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Bonds.What Are They? |
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This page ran longer than I had originally planed so I am going to put the review/synopsis here at the top. If you only want the short answer it is here in this table. If you want the longer version keep reading.
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Questions or Comments to
Dan@Hardy.com|
Essentially, a bond is an IOU between an investor and an issuer of the bond. They are debt instruments. The issuer can be the US government (or any government such as Great Britain or Germany), a municipal government such as your state, county or city, or it can be a corporation. That IOU is a loan from an investor to the issuer. The issuer (borrower) agrees to pay the lender a fixed and predetermined rate of interest for a specified period of time. The bond has "matured" at the end of that specified period. The interest rate is simple interest versus an APR (Annual Percentage Rate) you would pay on a loan for a new home or credit card debt. The interest paid on municipal bonds, those issued by a state, county or city government, is tax exempt by a ruling of the US Supreme Court under the Necessary and Proper Clause of our constitution. Consequently, the yield (yield - like the income you receive from stock dividends), or interest paid is usually much lower than with federal government or corporate bonds. More about which might be better for you later. Before you buy municipal securities it's probably better to consult your accountant or tax attorney to insure they are the best income investment for you. You may also be subject to the AMT (Alternative Minimum Tax) requirements. Don't you just love the tax code... Bonds normally trade in principal amounts of $1,000.00. There are some exceptions but they are rare. Most bonds must be purchased a minimum of five at a time, or approximately a $5,000.00 investment. The principal amount of a bond is known as its "face value". Again, that is normally $1,000.00. A bond's interest rate is paid on its face or "par" value. Both terms, face and par, mean the same thing, the principal amount of the bond. A bond's interest rate is also known as its coupon rate. It's an old term that has hung on regardless of the way bond interest is paid now. Long ago bonds were issued in physical, or certificate, form just like stock. When you bought a bond you would receive it in the mail. Each bond stated the name of the issuer, its maturity date, the months the interest would be paid and the interest, or coupon, rate. Attached to the bottom of the bond certificate were the coupons that the owner would clip off and mail to the issuer or the issuer's transfer agent. In return the owner would receive his or her semi-annual interest by check. Once a bond matures the owner receives the last interest payment along with the principal amount of the bond. Example #1: Let's say you buy a bond from XYZ Corp. at par, or $1,000.00 exactly, and that bond has a coupon rate of 10%. Twice a year you will receive $50.00 interest from the issuer. Of course, $50.00 twice a year is $100.00 annually, or 10%. Bonds, like all traded securities, are subject to the laws of economics: supply and demand. In the case of bonds it goes beyond that, though. Normally, the price you will pay or receive for a bond when you buy or sell is based on supply and demand and those supplies are affected by the interest rate climate as dictated by the US Federal Reserve, and to a lessor degree the stock market. More on that later. After a bond's IPO the original buyer may sell his bond to another interested party in the open or "secondary' market. Stocks trade the same way. Bonds, like stocks, are traded on exchanges, like the NYSE, or Over The Counter, the NASDAQ market. By the way, NASDAQ stands for National Association of Securities Dealers Automated Quotation. I've never seen any of the financial media reveal that or explain it. Maybe you saw it here first. Maybe I just missed it. Exactly like stocks, the price you pay for a bond, the "Ask" or "Offer" (same thing), is always greater than the price you will receive, the "Bid" if you are selling. That's provided you buy and sell it at the same moment in time. Just like if you buy a new car and drive it around the block and then sell it back to the dealer you would not expect to receive what you paid. With stocks and bonds, though, if you wait long enough you might get more than you paid provided demand has pushed up the price of the security. The price for cars almost never works like that. When you buy or sell a bond the price you pay or receive is stated, or quoted, as a percentage of its face or par value. In other words, if you buy a bond (remember, bonds almost always trade in incremental values of $1,000.00) for a thousand dollars you have bought the bond for 100, as in 100% of par. You can also say that you bought the bond at par. If you pay more for the bond than par value you have paid a premium. By the same token, if you buy the bond below par you have paid a discount. Therefore, bonds are said to trade at a premium or a discount to par value. Example #2: Let's say you pay a premium, 101, for a bond. You are paying 101% of par or $1,010.00. If you pay 115 you are paying $1,150.00, or 115% of par. Like stocks, bond prices and quotes are also fractionalized depending on market conditions. Hence, a bond may be quoted at 102 1/2. The bond would be priced at 102.5% of par, or $1,025.00 The same logic holds for bonds trading at a discount. If you buy a bond at 95, 95% of par, you trade the bond for $950.00. So think about this. If you buy a bond at 95 and the bond has a 10% coupon rate you are getting a return on your investment greater than the coupon rate. The rate you receive is called the current yield, and that term applies whether you purchased your bond at a discount, par or