If something sounds too good to be true, it probably is. The bond market is dominated by sophisticated institutional traders, who will always know more than you, before you know it.
There are 6 basic factors involved in selecting a bond investiment:
- Issuer
- Insurance
- Seniority
- Warrants or convertability (kickers)
- Par value
- Maturity date
Issuer
Obviously, it’s safer to lend money to someone with a good credit rating than someone who is teetering on the verge of bankruptcy. Bonds are rated on a scale that ranges from AAA (the best) down to D (in default). Bonds rated Baa (think of it as B++) are at the low end of investment grade and, all other things being equal, should pay a higher interest rate than bonds rated AAA (a rating reserved for US government bonds and the bonds from a very small number of the most financially stable companies.
A certain percentage of companies will go bankrupt or otherwise not pay their interest and principal payments on time. The higher the issuer’s credit rating the less likely this will happen. The safer bonds pay a lower interest rate but this is offset by a higher probability that you will be paid in full and on time. If a Baa bond pays a much higher interest rate than a comparable AAA bond, then the Baa bond may be the better investment, but make sure that there isn’t some bad news that means the issuer’s credit rating is at risk.
Insurance
Insured bonds have a credit rating based on the financial strength of an insurance company that guarantees the bond. If the issuer is unable to pay you in full on time, the insurance company is required to make good on the bond. The problem with bond insurance today is that the insurance companies aren’t in as good shape as they used to be, so do your homework and make sure that the issuer itself is a good risk - check the credit rating on some of their uninsured bonds.
Seniority
Some bonds are considered subordinated debt because there are other bonds or obligations that get payment priority over your bonds. This raises your risk and, all things being equal, means you should be compensated for this risk with a higher interest rate. Senior notes are not subordinated to other debt.
Warrants or convertability (kickers)
In addition to paying interest, some bonds come with warrants (think of them as long term stock options). Others are convertible into shares of the company’s stock at a prearranged price for a certain number of years (again, think of it as a long term stock option, except that you are using your bond to purchase the stock). In either case, these are kickers that can give you extra profits if the company’s stock goes up in time for you to exercise your rights.
Callability
If the issuer adds a call feature to a bond, it means they have the right to buy it back at a prearranged price. Think of it as an option that the issuer of the bond has insisted on as part of the deal. This limits your ability to profit if interest rates get lower and so callable bonds should pay a higher interest rate than non-callable bonds.
Par value
The par value of a bond refers to the amount of money you will receive when the bond reaches its maturity date. In other words, you will receive your initial investment back when the bond reaches maturity.
Maturity date
The maturity date is of course the date that the bond will reach its full value. On this date, you will receive your initial investment, plus the interest that your money has earned.
Coupon rate
The coupon rate is the interest that you will receive when the bond reaches maturity. This number is written as a percentage, and you must use other information to find out what the interest will be. A bond that has a par value of $2000, with a coupon rate of 5% would earn $100 per year until it reaches maturity.
Yield to Maturity or Yield to Call is the effective annual yield for a bond and is more useful than the coupon rate to knowing your predicted rate of return absent any additional return from warrants or convertability features.
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