Bonds Essay, Research Paper

Perhaps one of the most interesting types of bonds is the “foreign bond”, which is often

also referred to as an “international bond”. These bonds do not necessarily have to have

any ’special’ features, as one is automatically built in. As with regular bonds, the holder

will receive interest payments throughout the year and the face value when the maturity

date is reached. However, when purchasing an international bond, what you are actually

doing is investing in another country’s currency. Consequently, you must take both the

bond price and the currency rate into account. This additional ‘investment within an

investment’ can greatly increase your profit; however, there is also the risk that the

country’s currency might decline in worth, which in some instances could be quite

disastrous. This last problem can usually be avoided if an investment is made in a country

with a relatively stable economy. Another advantage to foreign investment and

international bonds is the choice which you are presented with. Because you are

expanding into the international marketplace, you have many more choices as to what

you may invest in and, if investing internationally, you also have a wide range of interest

rates.

There are many companies which rate the different bonds on a bond rating scale. These

bond ratings carry with them immense power in the financial marketplace. Many

money-lending agencies use these ratings to determine the percentage of interest they

will charge others to borrow money. These bond ratings, when changed, may cause a

great disturbance in a company and may sometimes even lead to its bankruptcy. Of

course, the lower the business is rated on the bond rating scale, the more unstable it will

appear to potential investors. Too, businesses that would be considered unstable would

also have to pay a considerably larger rate of interest in order to obtain a loan, while

other higher rated businesses would not have to pay quite so much. If a business is unable

to make its loan payments, its rating will suffer even more and eventually it will enter a

downward spiral until it sinks into the depths of bankruptcy.

There are always variations and differences in the rating of companies’ bonds on the bond

rating scale. This is because of the number of different companies involved in actually

doing the rating. As bond ratings are not derived from applying numerical formulas to

financial data, many companies are rated at a level that is higher or lower than the level

assigned by other rating agencies. An example of these discrepancies can easily be seen

when one looks at the ratings for Calmar Inc.

Prior to November 25, 1991, Moody’s Investment Service rated Calmar Inc. with a B

rating, while Standard & Poor’s rating was significantly lower at CCC+. On November 25

of that year, Moody revised its rating to a Ba rating, supporting what they believed to be a

strengthening trend. Two days later, Standard & Poor’s rating agency decided that the

outlook for Calmar Inc had switched from positive to negative. Both of these decisions

were made using the same financial data, yet each agency regarded Calmar’s credit

quality differently. While Standard & Poor’s agency had remarked that the earnings for

the year were the same as last year, Moody’s agency believed that there was a great

potential for further growth.

The following are but a few of the rating agencies that one can find in today’s financial

market: Moody’s Investment Service, Standard & Poor’s, A.M. Best, Duff & Phelps, and

Fitch Investors Service. The two largest rating agencies, Moody’s Investment Service and

Standard and Poor’s, are regarded as the paragons of the rating business. Below are the

ratings used by Moody’s Investment Service.

MOODY’S INVESTORS SERVICE, INC. Ratings Chart:

Aaa.: This is the highest rating a bond can receive. Bonds in this category are of the

highest quality. These bonds carry with them the smallest degree of investment risk,

often referred to as the “glit-edge”. Their interest is protected by a large or exceptionally

stable margin, and the principal remains secure. Any changes in the economy are not

likely to change the financial position of the company.

Aa.: Bonds with this rating are regarded as high quality by all financial standards. The

margin of security, however, may not be regarded as large as Aaa bonds. There may also

be some slight problems within the company which may make the long-term risks

slightly greater than the Aaa bonds. Together with the Aaa group, these bonds comprise

what are generally known as the ‘high grade’ bonds.

A: These bonds have many favourable attributes and are considered upper medium grade.

The security offered on principal and interest are considered adequate but something may

be present which might suggest a susceptibility to weakness later on in the life of the

company.

Baa: This is a medium grade rating. Moody’s believes these bonds to be poorly secured or

not highly protected. The interest and principal payments appear good at the present

time; however, the long term is uncertain as some protective elements may be lacking.

Ba: The bonds falling under this rating are judged to have speculative elements. The

future is not well-guaranteed. The security of principal and interest payments is very

moderate. Uncertainty characterizes bonds in this class.

B: Moody’s Investment Service believes these bonds to lack characteristics of desirable

investment. The assurance of stability in these bonds is small.

Caa: Bonds belonging to this category of rating are regarded as poor investments. These

companies may default on some or all of their payments. There may also be considerable

elements of danger present with respect to future principal or interest payments by this

company.

Ca: This is the second worst rating that can be attained by Moody Investment Service Inc.

Bonds which fall into this category are highly speculative. Companies listed under this

rating often have marked shortcomings.

C: Bonds which receive this rating are the lowest rated class of bonds, and companies

with this rating can be regarded as extremely poor prospects of ever attaining any real

investment standing. It is quite inadvisable to invest in such companies or corporations.

As is evident, there are many different levels on which a bond can be rated. It is no

wonder that a bond can be rated at two different levels by two different rating agencies.

In many cases, it is merely an investor’s opinion of an agency’s possible future that

decides what rating the bond is to be assigned.

Bonds, like many other forms of investment, require potential investors to be aware of

current economic conditions. I would stress that a great deal of money can be made if

investors consider selling their bonds before they reach their maturity. As with stocks,

previously issued bonds are traded every day. The price they are sold for is determined by

what the market will bare, that is, the willingness of others to buy a particular bond.

People sell their bonds as the interest rates increase and decrease due to different

economic conditions. In fact, the two main determiners of bond prices are interest rates

and credit risk.

With respect to the risk of the credit quality of the bond issuer, imagine if you will,

investing money in a nation that is in financial ruin, for example, Somalia. The borrower,

in this case Somalia, might not be able to pay interest on a regular schedule or return

your principal amount as promised in the end. Somalia might default on some or even all

of their payments. As is quite evident, this would not be a wise investment, and this is

why the Somalian bond prices suffer as there is no demand in the financial market for

them. Bonds issued by Canada’s federal government are considered to have virtually no

credit risk, since the Canadian treasury is unlikely to default on a loan. For corporations,

however, the possibility of “going broke” is not all that inconceivable. Therefore

corporate bond prices fluctuate depending on how well the issuing company is doing in

the marketplace.

The other main determinant of bond prices is the interest rates in the current economy.

When interest rates rise, bond prices will fall. However, during times of declining interest

rates, bond prices will rise. There is quite a logical reason for this change in prices when

interest rates fluctuate. When the interest rates fall, many people turn to bonds as there is

a greater rate of return. The more people who buy bonds, the greater the demand which

leads eventually to higher prices, and for the investor, a large profit on the sale of

previously purchased bonds. Interest rates rising, on the other hand, leads to a lesser

demand for bonds and consequently the prices of previously purchased bonds decrease.

If you are able to hold onto your bond until the maturity date is reached, temporary

changes in interest rates will not affect your financial investment; however, if you need to

sell the bond before the marked maturity date, you might have to accept LESS than what

you paid for it. This volatility can work to your advantage too, because it is possible that

your bond could be worth more at the time you decide to sell. This is why it is important

to keep up to date on bond prices. You may be able to make money by simply selling

your bond before it’s maturity date.

In conclusion, I would suggest that bonds are a wise venue for anybody wanting to

financially invest in different corporations or governments. I would caution, however that

when selecting a bond, one should seek the guidance of an experienced investor. By

choosing a bond that is right for you and your lifestyle, you have the potential of

increasing your profits greatly and going home wealthier and happier.