Investing - Part VIII

Bonds

OK, time for part eight of my four part series (four parts - what was I thinking?) on investing knowledge I learned as a broker. In this episode we'll take on bonds. All kinds of bonds: Government bonds, agency bonds, corporate bonds and munis. It's going to be great fun! Let's get started!

Bonds are actually the one class of investment that I saw misunderstood more than anything else. More people could explain complex option orders than could comprehend bonds. It really wasn't right - bonds aren't that hard. People just don't know much about them for two reasons: stockbrokers hate them and they're generally viewed as being boring old-people investments.

So what is a bond? Simply put, a bond is a debt. When you buy a bond, you are loaning the issuing government, corporation, agency, or whatever money, usually $1000. In return they promise to pay you back your $1000 by a certain date plus interest at regular intervals. Nothing real complex about that.

Why do stockbrokers hate bonds so much? A couple of reasons really. First, when you buy bonds, you tend to hold them for a while. Since the broker gets paid only when you trade, a long-term holding isn't too valuable to him. Second, there are quite a few firms that don't even let their stockbrokers trade bonds. Again the lack of commission is a real turnoff for the guy who needs to make his Porsche payment.

The other reason why bonds aren't real popular is because some people view them as "old people investments." There is a bit of truth to this. Most of the bond investors out there are older. Part of the reason is because it takes money to play in the bond market (unless you're using mutual funds) and part of it is because bonds are a conservative type of investment, not exactly what you want your portfolio to be primarily comprised of when you're in your 20s and 30s.

But why do people buy bonds? What's their advantage?

Bonds are a relatively safe investment. They also generate income in excess of that available through money market funds or bank savings accounts. They also provide opportunity for small capital gains for the patient investor.

Let's look at what a bond consists of. It is really going to be two parts: the principal and the interest. The principal is the $1000 that you originally loaned to the issuer. The bond contract will specify a final date of repayment on which the $1000 principal will be repaid and also will state the rate of interest that will be paid on the issue. The interest payment is known as a coupon (from the days in which you actually had to redeem little coupons clipped from the bottom of the bond in order to collect the interest).

But bonds trade on the bond market and the values may vary depending on the degree of risk that is factored in to that particular issue. So when you think of investing in bonds there will be two numbers that you're most interested in: the Yield to Maturity (YTM) and the price (which you will need to multiply by ten to get to the real price per bond).

The YTM is essentially stating what your return would be, in an annualized percentage, if you held the bond from that day until redemption. The YTM takes into account both the rate of interest and any capital gains or losses that might be incurred due to the current price.

Now there are special bonds known as municipal or muni bonds, in which the YTM will actually be a Tax-Equivalent Yield (TEY). This is because munis are tax free to some extent usually (more on this in a minute). The TEY will always take the tax-free yield and normalize it by assuming that taxes we're paid at the highest tax rate so that you can see how the muni would compare with similar taxable bond issues.

So who exactly issues bonds? Bond issues are primarily made up of four different types: Treasury bonds, muni bonds, Agency bonds and corporate bonds.

Treasuries are the safest investment in the marketplace today. Occasionally, you will hear the phrase "risk free rate of return" thrown around in investing circles. This is referring to the return on a Treasury. These bonds are backed by the full faith and credit of the US government (key phrase there). The Treasury market is one of the most active, with major banks and corporations trading huge blocks back and forth all day long, and is also the most accessible to the individual. The Treasury Department has a wonderful program known as Treasury Direct, which will let you purchase new issue Treasuries in the same auctions and at the same rates as the big players. Treasury Direct has been one of the biggest and most important advances in the bond market in years.

Next on the pecking order of safety are agency bonds. These are the bonds that are issued by the various government and quasi-government agencies like the Federal Home Loan Agency (FHLA), Sallie Mae, or Freddie Mac. These bonds are issued by an agency of the government, but they are not backed by the government. No federal agency has defaulted on a payment on one of these issues, but the possibility is there that it could happen before there would be a default on Treasuries. Hence the agency bonds tend to carry a little higher rate of interest and a higher YTM in general.

After the agency bonds, we get into everyone's favorite - muni bonds. Muni bonds are the most unique, widely held investment out there. Most all munis will be tax-free in the issuing jurisdiction and superior jurisdictions. This means a bond issued by the State of New York will be free of New York State income tax and Federal income tax, but not from city income tax for a resident of New York City. In contrast, a muni issued by the City of New York will be tax free at all three levels: city, state and federal. Munis are also usually insured and depending on the financial standing of the insurer, the muni may be considered to almost as safe as a Treasury. But remember WHOOPS. Munis can and do default sometimes, which is not true for agencies or Treasuries.

And finally at the bottom of the list we have the corporate bonds. Corporates run the gamut of security from General Electric's bonds - which are usually rated as being almost as safe as a Treasury - to the junk bonds made famous by Michael Milken. Smart investing in the corporate debt arena can be very rewarding, but you have got to do your research on the issuing companies.

There are also other variations of bonds such as zero-coupon (they sell at a big discount and pay all the interest in one payment at the end), equipment trusts (popular with railroads and airlines, they're backed by mortgages against the equipment), mortgage bonds (usually against a piece of property somewhere) and many, many other types. Should you ever run across a bond that seems to have an odd caveat to it, I would recommend researching the issue further. There is nothing worse than to find out that you just bought the 3rd junior subordinated 2nd mortgage series bonds backed by a piece of swampland somewhere about 25 miles east of Miami.

So what kind of bond is right for you and your portfolio? Depends on what you're looking for. If you're after safety, go with Treasuries, agencies and maybe some munis and high grade corporates. Looking for income? Go for high yield corporates and munis. Looking for tax sheltered income? Munis are the way to go. The type of bond you buy is usually dictated by your needs at the time.

The other big concern with bonds is the cost. Most bonds are $1000 face value (the principal amount). To create a real, diversified bond portfolio using individual bonds, you're going to be looking at an initial investment of at least $50,000 - and usually more. Mutual funds are a great way to invest in bonds and for high yield issues - funds are the only way to go. The risks to the principal in a high yield bond is really just too great unless you have big money invested in the market and you have just a little, tiny piece in any one junk issue.

Bonds shouldn't be the big scary investment that you know you need, but that you're afraid to learn about. The basic concepts are familiar to most all of us - especially if you've ever gotten a mortgage.

Bonds should be an important part of your overall financial picture. Educate yourself on them. Ask your broker questions about them. And then figure out how they fit into your overall asset allocation model.

This will probably be the last investing topic for a few days (I think I said that four posts ago, though). I am still looking at doing an advanced options post and maybe one or two others (topics still undecided). If this series has been useful or interesting, please let me know by leaving a comment. I would really appreciate it.

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part III - Options

Part IV - The Economy and The Market

Part V - Market Mechanics

Part VI - Mutual Funds

Part VII - Asset Allocation