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Bond
Investing
Bond
Investing
Bonds can provide a steady and
reasonably secure
income, while adding ballast to your portfolio, but only if you really
understand what you're buying.
What to look for:
Stocks
do not always outperform bonds.
Stock and bond returns were a wash from about 1870 to 1940. It is only
in the post-World War II era that stocks so widely outpaced bonds in
the total-return derby. For example, since 1950 large company stocks
have returned 13.4 percent per year on average vs. 5.9 percent for
long-term U.S. Government bonds, according to Ibbotson Associates.
You can lose money in bonds.
Bonds are not turbo-charged CDs. Though their life span and interest
payments are fixed, thus the term "fixed-income" investments, their
returns are not and they are subject to a number of risks.
Bond prices move in the opposite direction of interest
rates.
When interest rates fall, bond prices rise, and vice versa. But if you
hold a bond to maturity, price fluctuations don't matter. You will get
your principal back, along with all the interest you expect, when the
bond matures.
A bond and a bond mutual fund are totally different
investment vehicles.
With a bond, you always get your interest and principal at maturity,
assuming the issuer doesn't go belly up. With a bond fund, your return
is uncertain because the fund's value fluctuates.
Stick with new issues when buying individual bonds.
You get them wholesale. Older bonds are more dicey. They trade on the
secondary market, and their prices include a dealer's markup. Sometimes
these markups are excessive, but you will never know what spread you
are paying unless you ask, and your broker is willing to tell you.
Don't invest all your retirement money in bonds.
Inflation erodes the value of bonds' fixed interest payments. Stock
returns, by contrast, tend to keep pace with inflation. Young and
middle-aged people should put a large chunk of their money in stocks.
Even retirees should own some stocks, given that people are living
longer than they used to.
Consider tax-free bonds.
Tax-exempt municipal bonds yield less than taxable bonds, but they can
still be the better choice for taxable accounts. That's because
tax-frees sometimes net you more income than you'd get from taxable
bonds after taxes, provided you're in the 28 percent federal tax
bracket or higher.
Pay attention to total return, not just yield.
Returns are a slippery matter in the bond world. A broker may sell you
a bond that is paying a "coupon" or interest rate of 8 percent. If
interest rates rise, however, and the price of the bond falls by, say,
3 percent, its total return for the first year 8 percent in income less
a 3 percent capital loss would be only 5 percent.
Go long for capital gains
Gamblers who want to bet on the direction of interest rates should buy
long-term bonds or bond funds, especially "zeros." Reason: when rates
fall, longer-term bonds gain more in price than shorter-term bonds. So
you win big, scoring a large potential capital gain in addition to
whatever interest the bond may be paying. If rates rise, on the other
hand, you lose big, too.
If seeking steady income, stick with short to medium.
Investors looking for income should invest in a laded portfolio of
short- and intermediate-term bonds.
Bonds Anyone?
A
bond is just a promise, and fraught with all the problems that implies.
Think
"bonds," and you probably think "safe," "reliable", in a nutshell,
"boring." But that is only half the story. Bonds can provide a
worry-free stream of income. But this class of securities includes a
wide array of instruments with varying degrees of risk and reward, some
of which offer gains or losses comparable to those of any white-knuckle
stock.
Used improperly, bonds can really mess up your financial life. Handled
with care, however, bonds are among the most valuable tools in your
investment kit. Here are some of the benefits bonds can provide:
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Diversification: Large company
stocks have posted compound annual returns of around 11.3 percent since
1926, versus 5.1 percent for long-term U.S. government bonds. But while
stocks have returned more than bonds over most of this decade, they are
also more volatile. Combining stocks with bonds will net you a more
stable portfolio.
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Income: Because bonds pay
interest regularly, they are a good choice for investors, such as
retirees who desire a steady stream of income.
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Security: Next to cash, U.S.
Treasuries are the safest, most liquid investments on the planet.
Short-term bonds are a good place to park an emergency fund or money
you'll need relatively soon, say to buy a house or send a child to
college.
