Bond Investing and Due Diligence
When you buy a bond, you’re loaning money to the bond’s issuer—which could be a corporation, a local municipality, a government agency or the federal government—with the intention of receiving back your initial investment and, in most cases, interest. But not all bonds are created equal. Before buying a bond, you should assess the many characteristics that are associated with these fixed-income securities, including maturity, security provisions, yield, call status, tax treatment and credit rating. Performing this due diligence will allow you to better gauge the likelihood of timely interest payments, principal repayment and overall suitability with your investing needs.
Why Due Diligence Is Important
Certain bonds—notably U.S. Treasury securities—are generally considered low risk since they’re backed by the U.S. government. But this low risk status doesn’t apply to other bonds. The type of bond, its credit rating, security provisions and whether you plan to hold it to maturity all shape the scope of your due diligence and the specific risks you need to evaluate. That’s why it’s important to consider when you expect to need access to the funds, as well as your investment goals and risk tolerance, before deciding which bonds to purchase.
After you determine your investing preferences, you can then start the due diligence process.
Finding Out the Basics About U.S. Bonds
Review creditworthiness. Knowing how much debt an issuer has already offered can provide you with insights into their financial health and plays a major role in determining a bond’s credit rating—one of the most important measures of an issuer’s ability to repay its debt. Bonds are evaluated by credit rating agencies. Those that have registered with and operate under the regulatory standards prescribed by the Securities and Exchange Commission (SEC) are known as Nationally Recognized Statistical Rating Organizations (NRSROs). Each NRSRO has its own rating systems to determine the ability of an issuer to make interest payments and pay back its debt in full at maturity. You can find a list of the current NRSROs and links to their websites at SEC.gov.
Credit ratings also impact a bond’s yield—issuers of high-yield bonds often have lower credit ratings, which typically means these bonds come with greater risk.
Access real-time data. FINRA’s Fixed Income Data offers an easy way to access real-time data and credit ratings for corporate and agency bonds, as well as important educational information. This data is provided by TRACE—Trade Reporting and Compliance Engine—which is FINRA’s fixed income market price reporting and dissemination service.
TRACE collects and disseminates time of execution, price, yield and transaction size for eligible fixed income securities, including public and private corporate bonds, agency debt, and securitized products such as asset-backed securities and mortgage-backed securities. You can search Fixed Income Data by product category for information about specific fixed income securities and view trade activity and volumes to help you compare and evaluate investments. Note that some bonds may have limited secondary market trading, an important consideration that can impact liquidity if you want to sell the bond before maturity.
Monitor financial markets. Bond prices and interest rates have an inverse relationship, so it’s vital to monitor economic activity and to understand how economic indicators impact interest rate decisions by the Federal Reserve. Stronger economic data, or higher inflation readings, could send bond prices lower if markets are anticipating higher interest rates. Conversely, if economic prints are weak, or weaker than expected, bond prices could rise as markets expect lower interest rates. These events impact a bond’s duration—the measure of the degree to which a bond investment is likely to change in value if interest rates were to rise or fall.
Assess the bond’s taxable status. Different bonds have varying types of tax treatment. Understanding if you’ll need to pay taxes on a bond’s interest or dividends is critical as it can significantly impact your after-tax return. Consider consulting with a tax and/or investment professional about your personal circumstances before making investment decisions.
Other Ways to Research Bonds
In addition to FINRA’s Fixed Income Data, you can learn more about the different types of bonds using the following resources.
Corporate Bonds − The SEC’s EDGAR database provides free public access to corporate information, allowing you to research a public company’s financial information and operations. Corporate bonds, if publicly offered, must be registered with the SEC and will have their quarterly and annual reports posted online. These reports, along with balance sheets and income statements, can provide insights into a company’s financial health, including debt schedules and debt ratios.
Municipal Bonds − EMMA, a free source of data for virtually all municipal bonds, is operated by the Municipal Securities Rulemaking Board (MSRB) and is designated by the SEC as the official source for municipal securities data and disclosure documents.
Government Bonds − TreasuryDirect has information about U.S. Treasury bonds, including rates, calculators, and auction results, as well as the ability to buy or redeem Treasury savings bonds and notes.
Agency Bonds − The Securities Industry and Financial Markets Association (SIFMA) provides free resources on government agency and government-sponsored entity bonds, including issuance, trading volume and yield data.
If an Issuer Defaults
One of the primary risks of investing in bonds is the risk of the issuer failing to fulfill its obligation to pay the interest payments or the principal as agreed, also known as a default. A default could cause you to lose all or a substantial part of your investment, making an issuer’s creditworthiness a vital consideration, Generally, the lower the credit rating, the higher the risk of default.
As creditors, bondholders may have priority over other obligations of the issuers in the event of a default. You should carefully review a bond’s offering documents to find out the issuer’s terms and conditions in the event of a default.
Fees and Other Factors
The fees you pay for buying or selling a bond depend on a number of factors, including the role of your investment professional in the transaction, and these costs may not always be clearly disclosed until after the transaction is complete. Find out the fees associated with buying a bond by asking your investment professional or by reviewing the issuer’s offering documents.
Performing due diligence before investing in any product is an important step. For example, stocks have distinct characteristics from bonds that requires separate due diligence. Read more about due diligence for stocks.
In addition, be sure to use FINRA’s BrokerCheck tool to research investment professionals and brokerage firms you’re considering working with. You can also refer to the SEC’s Public Alert: Unregistered Soliciting Entities (PAUSE) site to research intermediaries who might be involved in the solicitation of an investment opportunity without being properly registered. Any entity that solicits U.S. investors to buy or sell securities for their own accounts must be registered with the SEC.
