CHAPTER
12

Investing in Bonds

In This Chapter

• Should you invest in bonds?
• The pros and cons of bonds
• Different types of bond investments
• How to buy bonds

Individual bonds were once part of every rich person’s portfolio, and many independently wealthy people relied on them for guaranteed income. When interest rates are extremely low, new bonds fall out of favor because they pay so little.

Rewind a few decades back, especially during the Carter administration, and people were reluctant to snap up bonds even though rates at the time were quite high. Short-term money market accounts and 1- to 5-year bank certificates of deposit were paying extremely high rates, so why lock up your money in a bond? Those who had the foresight to purchase long-term, high-quality bonds at the time had the good fortune to collect a now-unobtainable rate of guaranteed return. Let’s look at whether it’s worthwhile to buy bonds, and how to go about doing so.

Generally, bonds and stocks move in opposite directions: when the market is hot, interest rates are low, and bonds are unpopular. When the stock market tanks, people “flee to safety” and bonds become popular. Because of this negative correlation, you can diversify the overall risk of your portfolio by including some bonds to balance stocks.

Tip

Bonds won’t give you a high return, but they won’t desert you in a pinch. Think of stocks as your hot date who takes you great places, while bonds are your steady-Eddie cousin who’s boring but will loan you some money from time to time.

You’ll want to balance your bond holdings with your needs and risk tolerance too. An all-bond portfolio won’t generate enough growth to allow you to keep up with inflation and still withdraw enough cash in retirement to maximize income from your portfolio. An all-stock portfolio can be so risky that you might not have a portfolio in retirement.

Why do bonds provide stability? Besides their negative correlation with stocks, they offer two forms of return: their price (if they are sold) and their yield. Price and yield move opposite to each other. When bond prices go up, the yield goes down. When prices are down, the yield goes up. This combination is not a perfectly equal exchange, but it tends to smooth out returns in mutual funds devoted to bonds. If you hold a portfolio of individual bonds to maturity, as long as you hold the bonds (and they’re of decent quality) you’ll receive rock-steady income from them, with a return of principal at the end.

How many bonds are enough? If you have a long time horizon for your investments, maybe none at all. By now you’ve heard of the 4 percent rule: that you can withdraw about 4 percent of the value of your portfolio each year in retirement and expect it to last about 30 years (at least). But that rule is based on your having at least 50 percent in stocks, and no more than 50 percent in bonds, in order to get the growth that stocks provide over the long term. For very elderly people, investment managers will sometimes select a predominantly bond mix—say 70 percent bonds, 30 percent stocks—because this group has a strong need for safety and probably a shorter time horizon for inflation to erode buying power. But this, as with all other investment decisions, is dependent on the individual’s financial picture.

Bond Basics

A bond is a loan you make to a government entity or corporation. In return, the borrower agrees to pay you interest for a specific period of time. At the end of the bond’s lending period (the term), the borrower agrees to pay you back the original sum (the principal) you invested.

Depending on how good the borrower’s credit rating is, they may have to pay you more or less interest to make loaning them money attractive. The safest bonds pay the least. The most risky bonds will give you the most income.

The longer the time you agree to lock up your money, the more you will generally be paid, because you’re sacrificing access to your money for a longer period of time and you’re running the risk that interest rates could go higher or the borrower could default, in which case you would lose your principal.

Tip

There have been a few historical periods where short-term interest rates were actually higher than long-term interest rates (called an inverted yield curve). Why? Generally these were periods of high inflation. Experienced investors may have realized at the time that all rates were at uncharacteristic highs, and long-term bond buyers were trying to lock up those relatively high rates for the long term—thus, issuers could attract buyers with somewhat lower rates. Watch for that opportunity!

When bonds are offered to the marketplace (individuals, pension funds, endowments, etc., all buy bonds) they are referred to as an issue. Governments and companies (the issuers) use them to raise money at a predictable cost (rate of interest), while delaying payment until sometime in the future, when hopefully the money will be available to repay bond holders. If a company does default, bondholders are ahead of stockholders for distribution of any remaining assets of the company.