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Tax savings: Certain bonds
provide tax-free income. Although these bonds usually pay lower yields
than comparable taxable bonds, investors in high tax brackets
(generally, 28 percent and above) can often earn higher after-tax
returns from tax-free bonds.
To enjoy these benefits, though,
you need to know how bonds work and how to buy them.
The Working of Bonds
The
ins and outs of taxable
and tax-free debt
Companies
and governments issue
bonds to fund their day-to-day operations or to finance specific
projects. When you buy a bond, you are loaning your money for a certain
period of time to the issuer, be it General Electric or Uncle Sam. In
exchange, the borrower promises to pay you interest every year and to
return your principal at "maturity," when the loan comes due, or at
"call" if the bond is of the type that can be called earlier than its
maturity (more on this later). The length of time to maturity is called
the "term."
Because a bond's life span and schedule of interest payments are fixed,
bonds are known as "fixed-income" investments. And because a bond
represents an IOU, rather than an ownership interest like a stock,
bondholders go to the front of the creditors' line if the issuer goes
bankrupt. Stockholders stand at the rear.
A bond's face value, or price at
issue, is known as its "par value."
Its interest payment is known as its "coupon." A $1,000 bond paying 7
percent a year has a $70 coupon (actually, the money would usually
arrive in two $35 payments spaced six months apart). Expressed another
way, its "coupon rate" is 7 percent. If you buy the bond for $1,000 and
hold it to maturity, the "yield," or actual earnings on your
investment, is also 7 percent (coupon rate divided by price = yield).
If you buy the bond for $1,100 in the secondary market, though, the
coupon will still be $70, but the yield will fall to 6.4 percent
because you paid a "premium" for the bond. For an analogous reason, if
you buy it for $900, its yield will rise to 7.8 percent because you
bought the bond at a "discount." If its current price equals its face
value, the bond is said to be selling at "par."
The bottom line: There are many ways of expressing a bond's return, but
"total return" is the only one that really matters. This includes all
the money you earn off the bond: the annual interest and the gain or
loss in market value, if any. If you sell that $1,000 bond with the $70
coupon for $1,050 after one year, your total return is $120, or 12
percent -- $70 in interest and $50 in capital gains. (Prices are
usually expressed based on a par value of 100, by the way, so when you
sell that bond for $1,050 the price would be quoted as 105.)
Types of Bonds
U.S. Treasuries are the safest
bonds of all because
the interest and principal payments are guaranteed by the "full faith
and credit", that is, the taxing power of the U.S. government. Interest
is exempt from state and local taxes, but not from federal tax. Because
of their almost total lack of default risk, Treasuries carry some the
lowest yields around. Nevertheless, because their safety is so
alluring, Treasuries are among the most liquid of debt instruments.
Treasuries come in several flavors:
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Treasury
bills, or "T-bills,"
have the shortest maturities, 13 weeks, 26 weeks and one year. You buy
them at a discount to their $10,000 face value and receive the full
$10,000 at maturity. The difference reflects the interest you earn.
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Treasury
notes mature in two to
10 years. Interest is paid semiannually at a fixed rate. Minimum
investment: $1,000 or $5,000 depending on maturity.
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Treasury
bonds have the longest
maturities -- 10 to 30 years. As with Treasury notes, they pay interest
semiannually, and are sold in denominations of $1,000.
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Zero-coupon
bonds, also known as
"strips" or "zeros," are Treasury-based securities that are sold by
brokers at a deep discount and redeemed at full face value when they
mature in six months to 30 years. Although you don't actually receive
your interest until the bond matures, you must pay taxes each year on
the "phantom interest" that you earn (it's based on the bond's market
value, which usually rises steadily during the time you hold it). For
that reason, they are best held in tax-deferred accounts. Because they
pay no coupon, zeros can be highly volatile in price.
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Inflation-indexed Treasuries.
