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Corporate bonds play an important role in a diversified portfolio. The opportunity to receive regular income streams from corporate bonds can be appealing to investors, and the focus on capital preservation may be particularly appealing to risk-averse investors.

The following pages explain some commonly used bond terminology, and provide information on how bond returns are generated.

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A bond is a debt security, similar to an IOU. When you purchase a bond, you are lending money to a borrower (known as the issuer). In return for the loan, the borrower promises to pay you a specified rate of interest (or coupon) during the life of the bond and to repay the face value of the bond (the ‘par’ value) when it matures.

In the example on this page, an investor buys a bond for $20,000.The bond pays a coupon of 6% for a period of 10 years. Upon maturity of the bond (ie, in 2009), the issuer repays the bondholder the full par value of the bond ($20,000). While the price of the bond trading in the market may fluctuate below or above its par value during the bond’s lifetime, it will mature at 100% of its par value (in this case $20,000).

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Among the types of bonds you can choose from are government and agency securities, municipal bonds, corporate bonds, and asset-backed securities such as mortgage-backed bonds.

The yield is generally higher for corporate bonds compared to government and municipal bonds as the perceived risk for investing in corporate bonds is higher.Mortgage-backed bonds have a yield that typically exceeds high grade corporate bonds with comparable maturity, and have a low credit risk.

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Within corporate bonds, there is a number of classes of debt, ranging from senior bonds to preferred securities. Senior bonds have greater seniority in the issuer's capital structure than subordinated debt and preferred securities. That is to say, in the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment. Senior debt is often secured by collateral on which the lender has put in place a first lien.

In the banking sector, markets for subordinated bonds have existed for more than a decade. These securities have collectively been referred to as bank capital. In the field of bank capital, ‘hybrid’ is often used to refer to preferred securities.

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Imagine you are interested in buying a bond at a market price that’s different from the bond’s par value. There are three numbers commonly used to measure the annual rate of return you are getting on your investment. These are coupon rate, current yield and yield to maturity. In this section, we discuss some of the confusion that surrounds this terminology, and give an overview of how to calculate yields for bonds trading in the marketplace.

As explained earlier, when you purchase a bond, you are lending money to a borrower. In return for the loan, the borrower promises to pay you a specified rate of interest (or coupon) during the life of the bond, and to repay the face value of the bond when it matures.

In recent years 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 offered with a traditional fixed rate as given in the example on this page.Floating-rate - These are bonds that have variable interest rates that are adjusted periodically according to an index tied to short-term government bonds 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 par value, and redeemed for the full par value at maturity.

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The current yield is the annual interest rate paid by a bond, expressed as percentage of its current market price. While the current yield is fairly quick and simple to calculate, it does not take into account the present value of the coupon payments the investor will receive in the future. For this reason, when investors and analysts refer to yield, they are most often referring to the yield to maturity. We discuss yield to maturity in more detail on the following page.

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The yield to maturity is the best measure of the rate of return since it includes all aspects of your investment. The calculation of yield to maturity takes into account the current market price, par value, coupon and time to maturity. It is also assumed that all coupons are reinvested at the same rate. Calculating a bond’s yield to maturity is complex and is usually done by using a programmable business calculator.

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If you buy a new bond and plan to keep it to maturity, changing prices, interest rates and yields typically do not affect you. But when you buy or sell an existing bond, the price investors are actually willing to pay for the bond may fluctuate. And the bond’s yield, or the expected return on the bond, may also change.

Bond yields are a tricky concept for most investors to grasp initially because they are calculated based on a few moving parts. The first, and most important, concept to understand when discussing bond yields is that bond prices and yields have an inverse relationship. When bond prices are going up, bond yields are going down, and vice versa. To understand why this is, it helps to see bond yields as a measure of the profit you make from your bond investment. The less you pay for a bond, the greater your profit is likely to be and the higher your yield. Conversely, the more you pay for a bond, your profit is likely to be smaller and your yield lower.

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When the inflation rate rises, the price of a bond tends to drop. This is because the bond may not be paying enough interest to stay ahead of inflation. Remember, a bond's coupon rate is generally unchanged for the life of the bond. The longer a bond's maturity, the more chance that inflation will rise rapidly at some point and lower the bond's price. That's one reason bonds with a long maturity offer somewhat higher interest rates: they need to do so to attract buyers who otherwise would fear a rising inflation rate.

