Investments

What Is The Maturity Date Of A Bond

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 17 minute read

Bulls, who think stock prices will go up, and bears, who think prices will go down, are always at odds in the stock market. Therefore, the stock market’s value is notorious for wildly fluctuating, going up when bulls dominate and down when bears rule.

Because of the ongoing conflict between bears and bulls, many people are looking for solutions to protect their financial portfolios against severe losses. Diversification with fixed-income securities is a good strategy in this regard.

Investors can increase their profits in rising markets and reduce their losses in falling ones by holding a portfolio that includes both equities and fixed-income assets.

What Are Securities With Fixed Incomes?

Securities with a fixed interest rate are debt instruments issued by a government or a corporation to raise money for operational expenses. Essentially, it is a written promise to pay back a loan with specifics on the loan amount, the interest rate, the repayment schedule, and the lender’s recourse in the event of a default.

Debt securities do not represent a transfer of ownership (equity) in a corporation, but they do give the lender a higher priority claim to repayment in the case of a default or bankruptcy.

A wide range of debt instruments, including but not limited to the following, fall under the umbrella phrase fixed-income security.

  • Bonds. When a borrower issues bonds to investors, they are formally taking on debt on behalf of the investors who purchase the bonds. An indenture is a legal document issued in tandem with a bond issue that specifies the loan’s parameters, including its interest rate, maturity date, interest payment schedule, and any collateral used to guarantee repayment.
  • Debentures. An unsecured bond is called a debenture. This means there is no actual asset that can be liquidated if the debtor defaults on the indenture. The buyer of a debenture has no other means of assurance that the debt will be repaid except the borrower’s word. U.S. Treasury bonds are the most typical debenture.
  • Bills of exchange are also known as Promissory Notes. Promissory notes, another form of borrower-lender contract, are typically used for small, one-time loans between two individuals. Short-term and without recourse to any collateral, promissory notes are the norm.
  • Deposit Certificates (CD). To the tune of $250,000, the FDIC insures certificates of deposit (CDs) issued by banks and savings and loan associations against loss of principal and interest. Federal regulator NCUA backs credit union certificates of deposit. The standard unit of a certificate of deposit is $1,000, and both the term and interest rate are fixed for the duration of the deposit.
  • Collateralized Debt Obligations (ABS). The financial obligations that make up these fixed-income securities have been pooled together, a process known as securitization. Credit card debt, auto loans, student loans, and mortgages can all be bundled together and sold to investors, with the interest rate and principal repayment period shifting as the underlying loans are paid off.
  • Annuities. Insurance firms often issue annuities, a specific form of debt instrument, in which the borrower agrees to make regular payments either immediately or in the future. Some financial experts advise against including them in a diversified portfolio. Annuities are not securities and are instead governed by the state’s insurance regulations. The insurance company’s return could be fixed or variable, and the payout could be made over a certain period of time or for the rest of your life (or the lives of you and your spouse, in some situations).
  • Bankers’ Acceptances (ETNs). The principal and interest of exchange-traded notes are not guaranteed. The rate of return is tied to the growth of a specific index or group of assets, such as the S&P 500 or the cost of crude oil. The return to the investor is just the difference between the purchase price and the maturity price of the underlying index, as the ETN holds no assets and pays no interest. Exchange-traded notes are discussed in length by the Financial Industry Regulatory Authority (FINRA), which also warns investors of the potential for large losses.
  • Fixed-Interest Investment Funds. Rather than buying individual stocks, many people opt to invest in mutual funds. In finance, a bond fund refers to a mutual fund that only purchases bonds and other debt securities. Each month, the manager will distribute interest to the investors and reinvest principal payments in new bonds.
  • Similar to Exchange-Traded Notes (ETNs), mutual fund shares fluctuate in value based on the performance of the fund’s underlying investments. Shares in mutual funds trade hands just like any other security on the market.
  • Mutual fund-style Investments in bonds. Bond ETFs are structured similarly to bond mutual funds, but instead of being actively managed, they mirror the performance of a bond index like the Bloomberg Barclays U.S. Aggregate Bond Index. Like stocks, ETF shares can be bought and sold, and investors are thereby taking a risk with their money. Since the maturation dates of the underlying bonds always vary, typical bond ETFs never mature, unlike exchange-traded notes or individual bonds. Fixed-maturity bond ETFs are available from a few managers.
  • Targeted-maturity bond exchange-traded funds (ETFs) are relatively new investment products, but they have caught on with the fixed-income investing community.