premium. Example #3: Let's say you buy a bond for 101 ($1,010.00) with a coupon rate of 9 1/2% ($95.00 annually). The current yield then is only 9.4% (95 divided by 1010 equals 9.4). You paid an excess of the bond's face value, a premium, but the coupon rate never changes. The bond will always pay only $95.00 a year so the ratio must be lower. If you bought another bond for 96 1/2 with a coupon rate of 8% you can calculate the current yield by dividing the coupon rate by the price paid. 80 / 965 equals 8.29% An example of a bonds quote might look like XYZ Corp. 7 1/4s 02/10 (XYZ Corp. 7 1/4% bond maturing Feb of 2010) Last Trade 99 1/8 99 Bid 99 1/4 Ask In this example you can see that you may be able to sell a bond for 99 or buy it for 99 1/4. The last trade is only history and there is absolutely no relation to, or indicator of, the price of the next trade. In this case, like in all cases, you can not tell if the last trade was a buy or a sell. It's just the last trade. It could have been equal to the current Bid or Ask but those prices may have changed based on the quantity of bonds traded last. The quantity of any security traded may have had an impact significant enough to raise or lower the prices based on supply and demand. These same rules are true for stocks and the ability to buy or sell a given amount of a security at a specific price is a matter of liquidity. In other words: how quickly can I convert an asset into cash at a specific price. If you need further clarification drop me a line. What Other Factors Affect Bond Prices? Actually there are several, but primarily the price of bonds are the result of interest rates. The US Federal Reserve, specifically the FOMC (Federal Open Market Committee) dictates monetary policy by the periodic review of our economic conditions such as the Consumer Price Index, Producer Price Index, unemployment numbers, Gross Domestic Product, worker productivity, inventories, etc., etc., etc. Making policy, raising or lowering interest rates, is a result of their review of all the economic indicators, not just the ones listed above, in order to determine if our economy is headed toward inflation (essentially too many dollars chasing too few goods and services resulting in higher prices due to the high competition for those goods and services) or recession (a significant downturn in too many of the economic indicators over a period of time). Making those determinations is like trying to steer a ship through a very narrow channel bounded on one side by the rocks of inflation and on the other by the sharp reefs of recession. A mistake can be very costly. When the Fed changes interest rates the price of bonds will also change and it will often affect the price of stocks. When interest rates go up the price of bonds goes down. Always. When interest rates go down the price of bonds goes up. Always. Here is why. Let's say you just bought a bond at 100 with a coupon rate of 7%, and tomorrow the Fed raises rates by a 1/4 of a point. Suddenly I can by a new bond with a higher coupon rate of 7 1/4% for 100. You bought your bond at par with a lower yield. Why would I be willing to pay 100 for a low yield bond when I can pay 100 for a bond with a higher yield? I wouldn't! However, if you wanted to sell your bond to me now I might be willing to pay you a discount from par in order to realize a current yield that reflects the existing interest rate climate. Do you see what happened? Interest rates went up and bond prices went down. The same logic holds when interest rates go down. Bond prices will go up because we are willing to pay a premium for an older but higher coupon rate. It's not just interest rates that determine the coupon rate of bonds but also the length of time of the loan and the credit worthiness of the issuer. Bonds with longer maturity dates usually yield higher returns because of the extended time your money is used. Credit worthiness is determined by an entity's willingness and ability to pay. Most government and corporate issuers certainly have the willingness, but their ability to pay may be in question contingent on existing debt and revenue expectations. If you buy a bond from an issuer whose credit is not absolutely pristine then you would expect a higher return on your investment for taking the extra risk that the issuer may default on their principal and interest payments in the future. The US Government is the only issuer of debt securities whose principal and interest is guaranteed. As well, they are extremely liquid. The P&I is backed by the full faith and credit of the US Government and these securities are considered the safest harbor for money in the world. Any broker that tells you that any other security or investment is guaranteed has broken the law and should be reported to their compliance department and the NASD. The price you pay for such safety is a lower coupon rate and current yield.CD's and bank savings accounts are considered the next safest thing. They are not backed by the full faith and credit of the government, but they are insured by the FDIC (Federal Deposit Insurance Corporation), a government insurance corporation, making those CD's and savings accounts' safety a direct obligation of our government. Notice the difference in terminology: "direct obligation" in contrast to "full faith and credit." It looks similar, but Uncle Sam pledges to pay the P&I on its treasury bills, notes and bonds before it reimburses you if your bank fails. That is only in the event they don't have enough money for both and that isn't likely due to their taxing power - hence full faith and credit. Adding a small element of risk, your bank accounts are only insured by the FDIC for $100,000.00. Any loss beyond that and you could be shortchanged. Though, when so many banks and savings & loans failed in the '70's Uncle Sam came through and covered the entire bill. I'd feel even better if they would stop