This is part eight in a series that will occupy the “money hacks” slot at Get Rich Slowly during April, which is National Financial Literacy Month.
Today’s episode of “Saving and Investing” moves us from the introductory material to the details of common investments. To begin, Michael Fischer explains bonds:
What is a bond? (2:38)
This video left me wanting more. Bonds, like leverage, have been a blank spot in my financial education. I’ve never owned a bond, nor has anyone in my family. Fortunately, Fidelity Investments has an excellent primer on how bonds work.
The basics as I understand them are these: a government or corporation issues bonds to borrow money from investors. A bond is generally issued with a $1000 face value. The first person to buy the bond pays some amount of money (not always $1000), and the issuer promises pay $1000 to repurchase the bond when it matures. (Bonds can be issued for nearly any length of time, though certain periods are more common than others.) After its initial purchase, the bond can be bought and sold on the open market, and may trade for more or less than the initial price.
A bond is issued with a particular interest rate. (The interest rate is also called its “coupon rate” because bondholders used to redeem physical coupons in order to collect the interest payments.) The bond issuer pays this interest rate at specified intervals. For example, if a $1000 bond is issued with a 5% coupon rate, it pays $50 interest each year, which might be paid in $25 installments every six months.
Bonds are rated based on their quality, or the likelihood that they’ll be repaid. The highest-rated bonds are those with the least risk, and therefor the lowest interest rates yields. The lowest-rated bonds are the so-called “junk bonds”, which offer high returns but come with exceptional risk.
There’s much more, of course — I’m completely avoiding the concept of yield — and if you’re interested, I encourage you to read the Fidelity primer.
Why would anyone buy bonds if they offer lower returns than stocks? Bonds offer less risk than stocks. As part of a diversified investment portfolio, they offer a safety net in times of a bear market. Bonds also appeal to those who require a regular income from their investments. Stocks may appreciate, but they don’t actually provide income until you sell them. (An exception, of course, is stocks that pay dividends. Unsurprisingly, bonds and dividend-producing stocks appeal to the same sorts of investors.)
Your Money or Your Life, one of my favorite personal finance books, promotes investing in U.S. government Treasury bonds as a step toward financial independence. (The goal being to acquire risk-free income-producing assets, and then to live exclusively off that income.) At current yields, however, one would need around $1,000,000 in Treasury bonds in order to pursue this sort of plan. (YMOYL was written in the 1980s when yields were significantly greater.)
Bond trivia: Singer David Bowie issued bonds secured by his music royalties. He used this $55 million cash infusion to buy back song rights from a former manager. Neat!
Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. Look for more episodes of Saving and Investing at Get Rich Slowly every weekday during the month of April. For more information, visit Michael’s site, Saving and Investing, or purchase his book.
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April 11th, 2007 at 1:52 pm
Bonds were a huge blank spot in my financial education (which wasn’t that great to begin with) until I read Liar’s Poker, by Michael Lewis. It’s not only a great read, but it conveys a good bit of information on bonds in general and the creation of the mortgage bond market in particular.
April 11th, 2007 at 5:55 pm
Important to remember is that bonds can be bought and sold just like stocks. As the underlying interest rates change, so does the resale price of a bond.
-limeade
April 11th, 2007 at 6:17 pm
I understand the basics of bonds, but I’m afraid I just don’t get the movement of bond funds. I mean, I understand the whole idea that when interest rates go up(down) a newly issued bond is worth more(less).
But my issue is this: How can a bond mutual fund actually lose money? Even if interest rates go up, the bond still pays out the coupon. So why a decline? I get that an equal amount of money invested at the new, higher interest rate would pay out more, but it seems to me that a bond mutual fund should never have a return less than some average interest rate.
April 11th, 2007 at 9:42 pm
Ok, you have some misconceptions:
> I understand the whole idea that when interest rates go up(down) a newly issued bond is worth more(less).
Wrong, new bonds are always worth their face value. It’s previously issued bonds that increase or decrease in value due to interest rate changes.
> I get that an equal amount of money invested at the new, higher interest rate would pay out more
Wrong, you continue to get paid the old rate. While pre-existing bonds may increase or decrease in value on the open-market, the rate they still pay is fixed.