A Fixed-Income Security’s Legal Features

The indenture describes the specific qualities that fixed-income instruments share with equity securities.

  • Average Value. The amount of money that will be paid to the owner of the security when the loan is due is known as the par value, which is also sometimes referred to as the face value. Interest is computed based on this principal amount. Bonds typically have a par value of $1,000. When bonds trade at a discount to their face value, they are referred to as “discount” bonds, whereas bonds that trade at a premium to their face value are referred to as “premium” bonds.
  • Calculating an Interest Rate. Interest rate, also known as coupon rate, is the indenture-specified percentage applied to the par value to determine the periodic interest payment. If the bond’s indenture specifies a 6% yield on a $1,000 face amount, the bond’s registered owner will earn $60 annually. The interest rate on the security may remain constant for the duration of the bond’s term, or it could “float,” fluctuating at regular intervals based on some formula. Interest rates, as with any loan, are strongly tied to the borrower’s creditworthiness.
  • Interest Periodicity Payments. The indenture specifies the interest rate to be paid on a yearly, semiannual, or monthly basis. The interest rate is not impacted by the frequency of payments. One annual payment of $60, two semiannual payments of $30, four quarterly payments of $15, or twelve monthly payments of $5 are possible with a 6% bond.
  • The Date of Expiation. The maturity date often called the principal payback date, is the date in the future on which the security issuer must redeem the loan. The “life” of a bond is the time between its issuance and its maturity, which decreases over time.
  • Collateral. Debt issuers could put up collateral to ensure they get paid back their principal and interest. Many Americans have experience with this procedure when buying cars, houses, and other expensive items. Failure to repay a loan will result in the borrower having to give up the collateral. Physical assets or a sinking fund, to which the issuer makes payments over the life of the bond to accumulate a reserve for eventual redemption, are two examples of collateral.
  • Conceivable Consequences and Solutions. In the event of default (i.e., failure to pay interest and principal as promised), the bondholder has the right to demand prompt repayment of the principal amount and any accrued but unpaid interest, as well as any other remedies provided forth in the indenture.

Fixed-Income Securities Issuers

Governmental institutions such as water districts, toll systems, and public airports are eligible to issue fixed-income securities alongside federal, state, and local governments. Companies, partnerships, organizations, and even private people can all issue fixed-income securities.

Municipal bonds are debt securities that are issued by local, state, or regional governments. Therefore, they are commonly known as “government bonds.” Interest earned on municipal bonds is exempt from income tax at both the federal and state levels. 

Municipal bonds typically offer lower interest rates than comparable corporate bonds since the interest earned on them is not subject to taxation. Investors should be aware that an alternative minimum tax may apply to the interest earned on certain municipal bonds.

Investors with the highest tax rates should compare the after-tax return on a corporate bond to the likely return on a municipal bond to decide which type of security offers the greatest net return.

Debt Securities Issued Publicly and Privately

Securities issued in the form of debt can be issued either publicly or privately. All public offerings are in accordance with federal and state law and have been registered with the Securities and Exchange Commission (SEC). Securities and Exchange Commission-registered debt instruments are freely tradable.

When it comes to specific transactions like a private placement, which is frequently used by entrepreneurs raising startup money, private issuers of debt securities must also meet federal requirements for an exemption from security legislation.

Investors in private bonds or stocks should be aware that the Securities and Exchange Commission (SEC) has placed limitations on how quickly they can resell their holdings in the event of an emergency.

Bonds Registered Versus Owners Registered

While “registered” usually refers to bonds that are traded publicly, it can also mean that the bonds’ owners have their names and contact details on file with the issuing business or agency. Any time the bond’s ownership changes, this data is updated in a protected electronic file.