New issues are sold at a specific price, for a specific guaranteed interest rate (the coupon rate), and a specific term, or period of time, until the principal must be paid off (the maturity date). So you might purchase a $10,000 30-year bond with an interest rate of 2.5 percent. You’d be paid $250 in interest every year, and at the end of 30 years you’d get your money back, provided the issuer was still in business.

The example I’m using is the current rate on U.S. Treasury bonds, so they’ll likely pay off.

Tip

Some bonds are sold at a discount to their face value (U.S. Treasury bills) or as zero-coupon bonds. These bonds pay no interest. You buy them for a lower price and at the end of the term you get the whole amount. The difference between your purchase price and your final value is the interest rate you’ve made.

Bond Quality

Bonds are rated for creditworthiness, to give you some idea of how likely you are to get your principal back, and to determine how much the issuer is likely to need to offer you in interest in order to entice you to lend them your money. Three different services—Moody’s, Standard & Poor’s, and Fitch—provide bond ratings, using slightly different numbers (and occasionally rating a specific bond differently). S&P’s ratings are the most frequently referred to. Bonds are divided into Investment Grade and Non–Investment Grade, with divisions ranging from safer to riskier, as shown in the following tables using the Standard and Poor’s rating system.

AAA bond ratings are granted only to extremely stable governments (e.g., United States, Australia, Canada) and very stable companies (e.g., Automatic Data Processing, Johnson & Johnson). Well-run corporations and less-stable governments can be found in the lesser grades. Once below BBB-, interest rates paid will be much higher but the risk also increases.

Warning

Unscrupulous brokers sometimes pitch low-rated bonds to unsuspecting investors, especially seniors, with the claim that these bonds will yield a good income. They will, until they default. In that case, you lose your income and your principal. Be sure you understand bond ratings before you purchase an individual bond, and know the average rating of bonds in any bond mutual fund in which you invest. High yield means junk.

Once a bond is issued, its rating can decline if the creditworthiness of the underlying issuer declines. As you might imagine, this makes it very difficult to sell the bond, and puts the holder of the bond at more risk of future default. These formerly higher-rated bonds are called fallen angels.

Other Bond Risks

New bond issues typically track inflation. When inflation is very low, so also are bond rates. In eras when inflation has exploded, bond rates have been very high as well. People will often refer to the good old days of high bond rates, forgetting that inflation was much higher at the same time.

But let’s say you were smart enough (or will be smart enough in the future) to purchase some bonds at high interest rates. Can you sit back and collect that interest for the term of your bond? Maybe; maybe not. You need to know whether the bond you are purchasing is callable. This means the issuer can call back the bond before the term is up, paying you back your principal and any interest owing up to the point of call. If interest rates drop substantially, and the company can afford it, they pay off the bonds costing them high interest payments, and refinance with new issues at lower prices (or possibly they are doing well enough to just pay the bonds off).

This is not good news for you. Although you do get your money back and therefore have no risk of default, you now have reinvestment risk, meaning that it’s highly unlikely you’ll be able to find the same interest rate at the same credit quality, in the current market.

As long as the bond is not called (or is not callable), you can sit back, collect your interest, spend it or invest it in something else, and collect the principal at term. However, what if you need the money before the term is up? Unlike annuities, you can sell a bond in the secondary market.

Definition

The market for used bonds is called the secondary market.

Generally, the current value of a bond will have some correspondence to now-current rates. For example, let’s look at the way an individual bond might change. In our example, John Elder bought $15,000 worth of BBB rated 30-year bonds in 1997. They paid 7.8 percent at purchase. In 2027 he or his heirs will get their $15,000 back, and in the meantime he collects $585 twice a year ($1,170 per year total) in interest. In retrospect, given current rates, it looks like a great deal.