> How can a bond mutual fund actually lose money?
Simple — investors bail out forcing the fund to sell their 5% bonds on the open market while new bonds are available for 7%. The only way to guarantee no principle loss is to limit fund redemptions to just the amount available for maturing bonds — not sure who would go for a forced 10-30 year loan. So just like how stock funds calculate a NAV based on what would happen if you did sell, bond funds do the same. It’s not a realized loss for you unless you force the fund to sell devalued bonds off to give you back your % of the money.
April 13th, 2007 at 8:56 am
I think I didn’t clearly articulate what I meant. By “when rates go up, new bonds are worth more,” I simply meant that you’d rather have a new bond based on the now higher interest rate. And by “an equal amount of money invested at the new, higher interest rate would pay out more,” I meant if you buy a $1k bond and hold it to maturity, you will make more money on the bond with the higher coupon rate.
Thanks for answering my question. It’s a great big “Doh!” moment, because it’s completely obvious when you say it. Silly investors with their need to redeem shares.
April 14th, 2007 at 1:38 am
There are simple reasons why I do not, as an individual, invest in the bond market. Let me review them for you.
1) The bond market is a gigantic over-the-counter market, consisting of networks of independent dealers, organized by the type of security they sell. Bond traders raise capital for companies and governments (national, state, local) through the issuance of debt. The buyers of this debt are not usually guys like me. They are primarily large institutional investors such as pension funds, insurance companies, banks, corporations, and mutual funds. Bottom line. Bond issuers and their dealers don’t care about my measly $10K. In fact, the smallest blocks on the municipal market (cities for crissakes) are a round lot of $100K.
2) Even if I wanted to run with the big dogs of bond investing, I would need to find the particular brokerage firm that handles the specific bond I am looking to invest in. U.S. Treasuries may be bought directly from the Federal Reserve Bank, but to buy a specific type of bond (say, an intermediate muni with a rating of A or better), you need to find a dealer that can trade that particular bond. You may have to approach several dealers before you find one who has what you want. That’s too “comic book collecting” for yours truly.
3) Since discount brokers generally do not maintain inventories, if you want to buy a certain type of bond, their traders have to buy it from another dealer. If you want to sell the bond, their traders ask for bids from other dealers. Guess what? You’re now paying two brokerages for one simple freakin’ transaction, and bonds are not lucrative enough as an investment to warrant even one “premium”.
4) Pricing varies from dealer to dealer. Dealers mark up their bonds independently. The markup depends on their own cost, the size of the order, and how much profit they want to earn. Pretty shitty, eh. Wait, it gets worse. Commissions costs are hidden, so that the buyer does not know either the cost to the dealer or the size of the markup. Basically, buying a bond is analogous to buying a stock without knowing either the size of the commission or the price on which the commission is based.
5) Scared off yet? Here’s another good one. Pricing information is proprietary, and the bond traders continue to resist efforts to make pricing information widely available. The financial press publishes some pricing information, but it is limited. The tables that appear in the financial newspapers list a few representative widely traded issues, but most of the prices apply to institutional-size trades on $1 million or more. If you want to either buy or sell smaller-size lots the price per bond will be higher if you buy, lower if you sell.
6) You still want to buy something with hidden fees, unclear costs, and poor return? Can I add another nail? With the exception of Treasuries, many bonds trade infrequently. If a bond has not traded for months, there is obviously no current valid pricing on it. Furthermore, the bond market includes millions of issues of all types, sizes, maturity dates, and credit quality. The same bond may be sold by different dealers for widely different prices, based on the price at which they bought the bond, the size of their markup, the size of the lot, and the direction of interest rates. So far, it seems like a “user friendly” atmosphere doesn’t it. It gets worse.
7) Finding a good source for bonds requires effort. Effort. I can buy or sell a stock anywhere, within two seconds. Bonds? Effort. You may need to try to locate either a firm that specializes in bonds or, within a bank or brokerage firm, an individual who specializes in selling particular types of bonds to individual investors. There are so many “bucket shops” (known for their high-pressure tactics) in the bond world, that you would be prudent to do background investigations, not on your investment, but on the firm placing your investment. Huh?