Previously, bondholders would clip coupons off their paper bond certificates and send them in with their payment requests. The payment was made to whoever presented the bond or coupon for redemption, regardless of the owner’s name appearing on the bond or coupons themselves. 

What this means is that whoever is in possession of a bond can sell it or redeem it without revealing their identity.

The Tax Equity and Responsibility Act of 1982 banned the issuance of new bearer bonds in the United States due to the lack of a mechanism by which an issuer could confirm the loss or theft of a certificate. Surprisingly, American corporations and the United States Treasury have kept issuing bearer bonds throughout Europe and to non-U.S. citizens.

Sweeteners and hybrid securities

Most fixed-income instruments are structured so that interest is paid regularly for a set period of time, after which the debt is redeemed at face value. As a means of luring investors and expanding the issuer’s flexibility, borrowers have sweetened their debt over time. 

Included in these characteristics are:

  • Redeemable/Callable Provisions. The issuer of a callable or redeemable security might require bondholders to turn in their bonds for redemption at a set price on or after a certain date. Bonds having coupon rates higher than the current market interest rate are more likely to be called, benefiting the issuer, while callable bonds paying at or below the current market rate will be left outstanding by the borrower. Any appreciation in value over the bond’s call price will be forfeited if the bond is called.
  • Modifiable Terms and Conditions. With retractable securities, investors can choose to have their bonds redeemed at par at a future date (the opposite of the call feature). If interest rates climb above the bond’s coupon rate, for instance, the bond’s value will decrease for the investor. The bondholder may request that the issuer redeem the bonds at par value rather than allow them to be sold at a loss.
  • The Clause is Open-Ended. Bondholders who purchase extensible securities get to postpone the original maturity date by a set amount of time. Because of this provision, bondholders can continue to accrue interest at a rate higher than the market rate for a certain time after the bonds’ coupon rate has matured, even if the market rate has dropped below the coupon rate.
  • Rate-Variable Functions. Bond coupons for variable-rate securities fluctuate with changes in a benchmark interest rate such as Prime or LIBOR. Coupon rates are often capped by a maximum and minimum rate, respectively. In this scenario, the issuer gains from a decline in interest rates while the investor reaps the rewards of an increase in rates.
  • Security Measures. The goal is to provide concrete guarantees to the investor community through these elements. Possible conditions include setting aside a fixed proportion of earnings until the cost of maturity is covered, pledging specific collateral in exchange for the bond, or establishing a sinking fund.
  • Options that can be converted to another type of currency. Convertible securities give bondholders the right, for a specified time period, to exchange their bonds for a predetermined number of common shares of the issuing business. Those who hold bonds issued by the issuing corporation may exercise this option to gain a stake in the company’s future success. If a bond’s conversion rate is stated as 20 common shares for every $1,000 in face value, then the conversion rate per share would be $50. If the issuer’s common stock is trading at $50 or less, the convertible bond will trade as a fixed-income instrument. If the same company’s common stock is trading at $60 per share, then the bond’s market price would be equal to or very close to the value of the shares that could be converted into cash, or $1,200 (20 shares at $60 per share), with the value of the bond being affected only tangentially by interest rate fluctuations.
  • Choice of Exchange. Exchangeable bonds are similar to convertible bonds in that bondholders have the option to convert their bonds into shares of common stock in a connected firm of the issuer. As an illustration, a parent firm may allow its bonds to be exchanged for common shares in a subsidiary.

Some bond issues come with warrants, or the right to buy a certain number of the issuer’s common shares at a predetermined price for a specified time period. Warrants are tradable securities that can be separated from the bond they are attached to.

Issuers may combine characteristics for specialized ends. As an illustration, a business may mix call and convertible features. Because of this, they would call the bond and force a conversion if the stock price of the underlying common asset rose above the conversion price. 

Instead of receiving face value on the call, bondholders are more likely to convert their bonds into shares and then sell them, reaping the benefits of both the initial principal and any appreciation in market value.

