Bonds and Risks to Fixed-Income Investments

A bond is a financial instrument and the quinessential example of corporate debt. Companies issue bonds to raise capital or fund their business enterprises. Bonds typically pay a fixed interest rate, called a coupon rate. This nomenclature has a historical context: traditionally, a bond investor was issued a bond certificate with coupons to cut out and mail to the company each time interest payments came due. Better known as bearer bonds, whoever bears the bond certificate is the owner and the person entitled to receive the interest payments. These days, electronic databases keep track of the owners and the interest payments. No paper is necessary.

There are a wide variety of bonds these days from zero-coupon bonds to perpetual interest-only bonds. Bonds that pay fixed interest rates fall under the umbrella term of fixed-income investments. I'll run through the specifics of a typical bond with an example of a bond I personally own.

023139AA6
AMBAC FINL GROUP INC DEB 9.37500% 08/01/2011

The first set of letters and numbers is the CUSIP, a 9-character alphanumeric security identifier. It is similiar to a stock ticker symbol. Use of it ensures the identification of the precise security (bond, stock). Many companies have bonds with different maturities and interest rates, so using a CUSIP saves time in identifying a particular bond. To say "I want to buy a General Electric bond" to a broker would be very inexact as GE has hundreds of bonds outstanding with different maturities and interest rates. A CUSIP would direct the broker to purchase a particular bond with its set maturity and interest rate.

In the example above, the bond I purchased is issued by AMBAC, the infamous municipal bond insurer who dabbled in the MBS/CDO universe and lost billions. Another great reason to use CUSIP is because different databases have different names and designations for bonds and it is sometimes impossible to find the bond you are looking for. For example, one database could have the bonds of the utility company, Consolidated Edison, as "Con Edison," while another could have it with the full name. Using the CUSIP can be a time-saver as it is universal.

What is not mentioned in the example is the par and the market price. Par is the bond's notional value (generally, 1 bond unit is $1000). I bought 1 bond and paid $970. A multitude of market factors (which could be a whole seperate discussion) explains why I paid below par. Market dynamics aside, as long as the bond is not in default, the bond operates at the par-value. Most relevant here is the interest calculation, which is based on par. 9.37500% is the interest or coupon rate of the bond. This bond will pay an annual interest rate of 9.37500% on the par amount. Since I bought 1 bond, I will receive 9.37500% x $1000 = $93.75 a year.

08/01/2011 is the maturity date, i.e. this bond matures on August 1, 2011. On that day, if there is no default, the final interest payment is paid and the par-value ($1000 per bond) is paid to the bondholders. The corporate debt is then paid-off and the bond ceases to exist. This bond, like most bonds, pays semiannually. So the annual interest payment of $93.75 is actually split into two equal payments per year: every August and February. You can always use the maturity date to as a reference as to when the interest payments will be paid.

Rationale for my investment:
I wanted to invest in something more stable (versus equities), but was willing to accept greater risk (for a higher return) in the corporate bond market. I bought this bond in June of 2008 and at that time, I felt that AMBAC would survive the financial mess at the time (I may be totally wrong). Assuming I am right, on August 1, 2011, I will receive $1000 for my $970 investment in principal and have collected interest at a rate of 9.375% on $1000 during the time I held the bond.

Universal risks applicable to this and any other fixed-income instrument:
1) Interest rate risk: the bond earns interest at a fixed rate; any drastic increases in interest rates diminishes the value of the bond

2) Inflation: the bond earns interest at a fixed rate; any drastic increases in the rate of inflation diminishes the value ofthe assets. The "real" return (after adjusting for inflation) can be negative should the compounded rate of inflation exceed that of the coupon rate.

3) Currency risk: the bond is denominated in US Dollar; any depreciation of the dollar will diminish the value of theassets. While the obligations of the bond may be met, your resulting cash flow has reduced purchasing power.

4) Default risk: the performance of the bond depends on the financial stability and viability of the underlying company, the bond is at risk of defaulting if the company is unprofitable for too long and unable to "break-even." Generally, an instrument is in default when any obligation is not met, e.g. interest payment isnot paid in full or not paid at all.

In the case of Washington Mutual Bank, its assets were seized by the FDIC and sold to J.P. Morgan Chase. The supermajority of bondholders and equityholders were given nothing in compensation. The interest (and principal due) on Washington Mutual bonds will remain unpaid and as a result are in default.