1) The characteristics of the issuers
· How secure is the bond? Can you be sure the issuer will pay you back?· Is the issuer a governmental entity that might allow you to qualify for tax-free income?
2) The type and amount of interest they pay
· How much will you be paid? How many payments are there in a year (is it monthly, quarterly, or less often)?· Is the coupon rate always the same or can it change (fixed or floating)?
3) The terms of repayment
· Is the principal only payable at the end of the time period (straight bonds)?· Can the issuer, under certain conditions, repay the principle early and end the loan obligation (callable bonds)?
· Can the borrower, under certain conditions, force the issuer to repay the principle before the end of the time period (puttable bonds)?
1) Characteristics of issuers:
When an individual applies for a credit card, a home loan, or any other type of debt the bank or other financial institution always checks the person's credit rating. Some companies like TRW (now Experian) specialize in assessing the ability of millions of individuals to pay back all of these IOU's. Depending on personal credit ratings, financial institutions might charge different individuals different interest rates for the same type of loan. In fact, we all know that if one's credit rating is too low, they won't be able to get any type of loan or even a credit card.The importance of creditworthiness of a fixed-income issuer is just as important. Now that the shoe's on the other foot, you want to be reasonably sure that the bond issuer you loan money to is going to pay you back. At the very least, you would expect a higher return from a more risky investment. In general, the better the quality of the credit, the lower the interest rate offered to investors.
Just as with individual credit ratings, third party companies, such as Moody's and Standard and Poor's, determine the creditworthiness of bond issuing organizations. The rating scales developed by these companies start by defining United States Treasury Securities as the top quality level (despite all the jokes about the US' fiscal responsibility, they have never defaulted on a loan obligation). US Treasury Securities are considered risk-free and generally offer the lowest interest rates to investors. At the other end of the scale are the bond issues of cash-strapped and financially troubled corporations. These issues, often referred to as junk bonds, offer attractive interest rates and correspondingly higher levels of risk.
The full Moody's and Standard and Poor's rating scales can be found here.
2) The type and amount of interest they pay
Fixed Income investments are offered with varying terms to maturity, ranging from very short term to thirty years (even some 100-year bonds have been issued). The normal situation has longer maturities yielding more than shorter maturities (see Understanding the Yield Curve). Investors are thereby compensated for the increased risk and uncertainty that goes with longer periods of time. Maturity ranges can be broken up into four categories: 1. Money Market: maturities up to one year 2. Short-term notes: maturities up to two years 3. Medium-term notes: maturities two to ten years 4. Long-term bonds: maturities greater than ten years.A brief description of the various major Bond classes follows:
1. US Treasury Securities:
Us Treasuries are backed by the full faith and credit of The US Government; consequently, they are, by definition, risk-free securities. The market for Treasury securities is the most liquid securities market in the world. Interest paid on US Treasury Bonds is exempt from state and municipal taxation.
2. Municipal Obligations:
Municipal Bonds ("Munis") include issues from states, counties, cities and other municipal tax districts. In addition, they include obligations of state and local agencies, local commissions, community colleges and universities and other local authorities. The wide variety of issuers has generated a wide variety of issues. Federal Law provides that income earned from Munis be exempt from Federal Income Tax (though this favorable treatment does not extend to capital gains earned on Munis and may be subject to the Alternative Minimum Tax). Many states exempt their obligations from state taxation as well.
3. Corporate Bonds:
Corporations of various levels of creditworthiness use the bond market to raise capital to finance investment in technology, research, business expansion and other general business purposes. Holders of corporate debt have a senior claim on the underlying assets of the corporation to owners of company stock.
4. Mortgage-Backed Securities:
A mortgage-backed security is an instrument whose cash flow depends upon the cash flow from an underlying group, or pool, of specific mortgages. Financial institutions pool similar loans together and sell interests in the cash flows derived form the underlying pools. Many of these securities are guaranteed by government agencies. Only those backed by the Government National Mortgage Association (GNMA) are backed by the full faith and credit of the US Government.
5. Asset-Backed Securities:
Asset-Backed Securities are an extension of the idea that loans, such as mortgages, can be pooled together and then sold as securities. These securities represent receivables on other types of debt including automobiles, credit cards, equipment leases and other loan types.
6. Preferred Stock:
Preferred Stock is a hybrid security, having both equity and fixed income components. The dividend on a preferred is fixed, and the owners have a prior claim on company assets to holders of common stock. The firm, however, unlike with a bond, is not legally required to pay this dividend. Owners of preferred stock are not generally given voting rights. Public utilities have been the main issuers of preferred stock.
7. Convertible Issues:
Convertible Bonds are Bonds that can be exchanged for specified amount of the common stock of the issuing firm. The terms of conversion are provided in the bond's indenture. Important terms include the stock price at which the bonds can be exchanged (Conversion Price) and the ratio of how many shares can be converted per Bond (Conversion Ratio). Convertible Issues carry somewhat lower rates of interest than their non-convertible counterparts.
8. International Bonds:
The term "International Bond" generally refers to the home country of the issuing party (though it can refer to the location of the primary trading market), be it a foreign sovereign entity or a foreign corporation. Regardless of the domicile of the issuing party, the price and yield of these bonds is primarily affected by the currency of issuance. A French corporate Bond, for instance, that is issued in US Dollars will be primarily affected by general movements of US interest rates.