Prices of Bonds and Interest Rates

Interest rates, the cost of borrowing money, are dynamic because of:

  • The Supply and Demand of Credit. Interest rates increase when there are more borrowers than lenders, resolving the imbalance. Interest rates decrease until a balance is reached when there are more lenders than borrowers.
  • Inflation. With higher inflation, the value of the money needed to repay loans will decrease relative to the original loan amount, which causes lenders to charge higher interest rates. When comparing returns, investors typically look at two different metrics; the nominal return and the real rate of return.
  • Decisions made by the government. By adjusting its monetary policy, the Federal Reserve can either speed up or slow down the economy. The federal funds rate (the interest rate at which banks lend to one another for short periods of time) is a key factor in commercial interest rates because it is determined by the Fed. The Federal Reserve also engages in open-market operations, such as the purchase of corporate bonds, that alter the availability of credit.

In general, bond prices tend to decline when interest rates rise. In general, bond prices go down whenever interest rates go up and vice versa. All investors in fixed income are exposed to interest rate risk, which is the risk posed by this inverse connection.

For instance, the market price of a bond that is sold prior to its maturity may be more or lower than the original purchase price depending on fluctuations in the market interest rate. A bond’s coupon rate remains constant even while the market interest rate fluctuates over time. 

As a result, your bond’s market price will shift such that investors can receive returns that are competitive with those offered by bonds of similar quality but with different coupon rates and durations.

Since the bond’s face value will be reimbursed to you in full regardless of fluctuations in interest rates, holding it until maturity eliminates risk.

Fixed-Income Securities Credit Ratings

Companies and governments pay interest on their loans dependent on how creditworthy their lenders believe them to be. Loan rates for those with low credit scores are often higher than those for people with higher scores. In a similar vein, bond issuers with lower creditworthiness pay a higher interest rate when borrowing money.

Most credit ratings for corporate and government bond issuers are assigned by one of three independent agencies; Standard & Poor’s, Moody’s, or Fitch. In the same way that FICO assesses individuals, each issue is evaluated and graded based on the agency’s assessment of the borrower’s propensity to make timely interest and principal payments. 

Each agency uses its own credit rating scale, with investment grade indicating excellent credit and speculative indicating poor credit.

All three major rating agencies have consistently given the highest possible grade to debt issued by the United States Treasury, making these securities the safest in the world. U.S. debt was downgraded from AAA to AA+ by S&P for the first time ever in 2011. 

Since then, their rating has remained unchanged, despite the fact that the two other major credit agencies have maintained their acclaim for the government.

Insights from Bond

In order to ascertain if security is worth purchasing, fixed-income investors look at a number of different metrics.

Duration

A bond’s price will drop more steeply in response to an increase in interest rates if its tenure is longer. Bonds are evaluated based on how long it will take for their yield-discounted future cash flows to equal their current worth to the bond’s present value. 

The greater the term, the more sensitive the bond’s price is to changes in interest rates, and this is something investors should be aware of. One of the most well-known and widely-used duration calculators was created by Frederick Macaulay and is available for no cost on the internet. 

The length of time is dependent on:

  • Cost of a Bond. The duration of bonds bought at a premium (above par) is shorter than that of bonds bought at a discount (below par).
  • The yield on Investment. Because a higher coupon rate generates more early income, bonds with lower coupon rates tend to have longer maturities.
  • Maturity. The longer a bond is held, the higher its duration will be.
  • Give Fruition (YTM). High-yield-to-maturity bonds mature more quickly than those with lower yields.
  • Existence of an Accumulating Deficit Account. Due to the increase in initial cash flows, the length of a bond can be reduced through the employment of a sinking fund.
  • Tentatively Titled. Confer Provisions. Because bonds with a call provision are more likely to be redeemed before maturity, their maturities are shorter.

Investors might benefit from selecting bonds that are a good fit for their needs by learning more about duration. If an investor anticipates a rise in interest rates, they may choose to purchase bonds with higher coupons and shorter maturities.

Current Yield (CY)

A bond’s current yield, or annual return on the initial investment, can be determined by dividing the amount of interest accrued in a given year by the bond’s purchase price, regardless of the bond’s remaining duration. 

An investment bond’s current yield is the same as its coupon rate if purchased at par. A bond with a par value of $1,000 and a coupon rate of 5% yields 5% ($50 / $1,000) at the current rate.