paying fifteen hundred dollars each for thousands of left-handed wrenches. At any rate, CD's and savings accounts usually yield just a bit more than Treasuries. Next on the safety ladder are municipal and corporate bonds with a AAA ratings by one or both of the companies, Moody's and Standard & Poors. These rating services analyze debt, revenue, tax obligations and accounting practices of municipalities and corporations and rate the credit worthiness of the issuers and the specific issues. AAA ratings are generally only given to issues that are insured by a large insurance companies like the MBIA (Municipal Bond Insurance Administration) or Aetna. The Tax Equivalent Yields (defined below) of municipal bonds and the taxable yields of corporate bonds are usually higher than bank and government yields because the risk, though insured, is a little higher than that of the Federal Government which is theoretically guaranteed by direct obligation. Next down the line are AA bonds, A Bonds, Baa bonds and so on. Moody's and S&P use slightly different ratings nomenclature, but you should get the picture. Each time you step down in safety the yield should be higher. Junk bonds have the highest yield of all publicly traded bonds. At one time, during the '70's, junk yields were in the 18% range. Of course, many suffered the consequence of the higher risk and either settled for pennies on the dollar or just lost their money all together. Better luck next time. Municipal Bonds As I stated above, municipal bonds are debt securities issued by local governments: your city, county or state. The interest they pay is exempt from federal income tax (you may be subject to the AMT), and depending on where you live and the bonds you purchase, they are exempt from state, county and city taxes too. When municipal governments offer bonds they are raising money to finance a myriad of different projects: road works, local government offices, sports facilities, libraries, utilities, sewers. There are all kinds of municipal bonds too. Most are General Obligation bonds or GO's (pronounced Gee-O). The debt service (interest payment) revenues for GO's comes from ad valorum (meaning at the value) taxes on real estate. If you are a homeowner then you are familiar with ad valorum taxes and how often your municipality can raise them. The other two major types of munis are tax and revenue bonds. The tax could be from local sales taxes and revenues could be from toll roads or concessions from a sports complex. The interest on munis is tax exempt because the capital raised from their issue is used for municipal improvements - we hope... Because the interest is tax exempt, municipal bonds have much lower coupon rates than other bonds. For instance if a treasury bond that matures in 30 years provides a current yield of 5.82% a municipal bond with the same maturity may only yield 3.5 to 5.5% depending on the bonds rating. Contingent on your income needs and tax bracket one bond or the other may be better suited for you if you are a bond investor. One way to find out is by calculating the Taxable Equivalent Yield against a municipal bond. In other words if you are looking at a muni with a current yield of 3.75% what yield would you need from a fully taxable bond to equal the interest earned from the muni after you pay the income tax on the taxable bond. The calculation is easy. All you have to know is your current tax bracket. Once you know that you simply take the inverse of your tax bracket and divide the muni's yield into it. If your tax bracket is 28% then the inverse of that is 72. Now just do the simple arithmetic. Let's say the muni's yield is 4.3% divided by 72 = 5.97%. In this case you would need to purchase a taxable bond with a current yield greater than 5.97% to come out ahead after taxes. Simple, no? An issuer sells debt securities (which really means it is soliciting a loan from investors) with a Bond IPO (Initial Public Offering). Stocks are issued the same way, through IPOs. To find a new bond or stock IPO you can look in most financial publications like the Wall Street Journal. Announcements for pending sales and issues are listed in "tombstone" ads and will list all the underwriters and syndicate participants (brokerage firms) that will sell the deal. Otherwise, you can purchase existing stocks and bonds in the second market through broker/dealers who are obligated to get you the best price available, plus or minus applicable commissions or mark-up and mark-downs. There is a difference between the two but they should be relatively equal. Last, there are other kinds of bonds that do not pay interest but are bought at a deep discount from par. They are sometimes known as OID's or Original Issue Discount bonds. The ones most people are familiar with are EE or HH savings bonds that are purchased at banks or directly from the US Treasury (Broker/Dealers do not sell EE and HH bonds). OID's do not pay regular interest. Rather, they are purchased at a discounted percentage of their maturity, or face, value and accrete (grow) to full value. For instance, an OID that matures in 10 years and purchased new might be purchased at 60% of face value. There are many different types of OID's and all sorts of clever names like Zero Coupon Bonds, STRIPS, Cats, so on and so forth, but essentially they all work the same way. The most common OID is a US Treasury Bill. These have a face value of $10,000.00 and come due to maturity within six or nine months. They are extremely liquid, safe and a great place for short term money. There prices are interest sensitive (subject to decline if rates go up) so if you have to sell one prior to maturity you could wind up with a capital loss. Hopefully, you now have a little better understanding or bonds. If you need clarification, my email address is right down there. |
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Questions or Comments to
Dan@Hardy.com