds because they
are confused by the apparent complexity of the market. Bonds are actually very
simple debt instruments, if you understand the terminology. Let's take a look at
that terminology now.
Tutorial: Bond Basics
1. Basic Bond Characteristics
A bond is simply a type of loan taken out by companies. Investors lend a
company money when they buy its bonds. In exchange, the company pays an
interest "coupon" at predetermined intervals (usually annually or semiannually)
and returns the principal on the maturity date, ending the loan.
Unlike stocks, bonds can vary significantly based on the terms of the
bond's indenture, a legal document outlining the characteristics of the bond.
Because each bond issue is different, it is important to understand the precise
terms before investing. In particular, there are six important features to look for
when considering a bond.
Maturity
The maturity date of a bond is the date when the principal, or par, amount of the
bond will be paid to investors, and the company's bond obligation will end.
Secured/Unsecured
A bond can be secured or unsecured. Unsecured bonds are called debentures;
their interest payments and return of principal are guaranteed only by the credit of
the issuing company. If the company fails, you may get little of your investment
back. On the other hand, a secured bond is a bond in which specific assets are
pledged to bondholders if the company cannot repay the obligation.

Liquidation Preference
When a firm goes bankrupt, it pays money back to investors in a particular order
as it liquidates. After a firm has sold off all of its assets, it begins to pay out to
investors. Senior debt is paid first, then junior (subordinated) debt, and
stockholders get whatever is left over. (To learn more, read An Overview of
Corporate Bankruptcy.)
Coupon
The coupon amount is the amount of interest paid to bondholders, normally on an
annual or semiannual basis.
Tax Status
While the majority of corporate bonds are taxable investments, there are some
government and municipal bonds that are tax exempt, meaning that income
and capital gains realized on the bonds are not subject to the usual state and
federal taxation. (To learn more, read The Basics of Municipal Bonds.)
Because investors do not have to pay taxes on returns, tax-exempt bonds will
have lower interest than equivalent taxable bonds. An investor must calculate
the tax-equivalent yield to compare the return with that of taxable instruments.
Callability
Some bonds can be paid off by an issuer before maturity. If a bond has a call
provision, it may be paid off at earlier dates, at the option of the company, usually
at a slight premium to par. (To learn more, read Callable Bonds: Leading A
Double Life.)
2. Risks of Bonds
Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the
obligation will not be made as required. (To learn more, read Corporate Bonds:
An Introduction To Credit Risk.)

Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than
expected, normally through a call provision. This can be bad news for investors,
because the company only has an incentive to repay the obligation early when
interest rates have declined substantially. Instead of continuing to hold a high
interest investment, investors are left to reinvest funds in a lower interest rate
environment.
Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what
the investor expected. If interest rates significantly decline, the investor faces the
possibility of prepayment. If interest rates increase, the investor will be stuck with
an instrument yielding below market rates. The greater the time to maturity, the
greater the interest rate risk an investor bears, because it is harder to predict
market developments farther out into the future. (To learn more, read Managing
Interest Rate Risk.)
3. Bond Ratings
Agencies
The most commonly cited bond rating agencies are Standard &
Poor's, Moody's and Fitch. These agencies rate a company's ability to repay its
obligations. Ratings range from 'AAA' to 'Aaa' for "high grade" issues very likely to
be repaid to 'D' for issues that are in currently in default. Bonds rated 'BBB' to
'Baa' or above are called "investment grade"; this means that they are unlikely to
default and tend to remain stable investments. Bonds rated 'BB' to 'Ba' or below
are called "junk bonds", which means that default is more likely, and they are thus
more speculative and subject to price volatility.
Occasionally, firms will not have their bonds rated, in which case it is solely up to
the investor to judge a firm's repayment ability. Because the ratings systems differ
for each agency and change from time to time, it is prudent to research the rating
definition for the bond issue you are considering. (To learn more, read The Debt
Ratings Debate.)

4. Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most
often used, but it is important to understand several other yield measurements
that are used in certain situations.
Yield to Maturity (YTM)
As said above, yield to maturity (YTM) is the most commonly cited yield
measurement. It measures what the return on a bond is if it is held to maturity
and all coupons are reinvested at the YTM rate. Because it is unlikely that
coupons will be reinvested at the same rate, an investor's actual return will differ
slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use
Excel's RATE or YIELDMAT (Excel 2007 only) functions for this computation. A
simple function is also available on a financial calculator. (Keep reading on this
subject in Microsoft Excel Features For The Financially Literate.)
Current Yield
Current yield can be used to compare the interest income provided by a bond to
the dividend income provided by a stock. This is calculated by dividing the bond's
annual coupon amount by the bond's current price. Keep in mind that this yield
incorporates only the income portion of return, ignoring possible capital gains or
losses. As such, this yield is most useful for investors concerned with current
income only.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the
bond periodically. It is calculated by dividing the annual coupon payment by
the par value of the bond. It is important to note that the nominal yield does not
estimate return accurately unless the current bond price is the same as its par
value. Therefore, nominal yield is used only for calculating other measures of
return.
Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity
date. Investors will realize a slightly higher yield if the called bonds are paid off at

a premium. An investor in such a bond may wish to know what yield will be
realized if the bond is called at a particular call date, to determine whether
the prepayment risk is worthwhile. It is easiest to calculate this yield using Excel's
YIELD or IRR functions, or with a financial calculator. (For more insight,
see Callable Bonds: Leading A Double Life.)
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a
bond only for a certain period of time, rather than to maturity. In this case, the
investor will sell the bond, and this projected future bond price must be estimated
for the calculation. Because future prices are hard to predict, this yield
measurement is only an estimation of return. This yield calculation is best
performed using Excel's YIELD or IRR functions, or by using a financial
calculator.
Conclusion
Although the bond market appears complex, it is really driven by the same
risk/return tradeoffs as the stock market. An investor need only master these few
basic terms and measurements to unmask the familiar market dynamics and
become a competent bond investor. Once you've gotten a hang of the lingo, the
rest is easy.