Bond Terms

Maturity
One of the key investment features of any bond is its maturity. A bond’s maturity tells you when you should expect to get your principal back and how long you can expect to receive interest payments. (However, some corporates have "call," or redemption, features that can affect the date when your principal is returned. See "Understanding ’Call’ and Refunding Risk".)

Corporate bonds, in general, are divided into three groups:

• Short-term notes - Maturities of 1-4 years
• Medium-term notes/bonds - Maturities of 5-12 years
• Long-term bonds - Maturities greater than 12 years.

Structure
Another important fact to know about a bond before you buy is its structure. With traditional debt securities, the investor lends the issuer a specified amount of money for a specified time. In exchange, the investor receives fixed payments of interest on a regular schedule for the life of the bonds, with the full principal returned at maturity. In recent years, however, the standard, fixed interest rate has been joined by other varieties. The three types of rates you are most likely to be offered are these:

• Fixed-rate:
  Most bonds are still the traditional fixed-rate securities described above.
• Floating-rate:
  These are bonds that have variable interest rates that are adjusted periodically according to an index tied to short-term Treasury bills or money markets. While such bonds offer protection against increases in interest rates, their yields are typically lower than those of fixed-rate securities with the same maturity.
• Zero-coupon:
  These are bonds that have no periodic interest payments. Instead, they are sold at a deep discount to face value and redeemed for the full face value at maturity. (One point to keep in mind: Even though you receive no cash interest payments, you must pay income tax on the interest accrued each year on most zero-coupon bonds. For this reason, zeros may be most suitable for IRAs and, other tax-sheltered retirement accounts.)

Sinking-Fund Provisions
A sinking fund is money taken from a corporation’s earnings that is used to redeem bonds periodically, before maturity, as specified in the indenture. If a bond issue has a sinking-fund provision, a certain portion of the issue must be retired each year. The bonds retired are usually selected by lottery.

One investor benefit of a sinking fund is that it lowers the risk of default by reducing the amount of the corporation’s outstanding debt over time. Another is that the fund provides price support to the issue, particularly in a period of rising interest rates.

However, the disadvantage - which usually weighs more heavily on investors’ minds, especially in a falling-rate environment - is that bondholders may receive a sinking-fund call at a price (often par) that may be lower than the current market price of the bond.

Other Types of Redemptions
Bond investors should be aware of the possibility of certain other kinds of calls. Some bonds, especially utility securities, may be called under what are known as Maintenance and Replacement fund provisions (which relate to upgrading plant and equipment). Others may be called under Release and Substitution clauses (which are designed to maintain the integrity of assets pledged as collateral for some bonds) and Eminent Domain clauses (which have to do with paying off bonds when a governmental body confiscates or otherwise takes assets of the issuer).

Ask about these and any other special redemption provisions that may apply to bonds you are considering. You can avoid the complications and uncertainties of calls altogether by buying only noncallable bonds without sinking-fund provisions.

If you do buy a callable bond and it is called, be aware that its actual yield will be different than the yield to maturity you were quoted. So ask an investment professional to tell you what the yield to call is as well.

Puts
Just as some issuers have the right to call your bond prior to maturity, there is a type of bond - known as a put bond - that is redeemable at your option prior to maturity. At specified intervals, you may "put" the bond back to the issuer for full face value plus accrued interest.

In exchange for this privilege, you will have to accept a somewhat lower yield than a comparable bond without a put feature would pay.

Understanding Collateralization
In the event a corporation goes out of business or defaults on its debt, bondholders, as creditors, have priority over stockholders in bankruptcy court. However, the order of priority among all the vying groups of creditors depends on the specific terms of each bond, among other factors.

One of the most important factors is whether the bond is secured or unsecured. If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold, if necessary, to pay the bondholders.

If you buy a secured bond, you will "pay" for the extra safety by receiving a lower interest rate than you would have got on a comparable unsecured bond.

Risks and Yeilds

Understanding Interest-Rate Risk
Like all bonds, corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise.

Usually the longer the maturity, the greater the degree of price volatility. By holding a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.

Some investors are confused by the inverse relationship between bonds and interest rates - that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward: When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.

As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it. Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

Understanding Yields
Yield is a critical concept in bond investing, because it is the tool you use to measure the return of one bond against another. It enables you to make informed decisions about which bond to buy. In essence, yield is the rate of return on your bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates. Here’s an example of how yield works: You buy a bond, hold it for a year while interest rates are rising and then sell it. You receive a lower price for the bond than you paid for it because, as indicated above under "Understanding Interest-Rate Risk," no one would otherwise accept your bond’s now lower than-market interest rate. Although the buyer will receive the same dollar amount of interest you did and will have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours was - because the buyer paid less for the bond. ]

There are numerous types of yield, but two - current yield and yield to maturity - are of greatest importance to most investors.

Current Yield
The current yield is the annual return on the dollar amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par value bond paying 6% is 6%.

However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a $1,000 bond with a 6% stated interest rate after prevailing interest rates have risen above that level, you would pay less than par.

Assume your price is $900. The current yield would be 6.67% ($1,000 x.06/$900).

Yield to Maturity
A more meaningful figure is the yield to maturity, because it tells you the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons.

Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Don’t buy on the basis of the current yield alone, because it may not represent the bond’s real value to you.

Understanding "Call" and Refunding Risk
One of the most difficult risks for investors to understand is that posed by "call" and refunding provisions. If the bond’s indenture (the legal document that spells out its terms and conditions) contains a "call" provision, the issuer retains the right to retire (that is, redeem) the debt, fully or partially, before the scheduled maturity date. For the issuer, the chief benefit of such a feature is that it permits the issuer to replace outstanding debt with a lower interest-cost new issue.

A call feature creates uncertainty as to whether the bond will remain outstanding until its maturity date. Investors risk losing a bond paying a higher rate of interest when rates have declined and issuers decide to call in their bonds. When a bond is called, the investor must usually reinvest in securities with lower yields. Calls also tend to limit the appreciation in a bond’s price that could be expected when interest rates start to slip.

Because a call feature puts the investor at a disadvantage, callable bonds carry higher yields than noncallable bonds, but higher yield alone is often not enough to induce investors to buy them. As further inducement, the issuer often sets the call price (the price investors must be paid if their bonds are called) higher than the principal (face) value of the issue. The difference between the call price and principal is the call premium.

Generally, bondholders do have some protection against calls. An example would be a bond that has a 15-year final maturity, non-call two years. This means the investor is protected from a call for two years, after which time the issuer has the right to call the bonds.