But let’s say John needs that money now. He can sell the bonds today for $129.679 each, or a total of $19,451.85 (approximately). He won’t collect any more interest—his buyer now gets the interest. But, given the purchase price, the interest is worth only 6 percent to the buyer, the term is shorter, and the bond is still callable. (In real life, the buyer is also going to pay a commission, and any accrued [pro-rated] interest due to the original purchaser up until the time the bond is actually sold.) The buyer is taking more risk for less reward than the original bond owner, but compared to current market returns, it may be worth the risk. This is called the current yield.

However, there’s another way to think about the worth of a bond that you’re selling or buying, called the yield to maturity. This is a combination of the current income generated by the bond, plus any change in its value when it’s held until maturity. You’ll need a financial calculator to calculate the rather complex formula, so I’m not going to go into it here (and if you’re buying, the investment house should be able to tell you). On the earlier bond, the yield to maturity is about 4.38 percent. It’s generally thought to be a more accurate estimate of the bond’s return (of course, conditions can change) and is more in line with competitive current rates for the same type of bond.

Finally, there’s the yield to call, which is the yield if the bond were to be called on the earliest possible date. Weigh all three of these to scope out your potential return, depending on your time horizon and intentions for the bond. Services like Morningstar or the brokerage you’re using for trading can supply you with all these figures based on the day-to-day trading price of the bond.

Buying Bonds

Buying bonds is a bit different than buying stocks. There’s no specific exchange (like the NYSE or NASDAQ) for bonds, but they are traded between brokerages in an over-the-counter, or dealer-to-dealer, market. U.S. government securities can be bought directly from the feds via their website (TreasuryDirect.gov), or at banking institutions.

We’re going to look at the general characteristics of bonds, considering primarily corporate bond behavior. Then we’ll note some differences between corporate bond and government bond investing.

Tip

When buying bonds, it’s not quite as important to evaluate the underlying company as it can be with stocks, because the bond is going to carry a credit rating, and should be competitively priced based on the rating and the yield. Obviously, if a company or government authority has been in the news recently for credit problems, their bonds are more risky, but in general this is not as big a concern as it is when evaluating individual stocks.

Characteristics of Corporate and Government Bonds

An investment house is going to have specific bonds on offer, and you choose the type, then the specific bond. There will be a difference between the bid price (what buyers are offering) and the ask price (what sellers are asking). You may be told there’s no commission, but we know there’s always a hitch, right? So the bond’s price will be marked up to include a commission. Look up the price at Morningstar to see what they are quoting to know whether the marked-up price is in line.

Tip

The big investment companies, both full-service brokerages and discount brokerages such as Charles Schwab, Vanguard, Fidelity, and TD Ameritrade, will have the ability to assist you with bond purchases, and you should take advantage of their live help and online demonstrations and tutorials before purchasing individual bonds.

You usually need a fair chunk of change to purchase bonds. Most U.S. government issues have fairly large face values of $1,000, $10,000, or $1,000,000. For corporate bonds, you will usually need to make at least a $5,000 investment, even if the bonds are denominated in $1,000 face values.

It’s not prudent to put all your money into one bond. Sure, U.S. government bonds are as safe as you get, but what about changes in interest rates in the future? In a low-interest-rate environment, you don’t want to commit yourself to all low yield.

People who invest in individual bonds generally build what is known as a bond ladder. You purchase a set of bonds with differing maturities, depending on when you will need them—5 years, 10 years, 20 years, and so on. As you need cash, these mature and pay you a return on your investment. Problem is, when current rates are low, locking up a significant amount of money for a long time may have you kicking yourself in the future.

How do you know when rates are right to purchase bonds? It depends on your goals. If we estimate inflation to average about 3 percent, and you wanted your withdrawals from an all-bond portfolio to give you 4 percent a year, you’re going to need bonds paying 7 percent, at least, not easy to find these days.

On the other hand, you might consider locking up some guaranteed money when bond rates are at or about their historical average of 5 or 6 percent or better. Because bonds are not going to be your entire portfolio, securing a solid return (based on historical averages) for some part of your portfolio may be worth considering.

