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How to Invest in Bonds

Updated on December 7, 2012

Buying Bonds 101

Fixed income investing is vital part of the investment planning process. Any sound asset allocation strategy will have at least a partial exposure to fixed income. The definition of fixed income is quite broad. Included in this category would be CD’s, fixed annuities, and bonds. The bond market is the most liquid of these marketplaces, and is quite large in terms of available options. In fact the US bond market is more than twice the size of the US stock market. Because of its size and scope it can be quite confusing for the average investor. Generally speaking in terms of fixed income investing, it is usually suitable for investors to utilize a group of bonds funds to satisfy the need for diversity. For a better explanation see the below link…

http://landmarkwealth.hubpages.com/hub/Bonds-or-Bond-Funds

Buying Individual Bonds

Those individuals who prefer to own individual fixed income instruments should be aware of the risks around fixed income purchases. The first step is to evaluate whether or not you are buying taxable or tax free investments. If you are someone who is likely to fall into a relatively higher effective tax rate, it is often prudent to utilize municipal bonds for a better after tax return. However regardless of the tax treatment, there are other risks that are universal.

Interest Rate Risk

When you purchase a bond you are essentially a creditor of the issuer. You agree to loan them money for a stated period in return for an interest rate payment which is usually, but not always fixed. This interest payment is also known as the “Coupon”. Once you have acquired a bond you can either wait until its maturity date for a return of your principal or trade it in the secondary marketplace. The total return on the bond from the date of issuance to the date of maturity is called the “Yield”. Should you buy a bond as a new issue, and hold it to maturity, the yield and the coupon are the same. The interest rate risk is reflective of the changing interest rate environment after the purchase. So for example if you purchase a 10 year issue from an issuer at 3% per annum, and subsequently in the next two years interest rates rise…your issue is worth less in the secondary market. You now own a bond that has 8 years to mature at 3%...Yet new issues for only 5 year maturities may be hypothetically selling with interest payments for 5%. So why would an investor want your issue for 8 years at 3% when they can by another issue for 5 years at 5% ??? The answer is they wouldn’t unless you sold the bond at a discount. This means the principal value of the bond must be sold at a loss reflective of the interest rate changes. The inverse can also be true should the interest rate environment decline subsequent to your purchase. As a result your issue may be valued at more than your initial purchase.

Credit Risk

This type of risk is reflective of the ability of the issuer to be able to actually pay you back that which you have loaned them. The credit rating of an issuer is either investment grade or non-investment grade. Non-investment grade debt can also at times be referred to as “Junk Bonds” or “High Yield Bonds”. A more detailed explanation of the High Yield market can be found here..

http://landmarkwealth.hubpages.com/hub/Understanding-High-Yield-Bonds

The credit rating will typically impact the interest rate that is offered. The lower the rating, the higher the issuer will have to pay in an interest payment at issuance. Generally speaking Gov’t issued debt such as a US Treasury bond comes with a higher credit rating because it is backed by the taxing authority of the Gov’t agency. However, as many investors have learned the hard way, Govt's can and do default. Typically the more developed market places have had the higher credit rating for their national Govt’s debt issuance. Although in today’s marketplace this can be misleading. Most of the emerging market economies actually carry less National Debt as a share of their GDP when compared to more developed markets. Yet the ability for National Gov’ts to typically print money endlessly means that they technically do not go “bankrupt”. They simply pay you back with money that is less valuable. So the default risk of not getting repaid that which was agreed upon is relatively low.

In the case of corporate debt a company can and may go bankrupt if their finances are not in order. That can mean a complete loss to the investor, minus the interest payments that were already received. As a corporate bond holder, you are typically highest on the debt structure after the general creditors of the corporation. As such you may be compensated in a bankruptcy with stock in the newly formed entity should there be one.

In the case of municipal bonds, you are purchasing the debt issuance of a state or local gov’t. In the case of local govt’s, they do not have the ability to create currency and can go bankrupt. The statistical rate of municipal bankruptcies is extremely low. And in such cases, there is typically more of a restructuring of the debt rather than a total loss. However, the municipal market has various types of debt issuance tied to general obligations of a municipality or specific revenue linked to projects within the municipality. For more detailed info on the municipal market see the attached link…

http://landmarkwealth.hubpages.com/hub/How-to-Understand-the-Municipal-Bond-Market

Call Risk

Often times, bonds of corporations and municipalities are issued with what are known as a callable feature. This is essentially a refinancing option of the issuer. Should they issue debt for 10 years with an interest rate of 7% and then rates drop to 4%, the issuer may wish to call the bond away from those who hold it in order to issue new debt at a lower rate. In such a case the issuer will return the principal value of the bond earlier. Since subsequent interest changes often lead investors to buy bonds in the secondary market for more or less than the original value of the issue, this is an important feature. This means when an investor buys a bond with a callable feature, they need to be aware of not only the bonds “Yield to Maturity”, but also the “Yield to Call” in order to understand how their return on investment may be altered. A callable feature is usually available to the issuer after a specific date or during specific intervals. This feature does not guarantee it will be utilized. That will depend on the economic benefit to the issuer. However, the investor needs to understand this risk prior to purchase.

Accrued Interest

When buying a bond in the secondary market from another investor through a broker dealer, an investor is often trading the bond with accrued interest. Accrued interest occurs as a result of the difference in timing of cash flows. Accrued interest is typically added to the price of a bond transaction. This is interest which has been earned since the last interest payment. Because the bond hasn't matured and the next payment is not yet due, the owner of the bond hasn't officially received the money. If the investor sells the bond, accrued interest is added to the sale price. So the purchaser may be paying a premium for the bond because they will be receiving a payment that should have been owed to the seller.

Volume Pricing

Bonds in the corporate and municipal markets are often traded on a large scale block trade by institutions and fund managers. The price the average investor is receiving in a bond trading in the secondary market can be vastly different than that of which another investor or fund manager is receiving. The best way to envision this is to think of the last time you bought a car. You will typically negotiate the price you felt was fair. However, had you been buying 10 cars that day you would have had more negotiating power. The same is true in the fixed income markets. Brokerage firms and their brokers most often are selling bonds directly from their fixed income inventory they hold in the firm. They have a great degree of latitude in how much they will charge you. Often they may even prefer to sell you a bond in house that is more profitable for them to mark up then to go out to a bond dealer and complete a purchase for you in an issue that may be a better investment, simply because the profit margin is lower. In fact most brokerage firms place a price of a bond you hold on your statement which is generated through what is called the matrix pricing system. This is a system in which the average price of many fixed income investments with similar maturity dates, credit ratings and callable features are calculated. This average price is then placed on your monthly statement as the current value. However, should rates decline and you wish to sell a bond prior to maturity for a profit, you will be subject to having your broker go to the market place and request an actual bid that the market is willing to pay, or have them make you an offer and add the issue back to their inventory. While there are rules and parameters in terms of how much an issue can be marked up, it is unlikely that the average investor will get anywhere close to the best price possible. Additionally this pricing system is far from transparent. Your broker is not even legally required to disclose how much the markup was.

The bond market is in general is extremely complex. Fixed income products are often issued with many hybrid features that can affect maturity, tax treatment, credit status and cash flows. It is important to look closely at the features of each issue before you buy them, while balancing this with your expectations regarding the future of interest rates.

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