When prevailing interest rates rise, newly issued bonds typically offer higher yields to keep pace. When that happens, existing bonds with lower coupon rates become less competitive. That's because investors are unlikely to buy an existing bond offering a lower coupon rate unless they can get it at a lower price. Thus, higher interest rates mean lower prices for existing bonds. Conversely, when interest rates fall, an existing bond's coupon rate becomes more appealing to investors, driving the price up.

The financial health of the company or government entity issuing a bond affects the price investors are willing to pay for the bond. If the issuer is financially strong, investors are confident that the issuer will be capable of paying the interest on the bond and pay off the bond at maturity. If the issuer encounters financial problems, or if investors think that it might, then investors may become less confident in the issuer. If so, the price they are willing to pay for the issuer's bonds may drop.

Finally, market liquidity can have a significant impact on the price of a bond. The recent events we have witnessed in markets, where bond prices have fallen sharply, are a reflection of severe illiquidity in the marketplace where there has been a low level of trading activity.

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Duration measures the sensitivity of a bond’s price to interest rate movements. The duration figure is stated in years. For example, a 5 year duration means the bond will decrease in value by 5% if interest rates rise 1% and increase in value by 5% if interest rates fall 1%. Similarly, the price of a bond with an effective duration of 2 years will rise 2% for every 1% decrease in interest rates, and fall 2% for every 1% rise in rates.

Duration takes into account interest payments that occur throughout the course of holding the bond as well as the maturity payment. Basically, duration is a weighted average of all the income streams from a bond or portfolio of bonds. Therefore, the price of a bond with long-term cash-flows has more interest rate sensitivity than an asset with cash-flows in the near future.

Generally, the higher the duration (ie, the longer an investor needs to wait for the bulk of the payments), the more its price will drop as interest rates go up. If an investor expects interest rates to fall during the course of time, a bond with a long duration would be appealing because the bond’s price would increase more than comparable bonds with shorter durations. Likewise, if an investor expects interest rates to fall, a bond with a shorter duration would be appealing.

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A yield curve depicts yield differences that are due solely to differences in maturity. It conveys the overall relationship that prevails at a given time in the marketplace between yields and maturities. A yield curve can be created for any specific segment of the bond market, however the government bond yield curve is the most widely used. This is because government bonds have no perceived credit risk, which would influence yield levels, and because the government bond market includes securities of virtually every maturity, from three months to 30 years.

The yield curve is important for a number of reasons: Firstly, it can help you decide whether to purchase a long-term or short-term bond. (Investors generally expect to receive higher yields on long-term bonds. That's because they expect greater compensation when they loan money for longer periods of time. Also, the longer the maturity, the greater the effect of a change in interest rates on the bond's price.) The yield curve also provides market expectations about future interest rate movements. Finally, by anticipating movements in the yield curve, active bond managers can attempt to earn above-average returns on their portfolios. Several yield curve strategies have been developed in an attempt to boost returns in different interest rate environments.

As illustrated in the graph on this page, the normal shape, or slope, of the yield curve is upward (from left to right), which means that bond yields usually rise as maturity extends. A flat yield curve frequently signals an economic slowdown. The curve typically flattens when the central bank raises interest rates to restrain a rapidly growing economy; short-term yields rise to reflect the rate hikes, while long-term rates fall as expectations of inflation moderate. An inverted yield curve can be a leading indicator of recession. When yields on short-term bonds are higher than those on long-term bonds, it suggests that investors expect interest rates to decline in the future, usually in conjunction with a slowing economy and lower inflation.

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A bond issuer’s ability to pay its debts (ie, to make all interest and principal payments in full and on schedule) is a critical concern for investors. Most corporate bonds are evaluated for credit quality by credit rating agencies Standard & Poor’s and Moody’s Investors Service.

Bonds rated BBB or higher by Standard & Poor’s and Baa or higher by Moody’s, are widely considered “investment grade.” This means the quality of the securities is high enough for a prudent investor to purchase them.

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Spreads are the common way market participants compare the value of one bond to another. The term ‘credit spread’ refers to the difference between the yield of a corporate bond and a government bond of the same maturity. The actual spread of a corporate bond versus a government bond is usually referred to in terms of basis points (bps). One basis point equates to one hundredth of a percentage point. After purchasing a corporate bond the bondholder may benefit from a narrowing of the credit spread which contributes to a smaller yield to maturity. This drives up the price of the bond, delivering a capital gain.

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