Or you might consider a bond mutual fund. Bond funds can emphasize specific classes of funds (emerging markets, international, long-term, short-term, intermediate term, U.S. government) or can be a combination of all types (total bond market fund). You can get an initial reading of the risk level of the fund by examining its duration, and the mix of credit ratings or average overall credit rating of the fund. (See Chapter 10 for more on mutual funds.)

Definition

Duration is a calculation using present value, yield, maturity, and call features; luckily you don’t have to calculate it yourself. The mutual fund or sources like Morningstar will include this in its standard information. The longer the duration of a mutual fund, the more risk (in normal interest rate environments). Total bond market funds generally clock in at an intermediate duration because their short-term, long-term, and intermediate-term bonds will tend to balance to the mean.

Advantages of a bond mutual fund over bonds:

• Easier to buy and sell. There’s a share price every day, and the funds are either sold and redeemed by the company or listed on an exchange (for exchange-traded funds), so there should be no difficulty in finding a buyer or seller.
• Well diversified. Bond funds contain hundreds of bonds, and you can choose the level of quality, type of bond, and average term. You’ll hold far more bonds and spread the risk far better than if you held a few individual bonds.
• More responsive to market. Bond managers can sell and buy much more easily than you can, and shape their portfolio for maximum total return.
• Having a bond called won’t affect you very much. The risks and returns are all averaged.

Disadvantages of a bond mutual fund over bonds:

• Return is not as dependable. If you’re holding high-interest-rate bonds to maturity, you’ll get that yield. Bond funds will tend to drift to the current bond market.
• Yield differences. Yield will probably not be as great when a large number of bonds are averaged as it would be if you owned a high-return bond (when they’re available).

Types of Bonds

There are myriad types of bonds: U.S. government, corporate, municipal, mortgage, and foreign, to name a few. The U.S. government uses different names to denote the various fixed-income securities it offers:

Treasury bills are debts sold in denominations of $100 to $1,000,000, maturing in 3 to 12 months. They are sold via auction (you enter a noncompetitive bid) at a discount, so a $10,000 bond might sell at $9,700, which would give the holder 3.1 percent interest for the holding period. These are also the type of short-term securities that underlie some of your investment in money market mutual funds.

Treasury notes are intermediate-term debt (1- to 10-year term). They are sold in denominations of $100 to $100,000.

Treasury bonds mature in more than 10 years and are sold in denominations of $100 to $1,000,000.

Notes, bills, and bonds can be purchased through TreasuryDirect.com, or from banks and brokerages.

In addition to these three bonds, there are two familiar, consumer-oriented options: EE bonds and I bonds, otherwise known as savings bonds. Savings bonds were originally issued (as E bonds) to help finance World War II. There is no resale market for EE bonds, they can’t be used as security for a loan, and they can’t be transferred as a gift. They can be redeemed at banks, and pay 90 percent of the average rate paid by 5-year Treasury securities in the past 3 months. They used to make a popular gift at a baby shower or graduation, but it’s hard to justify investing in them at present because of the low interest rates and inability to sell them before term.

I bonds sell in denominations of $50 to $10,000, and interest rates are set twice a year by the Treasury, adjusting every 6 months. The rate combines a guaranteed minimum fixed rate and an adjustment for inflation. Maturity date is 20 years from issue date and is exempt from state income tax.

Tip

Both EE and I bonds are exempt from federal tax on interest if the bonds are used to pay qualified higher education expenses (see Chapter 17). There are better ways to save for college, but if you already have some of these bonds, using them for college expenses might be a good way to maximize their value to you.

Treasury Inflation Protected Securities, otherwise known as TIPS, are bonds designed to overcome one of the difficulties of other bonds: that they don’t rise with inflation. TIPS pay a pretty modest interest rate, but if the Consumer Price Index (CPI) goes up after issuance, the principal that the government owes goes up. If the CPI goes down, it’s possible that the bond would lose money. Obviously, these bonds are much more volatile than other bonds, and TIPS mutual funds have seen some wide swings in share prices. Probably no one would put all their bond investments into TIPS, but for some inflation protection they are worthwhile contenders (particularly as mutual funds).

