How To Turn Debt Into Fixed Income

by : William Smith

Bonds - Turning Debt Into Fixed Income

Bonds are an often overlooked component of a balanced investment portfolio. Bonds are almost always safer, and in certain economic cycles, bonds typically outperform the stock market. Although they're not right for everyone, a solid understanding of bonds is important for every serious investor.

The Basics

Whereas stocks represent ownership in a company, bonds represent the company's debt. When you buy a bond directly from General Motors, you are essentially lending the company money. For this reason, bonds are sometimes referred to simply as "debt."

If you buy a bond directly from its issuing company, the amount you pay for the bond is called its "face value" or "par value." Most bonds have a face value of $1000.

Bonds also have a stated "term to maturity." This could be one, five, ten, or thirty years, or any other duration imaginable. Disney actually issued 100 year bonds not long ago.

Every six months until maturity, bonds pay a set amount of interest called the "coupon rate". This term comes from the old days when people literally tore off and mailed in coupons that were attached to their bonds in order to be sent back interest payments. Upon maturity, the issuers of bonds must repay their holders the face value of the bonds..

If, for example, the coupon rate is seven percent on a $1000 face value bond, this means that the bondholder will receive interest payments of $35 every six months ($70 per year) until the bond matures.

The amount of interest paid every six months doesn't change, and for that reason bonds are sometimes called "fixed income securities."

Corporate Debt

Corporate bonds are the best known, and riskiest of all bonds. If a company goes bankrupt, for example, its bondholders may receive a mere fraction of their investments. Credit rating agencies, such as S&P, assign ratings to fixed income securities ranging from AAA to D.

Bonds with credit ratings of BB and below are considered junk bonds, meaning that their issuing companies face a realistic possibility of defaulting on their debt.

Changes in a company's credit rating effects the value of its debt. Although the face value always remains the same and the issuing company always redeems bonds at their original face value, bonds can also be traded between investors before they reach maturity.

These trades are said to take place on the "secondary market." For example, if the credit rating of a company were lowered and you wanted to sell one of its bonds that you paid $1000 for, your fellow investors in the market may only be willing to pay you $950.

But what most commonly has an impact on a bond's market value are changes in interest rates. Although the actual bond's interest rate is fixed, prevailing interest rates elsewhere in the economy can radically alter the value of a bond.

If interest rates go up, the value of bonds go down, and vice versa. This is because no one would be willing to pay $1000 for a bond with a seven percent coupon when they could buy a new one with a nine percent coupon for the same price.

Government Debt

U.S. government bonds are the safest of all fixed income securities. This is because all government debt is backed by the full faith and credit of the U.S. government. Essentially, this means that the federal government can't go bankrupt, because it controls the printing presses.

Municipal bonds are debt issued by cities and counties. They aren't quite as safe as U.S. government securities, but they do have one major advantage - they are virtually exempt from all levels of taxation. As a result, municipal securities typically pay a lower pre-tax coupon rate than federal government debt.

For people in high income tax brackets, the tax savings are enough to offset the lower coupon rate, and thus municipal securities are often great investment vehicles for the wealthy.

Safe Investment T.I.P.S.

If you're a really risk-averse investor, then for you, TIPS may be the greatest thing the government ever invented. TIPS, or Treasury Inflation Protected Securities, are a unique variety of ultra-safe fixed income government debt securities.

TIPS typically pay a very low interest rate, but they mature at the inflation adjusted equivalent of the original face value. Furthermore, the semi-annual coupon rate is also adjusted every six months.

For example, investing $100,000 into 20-year TIPS may promise a coupon rate of just 2.5 percent. This means that you would receive semi-annual interest payments of $1250.

However, if inflation were measured at three percent the first year after you purchased your TIPS, the new coupon rate would be 2.575 percent, resulting in semi-annual interest payments of $1287.50. What's more, the $100,000 face value of the TIPS would appreciate to $103,000.

After 20 years of inflation adjustment, the face value of your TIPS will have multiplied by several fold. Although you sacrifice the opportunity to realize outsized gains, TIPS are the ultimate in safe investments, as even inflation risk is avoided.