Issued in 10- and 30-year maturities (plus some five-year bonds issued
earlier that are still trading on the secondary market), these pay a
real rate of interest on a principal amount that rises or falls with
the consumer price index. You don't collect the inflation adjustment to
your principal until the bond matures or you sell it, but you owe
federal income tax on that phantom amount each year -- in addition to
tax on the interest you receive currently. Like zeros, inflation bonds
are best held in tax-deferred accounts.
Mortgage-backed
bonds represent an
ownership stake in a package of mortgage loans issued or guaranteed by
government agencies such as the Government National Mortgage
Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie
Mac) and Federal National Mortgage Association (Fannie Mae). Interest
is taxable and is paid monthly, along with a partial repayment of
principal. Except for Ginnie Maes, these bonds are not backed by the
full faith and credit of the U.S. government. They generally yield up
to 1 percent more than Treasuries of comparable maturities. Minimum
investment: typically $25,000.
Corporate bonds pay taxable interest. Most are
issued in denominations of $1,000 and have terms of one to 20 years,
though maturities can range from a few weeks to 100 years. Because
their value depends on the creditworthiness of the company offering
them, corporates carry higher risks and, therefore, higher yields than
super-safe Treasuries. Top-quality corporates are known as
"investment-grade"
bonds. Corporates with lower credit qualify are called "high-yield,"
or "junk," bonds. Junk bonds typically pay higher yields than other
corporates.
Municipal bonds, or "munis," are
America's favorite
tax shelter. They are issued by state and local governments and
agencies, usually in denominations of $5,000 and up, and mature in one
to 30 or 40 years. Interest is exempt from federal taxes and, if you
live in the state issuing the bond, state and possibly local taxes as
well. Note, though, that Illinois, Kansas, Iowa, Oklahoma, and
Wisconsin tax interest on their own muni bonds. And the capital gain
you may make if you sell a bond for more than it cost you to buy it is
just as taxable as any other gain; the tax-exemption applies only to
your bond's interest.
Munis generally offer lower yields than taxable bonds of similar
duration and quality. Because of their tax advantages, though, they
often return more after taxes, than equivalent taxable bonds for people
in the 28 percent federal tax bracket or above. (More on this shortly.)
They come in several flavors:
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General
obligation bonds, or
"GOs," are issued by states, cities and counties to finance things like
roads and schools, and are repaid with taxes collected by the issuer.
Because they are backed by the full faith and credit of the government
selling them, GO munis have traditionally been considered relatively
safe investments.
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Revenue
bonds are issued by
specific institutions, such as hospitals or utilities, and are
generally considered riskier than GOs because their payments are
secured only by revenue from the specific project being financed.
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Industrial revenue bonds are used
by communities to attract new businesses and are backed solely by the
creditworthiness of the benefiting corporation.
Incidentally,
just as the federal
government does not tax income on most bonds issued by states and
municipalities, many of the states and cities do not impose income tax
on earnings from bonds issued by the feds. Put another way, Treasuries
are usually exempt from state and local tax. Nobody makes a big deal
about this, though, since state and local income tax rates are
generally so low that the actual benefit is minimal.
The Sizing Up - Of Risk?
Are
bonds safe and predictable?
Many
people believe they can't
lose money in bonds. Wrong! Although the interest payments you'll get
from owning a bond are "fixed," your return is anything but. Here are
the major risks that can affect your bond's return:
Inflation risk. Since bond interest payments are
fixed, their value can be eroded by inflation. The longer the term of
the bond, the higher the inflation risk. On the other hand, bonds are a
classic deflation hedge; deflation increases the value of the dollars
that bond investors get paid.
Interest rate risk. Bond prices move in the opposite
direction of interest rates. When rates rise, bond prices fall because
new bonds are issued paying higher coupons, making the older,
lower-yielding bonds less attractive. Conversely, bond prices rise when
interest rates fall because the higher payouts on the old bonds look
more attractive relative to the lower rates offered on newer ones. The
longer the term of the bond, the greater the price fluctuation, or
volatility, that results from any change in interest rates.
