SEC Publishes Informative Investor Bulletins Discussing Characteristics of Bonds

Posted on July 2nd, 2013 at 10:15 AM

The Securities and Exchange Commission (SEC) has published several Investor Bulletins regarding bonds.  They cover corporate bonds, high-yield corporate bonds, municipal bonds and the relationship between bond prices and interest rates.  Let’s summarize the important advice for investors which the SEC provides in those four bulletins.

            First, let’s review the guidance with respect to corporate bonds.  All bonds have a certain maturity.  Maturities can be short term (less than three years), medium term (four to ten years) or long term (more than ten years).  Bonds and the companies that issue them also are classified according to their credit quality.  There are investment grade and non-investment grade (“high yield”) bonds.  Bonds pay interest, but how they do so varies.  Many bonds pay a fixed rate of interest throughout the term of the bond, and their interest payments are called coupon payments.  Other bonds pay floating rates that are reset periodically in relation to changes in market interest rates.  Still other bonds pay no interest payments until the bond matures.  That type of bond is called a zero-coupon bond.

            When a company goes into bankruptcy, corporate bondholders will have a claim on the company’s assets and cash flows.  But their place in line will vary and will depend upon the priority of their claim.  There are secured bonds, senior unsecured bonds and junior unsecured bonds.  Bonds with no collateral pledged to them are unsecured and may be called debentures.

            Apart from that credit or default risk, bonds face other risks.  They face interest rate risk, as discussed below, as well as inflation risk (inflation reduces the purchasing power of the bond’s interest payments), liquidity risk (lack of liquidity affects marketability and hence the price at which an investor can sell the bond), and call risk (bonds paying too well for investors sometimes may be called back by the corporation, leaving investors with a refund of their investment but no investment of similar quality in which to reinvest).

            A close cousin to the corporate bond is the high-yield bond.  High-yield bonds are issued by companies that face a greater default risk.  They pay a higher interest rate because they must do so to attract investors.  In addition to the risks detailed above, high-yield bonds face economic risk.  That is the risk that if the economy falters, investors first will dump their default-prone high-yield bonds and do what is known as a “flight to quality” – buying U.S. Treasuries typically.  As the flight to quality continues, having more sellers than buyers results in lower prices on the high-yield bonds.  During extreme sell-offs, prices fall dramatically.  Under the worst conditions, there is a risk that no liquid market exists because there are no buyers willing to buy the bond – at any price.

            The SEC cautions that investors considering high-yield corporate bonds must review the prospectus and consider (or at least attempt to understand) the bond offering, the financial condition of the company, how the company plans to use the bond proceeds, the terms of the bond and the significant risks.  In particular, the SEC recommends studying the covenant protections, the payment terms and the call provisions.

            The SEC likewise provides guidance with respect to municipal bonds.  Municipal bonds are either General Obligation Bonds or Revenue Bonds.  Investors carefully should review and attempt to understand the risks of revenue bonds, because interest payments and principal can be paid only from the project or entity involved, and not from the general funds of the municipality.  The Official Statement is a document that details both kinds of offerings.  In particular, and with respect to revenue bonds, the Official Statement usually contains a feasibility study showing the key assumptions made in evaluating the project.

            Beyond that, municipal bond investors need to understand the financial condition of the bond issuer.  In the case of revenue bonds, it is important to know whether the bonds are “non-recourse”; in other words, if the revenue is insufficient to pay bondholders, are there any other sources of revenue which will be used to repay the bondholders. 

            The fourth publication gives a detailed explanation of the relationship between interest rate movements and the prices of all types of bonds.  In short, the price of bonds moves inversely to interest rate movements.  Conversely, fixed rate bond yields move in the same direction as interest rate movements.

            Another risk that the SEC describes relates to bond insurance or government guarantees.  Often those claims are made.  But, even if there is insurance of a government guarantee, the market price and the value of all bonds do fluctuate.  In short, the insurance and the guarantee apply only when the bond is held to maturity.

            As one can see, the SEC bulletins provide helpful information to investors considering bonds.  They are a worthwhile read.

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