A PRIMER ON BONDS: The bond market is massive, actually dwarfing the market in stocks. Almost all my subscriber have some familiarity and experience with common stocks. Bonds are another story. Most subscribers (and their brokers, I might add) know little about bonds. Most subscribers have never bought a bond, and many brokers have never sold a bond.
Because bonds may be an increasingly important addition to your portfolio, I want to present this very basic information on bonds.
First, what is a bond? A bond is a debt security. It represent a loan from the government, a state, a county or municipality, or it can represent a loan from a corporation. A bond is simply a unit of debt that a borrower sells to an investor.
A bond is called a fixed income security because the interest rate or "coupon" that the investor receives at the time that the bond is issued remains fixed. The coupon does not change once the bond is issued.
When you buy a bond which provides a certain yield at the time of purchase, that is the yield you will receive on your original investment regardless of whether the bond rises or falls in price in the open market. For instance, say you buy a bond that has a 5% coupon and you buy the bond for a thousand dollars. No matter where that bond goes in the open market, you're going to receive that fixed rate of 5% or $50 per each thousand dollar bond.
Bonds are almost always issued in denominations of one thousand dollars, but bonds are quoted in percentages. In other words, a bond which is quoted at 100 or par would sell for exactly one thousand dollars, par equaling one thousand.
Interest rates in the open market change almost daily. These daily changes effect the daily market price of bonds. Bonds move inversely with prevailing interest rates. As interest rates move up, the price of bonds moves down, -- and as interest rates decline, the price of bonds moves up.
Now suppose interest rates rise on the open market. Your bond will decline in price so that its interest will be in line with the market's interest. But regardless, you will continue to receive your $50 a year interest on your bond, even though the market price of your bond is lower (most bonds pay semi-annually or twice a year).
This is important – if say rates decline and your bond rises, you then have to decide whether to keep the bond and continue to collect your $50 a year or to sell your bond at a profit -- but you can't have your cake and eat it too. In other words, you have to decide whether to continue collecting your 5% interest or whether to take the profit (and pay the taxes on your capital gains).
Of course, if you sell your bond and take the profit, you then have the problem of what to do with the money. If you want to buy more bonds, you're probably going to get less yield, because as I said, rates were going down, which is why your bond rallied in the first place.
As for bond yields, there are three items to consider. The first is the bond's yield to maturity, which is the yield based on holding the bond to maturity.
The second is the yield to call, meaning the yield if the bond is called at a certain price (the call price is stated when you buy the bond).
The third item is the yield based on the day or the hour you buy the bond.
Not all bonds are callable. But if a bond is callable, you want to know at what date that bond is callable and at what price it is callable. That could be a problem if you pay a premium for a bond. Say you buy a bond that is now selling for 113 and the bond is callable at 102. If the bond is called at 102 you're going to face a loss of 11 points. For this reason, I try to buy bonds that are selling at a discount rather than a premium, since a discounted bond is far less likely to be called.
Example – if I buy a bond for 78 and it's callable at 102, why would the issuer call the bond at 102 when the company could go into the open market at buy the bond at 78? They wouldn't, and that's the advantage of a discounted bond that's callable at a much higher price. The bond just isn't likely to be called.
I have called compounding "the royal road to riches." That's because if you buy a security that pays a good dividend or a decent rate of interest and you reinvest the dividends or the interest, then the compounding effect become very powerful over time.
The compounding effect is very important with bonds, even more so than with stocks, because in bonds you know exactly how much income is coming in. Furthermore, most bonds today provide a much higher return than do stocks.
Many died-in-the-wool bond investors follow a system of reinvesting their bond income, and thus they follow a policy of compounding through time.
If you compound long enough, the compounding effect becomes so powerful that after a number of years you'll be accumulating so much money that the original cost of the bonds becomes a non-factor. In other words, the increase in value of your overall portfolio will dwarf the cost of the bond that you bought earlier in the program.
The safest and most liquid bonds are bonds issued by the US government. The next safest bonds are those issued by a government agency. Treasury debt issued by the US government is extremely safe because it carries the full faith and credit of the US government.
Treasury bills or T-bills are sold in maturities of 91-days, 26 weeks or 52 weeks, and they are quoted in discounted form. In other words, you may buy a T-bill at $988 (it's always discounted) but it will mature in 91 days at par or one thousand.
T-notes are maturites of over one year up to ten years. They are quoted in 32nds of a point. When they talk about a T-note at 95.10 they mean 98 and 10/32nds of one thousand dollars.
US Treasury bonds are issued in maturities of more than 10 years. Some Treasuries are callable, meaning that at the government's option, the bonds can be called back to the Treasury at a fixed price and at a fixed time which is stated in the bond's original description. The bonds, if they are callable, will be called at par or 1000. T-bonds pay semi-annually.
By the way, Treasury bills, notes and bonds are taxable by the federal government, but they are free of state taxes.
The US government authorizes certain agencies to issue bonds. The Federal Farm Credit Banks the Federal Home Loan Mortgage Corp., the Government National Mortgage Association, the Inter-American Development Bank, they are all managed and backed by the US government. The Federal National Mortgage Association, Federal Home Loan Banks and the Student Loan Marketing Association are run by private corporations but they do have the quasi-backing of the US government.
OK, now for municipal bonds. Municipal or "muni" bonds are securities that represent loans by investors to a state or a municipality or a city or a legally constituted subdivision of a state or a US territory (Puerto Rico or the Virgin Islands). Munis are issued to finance public works and construction projects or even loans to universities -- always something that will benefit the public.
Munis vary in safety, and they are rated by a few rating agencies. Munis range in maturies from a month to half a century. Munis are usually exempt from federal taxation, and if you buy a muni that is issued in your own state, the bond is usually exempt from both federal and your own state's taxes.
The two types of munis are GOs or general obligation bonds which carry the full faith and credit of the issuer, and revenue bonds which are backed by the revenue which comes from the facility that is being financed.
I'm not going to go into corporate bonds, because I prefer either government bills, notes, bonds (highest safety) or munis (tax free).
When buying munis, I prefer buying munis that are rated AA or AAA on their own. However, many munis are insured by agencies, and if insured by a recognized agency the rating companies usually gives them an AAA rating.
I've been asked, "How good are the agencies which insure these bonds in the case of a national disaster?" I don’t have the answer to that one. Which is why I prefer muni bonds that are so solid that they are rated AA or AAA on their own, based on their superior credit worthiness.
Remember, bonds can advance sharply in an environment where interest rates are dropping. But bonds can also hit the skids in an environment where interest rates are rising.
Bonds are particularly sensitive to inflation or deflation. As a rule, bonds do not do well in an inflationary environment. Since World War II the US has tended to be on an inflationary path – thus, the public's increasing affection for stocks over bonds. But there are times when bonds will outperform stocks, such as during the first half of 2001.
Stocks and bonds both have their place in portfolios. In bear markets, you usually do best in high-grade bonds. In bull markets stocks (if purchased at the right time) will almost always beat bonds.
If you want to buy bonds, you can buy them over the internet or you can buy them through a broker. Personally, I prefer a broker, but important – he or she must be a broker who is thoroughly familiar with bonds. Most brokerage office have one or more brokers who specialize in bonds, and these are the brokers I would use (the great majority of brokers sell stocks or funds – for this reason, most brokers are not familiar with the specialized world of bonds).
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