As you might surmise, there is a
close connection between inflation
risk and interest rate risk since interest rates tend to rise along
with inflation. Interest rate shifts are also a concern for
mortgage-backed bondholders, but for a different reason: If interest
rates fall, home owners may decide to prepay their existing mortgages
and take out new ones at the lower rates. That doesn't mean you'll lose
your principal, if you happen to hold such a bond. But it does mean you
get your principal back much sooner than expected, forcing you to
reinvest it at the newly lower rates. For that reason, the prices of
mortgage-backed securities don't get as big a boost from falling rates
as other kinds of bonds.
Note, though, that price fluctuations only matter if you intend to sell
a bond before maturity, or you invest in a bond fund whose manager
trades regularly (more below). If you hold a bond to its maturity, you
will be repaid the bond's full face value. But what if interest rates
fall and the issuer of your bond wants to lower its interest costs?
This brings us to the next type of risk . . .
Call risk. Many corporate and
muni bond issuers
reserve the right to redeem, or "call," their bonds before they mature,
at which point the issuer is required to pay bondholders only par
value. Typically, this happens if interest rates fall and the issuer
sees it can lower its costs by selling new bonds with lower yields. If
you happen to own one of the called bonds, not only do you get less
than the market price of the bond, but you also have to find a place to
reinvest the money. Because of the risk that you won't get the income
you expect, callable bonds usually pay a higher rate of interest than
comparable, non-callable bonds. So, when you buy bonds, make sure to
ask not only about the time to maturity, but also about the time to a
likely call.
Credit risk: This is the risk that your bond
issuer
will be unable to make its payments on time or at all, and it depends
on the type of bond you own and the borrower's financial health. U.S.
Treasuries are considered to have virtually no credit risk, junk bonds
the highest. Bond rating agencies such as Standard & Poor's and
Moody's evaluate corporations and municipalities for their credit
worthiness. Bonds from the strongest issuers are rated triple-A. Junk
bonds are rated Ba and lower from Moody's, or BB and lower from
S&P. (You can check out a bond's rating for free by calling S&P
at 212-438-2000 or Moody's at 212-553-0377, or by "Buying bonds.") The
highest-quality municipal bonds are backed by bond insurance companies,
but there is a trade-off: Insured munis typically yield up to 0.3
percentage points less than comparable uninsured munis. Further, the
insurance only guarantees your interest and principal; it won't shield
you against interest rate or market risk. Some higher-coupon munis are
also "pre-refunded," meaning that, for esoteric reasons, they are
effectively backed by U.S. Treasuries. When a muni is pre-refunded by
an issuer, its credit quality and price rise.
Liquidity risk: In general, bonds aren't nearly
as
liquid as stocks because investors tend to buy and hold bonds rather
than trade them. While there is always a ready market for super-safe
Treasuries, the markets for other bonds, especially munis and junk
bonds, can be highly illiquid. If you are forced to unload a
thinly-traded bond, you will probably get a low price.
Market risk: As with most other investments,
bonds
follow the laws of supply and demand. The more popular or less
plentiful a bond, the higher the price it commands in the market. A
recent example: The price of U.S. Treasuries that ultimate safe haven,
rose dramatically during the economic meltdown in Asia and Russia.
You can't eliminate these risks altogether. But now that you understand
them, you may be able to reduce their impact by some of the methods
described in the next section of this lesson.
Buying Bonds
How
and where to invest
If
you've stuck with the lesson
to this point, you are probably interested in knowing more about how to
purchase bonds.
Here are the main ways:
Directly from the feds.
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U.S.
Treasuries are sold by
the federal government at regularly scheduled auctions. You can buy
them through a bank or broker for a fee, but why pay for something you
can get for nothing? The easiest and cheapest way to participate in
this market is to buy them directly from the Treasury.
You can check
out the so-called Treasury
Direct program on the Web or by calling 202-874-4000. |
You also can sell bonds you already own
before maturity through the Treasury's newer Sell Direct program.
