by James Copenhaver, Director of Investment Management, Wealth Enhancement Group

This article is the first in a two-part series on the topic of fixed-income securities. As the title suggests, this month’s discussion will focus on the high-level structure of bonds, laying the groundwork for a more complex article in next month’s eNEWS.

Fixed-income securities essentially involve the purchase of a specified stream of payments. Although there are numerous types of fixed-income securities, the most common is the coupon bond. A bond consists of an agreement between two parties in which the bond purchaser (creditor) provides the issuer (debtor) with cash. The issuer, in turn, provides a promise to repay the cash, plus interest, at some point in the future. Although the interest payments are typically semi-annual, they may differ depending upon the agreement. The cash (principle) is returned at the end of agreement, called the bond’s maturity. Because the terms of this agreement are concrete, the future payments from the bond are known in advance to anyone wishing to purchase the bond.

It seems easy enough: the purchaser buys the bond, gets periodic interest payments and then gets their money back at maturity. But what if the purchaser no longer wanted the bond and sought to sell it? Should they expect to receive the exact amount of their original principle? In practice, a potential new purchaser of the bond would look at the other bonds available and evaluate the options. If two bonds were each offered at $1,000 but one paid a 5% coupon while the other paid a 6% coupon, with all else being equal, the 6% coupon would be the better option. The “with all else being equal” caveat will be addressed next month, but for now we will assume the bonds have the same issuer and mature at the same date. If this were the case, no one would buy the 5% bonds. What can the seller do if no one wanted their bonds? Lower the price! In fact, if the price is lowered enough it will reach a level where the new purchaser will be indifferent about the coupon difference. The money saved on the purchase exactly makes up for the reduced coupon amount. Effectively, the yield with the newly reduced purchase price reaches 6%.

This brings to light a very important observation in bond pricing: the price of the bond and its yield are inversely related. This implies that a risk in buying bonds is that interest rates will rise and prices will fall. Next month we will discuss other issues that should concern a bond purchaser, such default risk and duration.