Ginnie Maes are bonds backed by Federal Housing Administration and Veterans Affairs mortgages. They were flying high not so long ago, but when mortgage rates are low, they’re not so popular. They have a face amount of $25,000 and have an expected term rather than a term-certain (because mortgages can be retired early). The payment you receive is a combination of interest and principal, and you won’t get a payment at the end of the term (so payments will seem much higher than other types of bonds). Again, these are probably easier to invest in via mutual funds.

There are other types of U.S. government bonds, but they are beyond the scope of a beginning investor. If you have determined to invest in bonds, these are the most common securities you’ll find individually or in bond funds. All-U.S. bond funds will contain a mix of government and corporate securities (unless they are specifically designated as only U.S. government or corporate).

State and municipal government bonds are exempt from federal taxation, and may be exempt from local taxation if you live in the jurisdiction. You won’t be surprised to learn that therefore these pay a lower rate of interest. Whether it’s worth it depends on your tax bracket: if it’s high, these may have a better net return than taxable bonds. State or municipal bonds can be either general obligation bonds or revenue bonds.

However, there’s no reason to hold these bonds in 401(k)s, Roths, or traditional IRAs, which are already tax exempt. Hold municipal bonds, or municipal bond funds, only in taxable accounts. It’s also very important to pay attention to ratings on these bonds—many states and municipalities are in bad financial shape and some may even default on these bonds. Once again, you can spread the risk by investing in a mutual fund.

Definition

General obligation bonds are backed by the general revenues (taxes) of a state or municipality. Since the government has the power to raise taxes, these bonds are regarded as safer than revenue bonds, which are used to raise money for a specific project, like a toll road, which will then produce its own income. If the project goes bust or loses money, the bond will be in trouble.

It can be worthwhile to diversify bond holdings into non-U.S. bonds. Depending on the strength of the country’s government, foreign government bonds can range from very safe (with low interest rates) to very risky (poorly governed and/or emerging market countries). As with international stocks, international bonds do not directly correlate with the U.S. bond market. While you might want to diversify your portfolio with an investment in foreign bonds, this is an area where you should almost certainly stick to investing in them via mutual funds, given the difficulty of evaluating them and having a sufficient number, in addition to your U.S. bond investments, to achieve diversification.

International bond mutual funds are available in just about every flavor—total international bond market (usually weighted toward the developed countries); developed markets (Europe, Australia, New Zealand, Canada, Japan); and emerging markets. However, you have an additional choice with international bond funds: hedged or unhedged.

Definition

Hedged means the fund has invested in currency instruments to protect against the blow if the dollar varies significantly, so that returns are only dependent on changes in the actual bond. Unhedged means no protection is in place with currency risks. Unhedged funds will offer more diversification to your overall portfolio (because they’ll be less correlated with U.S. bonds) but more risk and volatility. Hedged bonds are less volatile, but will act closer to U.S. bonds.

In my opinion, individual bonds are more complicated to invest in than individual stocks, but can provide a safety net for your other, more aggressive investments. In high-rate environments, you might consider locking up returns with purchases of individual bonds. But for any investor interested in bonds as part of their portfolio, bond mutual funds can offer easy access to many of the benefits.

The Least You Need to Know

• A bond is a loan you make to a government entity or corporation, in return for which the borrower agrees to pay you interest for a period of time.
• Bonds provide a safety check on your portfolio, because their price usually moves opposite to stocks.
• Bond mutual funds can diversify your risk and give you a portfolio of bonds, but they don’t lock in returns like ownership of individual bonds does.
• Bonds come in many varieties and can be issued by governments and corporations. Whatever the variety, return will be determined by risk and current market rates.
• Some bonds (and bond mutual funds) are safer than others; know the bond’s rating before you invest.
• Bonds can be sold before they mature, but the price and yield will likely be different from what they were when the bond was originally issued.