Through a broker. With the
exception of Treasuries,
buying individual bonds isn't for the faint of heart. Most new bonds
are issued through an investment bank, or "underwriter," rather than
directly to the public. The issuer swallows the sales commission, so
you get the same price big investors pay. That's why, when buying
individual bonds, you should buy new issues directly from the
underwriter whenever possible -- since you're getting them at
wholesale. Older bonds are another matter. They are traded through
brokers on the "secondary market," usually over the counter rather than
on an exchange, such as the New York Stock Exchange. Here, transaction
costs can be much higher than with stocks because spreads -- the
difference between what a dealer paid for a bond and what he'll sell it
for -- tend to be wider.
You will seldom know what spread
you paid, unfortunately, because the
markup is set by the dealer and built into the price of the bond. There
is no fixed commission schedule. One ray of sunshine: The Bond Market
Association recently began posting some muni bond prices on its Website. Alas, the prices
include dealer markups because dealers protested listing commissions
separately. Other sites that specialize in bond information include Bondagent.com and Munisonline.com.
If you do plan to invest in individual bonds, you should probably have
enough money to invest, say $25,000 to $50,000 at a minimum to achieve
some degree of diversification, as we'll explain below. (If you have
less, consider bond funds, also described below.)
Exactly how you invest it depends largely on your objective:
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If
your objective is to achieve
capital gains, concentrate on long-term issues. Reason: as noted in
"Sizing up risks," the longer the term of a bond, the more pronounced
are its price swings when interest rates move. That works to your
advantage if interest rates fall. Your long-term bonds, especially
zero-coupon bonds will suddenly be worth a lot more. Of course, it
works to your distinct disadvantage if interest rates rise, and your
portfolio drops in value. This kind of bond investing is essentially a
bet that interest rates will fall, and its subject to all the same
risks, including that of substantial losses as any other market-timing
investment.
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If
your objective is a steady,
secure stream of income, adopt a more conservative approach.
Specifically:
Stick to shorter terms. Bonds
with maturities of one to 10 years are sufficient for most long-term
investors. They yield more than shorter-term bonds, and are less
volatile than longer-term issues.
Spread your money around. Invest in
a variety of bonds with different maturities, either by buying a bond
fund or buying a half-dozen or more individual bonds.
Build a laddered portfolio.
Each rung
of your ladder consists of a different maturity bond, from one year
right on up to 10 years. When the one-year bond matures, you reinvest
the money in a new, 10-year issue. In this way, you always have more
money to reinvest every year, and you are somewhat protected from
interest rate shifts because you have locked in a range of yields.
Through
a mutual fund. It can
make sense to buy
individual bonds if you own a lot of them and hold them to maturity,
but most people are better off buying bonds through mutual funds. The
biggest reason is diversification. Because bonds are sold in large
units, you might only be able to purchase one or a handful of bonds on
your own, but as a bond fund holder you'll own stakes in dozens,
perhaps hundreds, of bonds. You will also get the benefit of
professional research and money management. Another advantage:
Dividends are paid monthly, versus only semiannually for individual
bonds, and can be reinvested automatically. Lastly, bond funds are more
liquid than individual bond issues.
The biggest drawback to bond funds, and it's a whopper is that they
don't have a fixed maturity, so that neither your principal nor your
income is guaranteed. Fund managers are constantly buying and selling
bonds in their portfolios to maximize their interest income and capital
gains. That means your interest payments will vary, as will the fund's
share price.
For this reason, don't choose a
fund based only on its yield. Look at
its total return, which combines the income the fund paid out with any
change in the value of the fund's shares. Also, look for a fund with
low expenses. Because bond funds with similar investment objectives
tend to hold similar types of securities, which perform similarly,
there are only two ways a fund manager can goose the yield: cut
expenses or take on more risk. If a fund's yield is more than one
percentage point higher than the average for its peers and the
difference can't be explained by lower fees, the manager is probably
dabbling in exotica.
Bond
Investing
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