The current yield will vary depending on whether the bond’s market price is higher or lower than par. If interest rates doubled to 6%, the identical 5% bond would cost $833.33 ($50 divided by $833.33). If interest rates were to drop to 4%, the same formula ($50/$1,250) would show that bond prices would increase to $1,250.

Yield to Maturity (YTM)

The difference between the current yield and the yield to maturity (YTM) is the total annual return you receive if you retain the bond to maturity. Bonds of various maturities and interest-rate coupons can be compared using YTM. 

The total amount due at maturity incorporates all accrued interest, plus any capital gain realized from purchasing the bond at a discount (if purchasing below par) or any capital loss incurred from purchasing the bond at a premium (if purchasing above par).

To get an accurate result from the YTM computation, it is necessary to perform several iterations. The good thing is that you can find a variety of calculators (Finance Formulas, Investing Answers, DQYDJ, etc.) on the internet. In addition, if you’re thinking about purchasing bonds, you can ask your financial advisor to supply you with the exact yield to maturity.

Yield to Call (YTC)

Bonds with a call feature have a YTC or Yield to Call. It’s very similar to the YTM, with the exception that it presupposes the bonds will be called as soon as possible. 

In most cases, a bond’s YTC will be lower than its YTM because the call feature caps the bond’s appreciation at the call price. If there is more than one call date, investors should determine the yield to worst (YTC) on each date, compare it to the yield to maturity (YTM), and choose the lowest return.

The Advantages and Disadvantages of Fixed-Income Securities

Investors who buy fixed-income securities can reap many advantages. However, they aren’t perfect and do come with some disadvantages. Most importantly, when weighing the benefits and risks of fixed-income instruments, you should think about:

The Advantages of Fixed-Income Securities

There are a number of advantages to investing in fixed-income instruments. 

Here are a few of the most crucial:

  • Income. Income stability is the primary attraction of fixed-income instruments. As a result, investors in such a security may count on receiving payments from the security’s issuer on a regular basis, making such investments not only a good option for retirees but also a crucial component of any diversified portfolio.
  • Priority in Liquidation. If a company that issues fixed-income securities declares bankruptcy, the company’s assets will be utilized to repay holders of fixed-income securities before common stockholders.
  • Stability. Fixed-income instruments don’t experience the same market volatility that traditional stock does because they provide a stable stream of income and have preference over common shares in the case of liquidation. This predictability appeals to risk-averse investors and acts as a useful hedge for those with a more volatile portfolio.

The Disadvantages of fixed-income securities

All investment vehicles have their disadvantages. Although fixed-income securities can provide a stable return on investment, investing in them is not without its share of potential challenges.

  • Moderate Expansion. Little risk usually means low potential return in the world of investment. Since fixed-income assets are safer than, say, common stock, their potential return on investment is smaller.
  • There is still a chance of something bad happening. The perceived safety of fixed-income assets makes them attractive to investors. Investing always involves some level of risk. The risk of default exists for all fixed-income assets, regardless of a credit grade. Therefore, it is never a smart idea to invest money in the stock market, the bond market, or anywhere else without first doing some research.
  • Fear of Inflation. Price inflation occurs when the economy is doing well. For investors, the opportunity cost arises when rising prices aren’t reflected in their coupon payments, as this means they’re missing out on the benefits of rising prices and improving economies.

Bottom Line

Investment portfolio diversification often includes fixed-income assets. However, not all fixed-income securities are created equal, just like any other investment instrument.

You should think about your long-term objectives and search for a fixed-income product that meshes nicely with your overall investing strategy before making any purchases.

Bear in mind that although fixed-income securities carry a low level of risk, they are not risk-free. The security’s risk of default and the income it pays are both affected by the financial health of the corporation or government issuing it. 

Therefore, it is crucial to take the time to learn as much as possible about the investment opportunity and to ensure that it is suitable for your level of risk tolerance.

Nonetheless, because of the safety and stability afforded by most fixed-income products, they constitute a vital feature of just about every investment portfolio, if only for diversification purposes.

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