Par, Premium, and Discount: The “par” value of a bond is its value at maturity; that is, $1,000. When a bond begins to trade, it normally ceases to sell at par. If it sells at less than par (less than $1,000), it is said to be selling at a “discount.” If it sells at more that par (above $1,000), it is called a “premium” bond.
CUSIP Numbers: The CUSIP numbering system was established in 1967 in order to provide a uniform method for identifying bonds. (CUSIP stands for Committee on Uniform Securities Identification Procedures.) This is a nine-digit number that identifies individual bonds. It is equivalent to a ticker symbol for a stock, and it identifies each bond issue precisely. Suppose, for example, you own a State of New Jersey bond. That bond is only one of perhaps hundreds of State of New Jersey bonds that are outstanding at any given time. Each one of these bonds has very precise and individual provisions. These bonds are not interchangeable. If you want to buy or sell a bond, the CUSIP number identifies the precise issue you are dealing with. CUSIP numbers are assigned to municipal, corporate, and pass-though securities. International issues are identified by a CINS number.
9) Are you still considering bonds? Rememeber when I told you that commission costs for buying or selling bonds are hidden. That’s because the price of the bond is quoted net. The broker will actually tell you, if you ask a broker about the commission, that there is no commission. Prices are quoted in pairs: the “bid” and the “ask” (also known as the offer). The difference between the bid and the ask is known as the “spread.” It represents the commission. Technically, the bid is what you sell for; the ask, the price at which you buy. But it is not difficult to remember which is which. Just remember this: if you want to buy, you always pay the higher price. If you want to sell, you receive the lower price.
Need an example? Suppose you get a bond that is quoted at “98 bid/100ask.” If you are buying the bond, you will pay 100; if you are selling, you will receive 98 (see below for the answer to 98 and 100 what).
Suppose, for example, that the market spread is “98 bid/100 ask.” If you are selling an inactively traded bond (and that description applies to most bonds), then the broker makes sure that they buy it from you cheaply enough so that they will not lose money when they resell. They do this by quoting a larger spread, say “97 bid/101 ask.” For that reason, commission costs to an individual investor are often wider than the market’s bid/ask spread.
The size of the spread (or commission) reflects what is known as a bond’s liquidity; that is, the ease and cost of trading a particular bond. A narrow spread indicates high demand and low risk: the dealer is sure she can resell quickly. Conversely, a wide spread indicates an unwillingness on the part of the dealer to own a bond without a substantial price cushion. An unusually wide commission (4% or more) constitutes a red flag. It warns you that at best, a particular bond may be expensive to resell and, at worst, headed for difficult times. The dealer community, which earns its living buying and selling bonds, has a very active information and rumor network that is sometimes quicker to spot potential trouble than the credit rating agencies. Now….are you scared enough to avoid buying bonds?
10) Let’s say you’ve got a bond with a great rate of interest payable to the holder, you. The issuer of the bond has one more great advantage over you, the investor. The issuer has the ability to call bonds. This protects issuers by enabling them to retire bonds with high coupons and refinance at lower interest rates. Calls are usually bad news for bondholders. A call reduces total return because bonds are called when interest rates are lower than the coupon interest of the bond that is being called. A high interest rate, thought to be “locked in,” disappears, and the bondholder is forced to reinvest at lower rates.
11) That’s cool though. It was retired or called early. At least I’ve got my capital back and can go look for more bonds. Not so fast, sport. You can, if a bond was purchased at “par”. But if the bond was purchased at a premium (say for $1,200 with the par or face value being $1000), an unexpected early call can result in a substantial loss of principal, since bonds are typically redeemed at or close to par. If the $1,200 bond is redeemed at par, then that translates into a $200 loss per bond.
12) Hey, I see why no one buys bonds. The bond market is favored in everyone’s direction except the buyer of the bond. You. You, the money supplier, is now expected to have read the prospectus to learn about the “call provisions”, “call dates” and “call prices”, which are typically somewhat above par, accept exposure to the “call” should the bond’s terms actually be in your favor, and mysterious overcharges, commissions, and the like, are hidden from your view. Fabulous. Sign me up.
I could continue this summary of why bonds are lousy individual investments, and should be left to large institutions, but why bother? Stick with stocks.