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PRIMER ON BONDS:
The bond market is massive, actually dwarfing the market
in stocks. Almost
all my subscriber have some familiarity and experience with
common stocks. Bonds are another story. Most subscribers (and
their brokers, I might add) know little about bonds. Most
subscribers have never bought a bond, and many brokers have
never sold a bond. Because
bonds may be an increasingly important addition to your portfolio, I want
to present this very basic information on bonds. First,
what is a bond? A bond is a debt security. It represent a loan
from the government, a state, a county or municipality, or it
can represent a loan from a corporation. A bond is
simply a unit of debt that a borrower sells
to an investor. A
bond is called a fixed
income security because the interest rate or
"coupon" that the investor receives at the time that
the bond is issued remains fixed. The coupon does not change
once the bond is issued. When
you buy a bond which provides a certain yield at the time of
purchase, that is the yield you will receive on your original
investment regardless of whether the bond rises or falls
in price in the open market. For instance, say you buy a
bond that has a 5% coupon and you buy the bond for a thousand
dollars. No matter where that bond goes in the open market,
you're going to receive that fixed rate of 5% or $50 per each
thousand dollar bond. Bonds
are almost always issued in denominations of one thousand
dollars, but bonds are quoted in percentages. In other words, a
bond which is quoted at 100 or par would sell for exactly one
thousand dollars, par equaling one thousand. Interest
rates in the open market change almost daily. These daily
changes effect the daily market
price of bonds. Bonds move inversely with prevailing interest
rates. As interest rates move up, the price of bonds moves down,
-- and as interest rates decline, the price of
bonds moves up. Now
suppose interest rates rise on
the open market. Your bond will decline in price so that
its interest will be in line with the market's interest. But
regardless, you will continue to receive your $50 a year
interest on your bond, even though the market price of your bond
is lower (most bonds pay semi-annually or twice a year). This
is important – if say
rates decline and your bond rises, you then have to decide
whether to keep the bond and continue to collect your $50 a year
or to sell your bond at a profit -- but you can't have your cake
and eat it too. In other words, you have to decide whether to
continue collecting your 5% interest or whether to take the
profit (and pay the taxes on your capital gains). Of
course, if you sell your bond and
take the profit, you then have the problem of what to do
with the money. If you want to buy more bonds, you're probably going
to get less yield, because as I said, rates were going down,
which is why your bond rallied in the first place. As
for bond yields, there are three items to consider. The first is
the bond's yield to maturity, which is the yield based on
holding the bond to maturity. The
second is the yield to call, meaning the yield if the bond is
called at a certain price (the call price is stated when you buy
the bond). The
third item is the yield based on the day or the hour you buy the
bond. Not
all bonds are callable. But if a bond is callable, you want to
know at what date that bond is callable and at what price it is
callable. That could be a problem if you pay a premium for a
bond. Say you buy a bond that is now selling for 113 and the
bond is callable at 102. If the bond is called at 102 you're
going to face a loss of 11 points. For this reason, I try to buy
bonds that are selling at a discount rather than a premium,
since a discounted bond is far less likely to be called. Example
– if I buy a bond for 78 and it's callable at 102, why would
the issuer call the bond at 102 when the company could go into
the open market at buy the bond at 78? They wouldn't, and that's
the advantage of a discounted bond that's callable at a much
higher price. The bond just isn't likely to be called. I
have called compounding "the royal road to riches." That's because if
you buy a security that pays a good dividend or a decent rate of
interest and you reinvest the dividends or the interest, then the compounding effect become very powerful over time. The
compounding effect is very important with bonds, even more so
than with stocks, because in bonds you know exactly how much
income is coming in. Furthermore,
most bonds today provide a much higher return than do
stocks. Many
died-in-the-wool bond investors follow a system of reinvesting
their bond income, and thus they follow a policy of compounding
through time. If
you compound long enough, the
compounding effect becomes so powerful that after a number of
years you'll be accumulating so much money that the original
cost of the bonds becomes a non-factor. In other words, the
increase in value of your overall portfolio will dwarf the cost
of the bond that you bought earlier in the program. The
safest and most liquid bonds are bonds issued by the US
government. The
next safest bonds are those issued by a government agency.
Treasury debt issued by the US government is extremely safe
because it carries the full faith and credit of the US
government. Treasury
bills or T-bills are sold in maturities of 91-days,
26 weeks or 52 weeks, and they are quoted in discounted
form. In other words, you may buy a T-bill at $988 (it's always
discounted) but it will mature in 91 days at par or one
thousand. T-notes
are maturites of over one year up to ten years. They are quoted
in 32nds of a point. When they talk about a T-note at 95.10 they
mean 98 and 10/32nds of one thousand dollars. US
Treasury bonds are issued in maturities of more than 10 years.
Some Treasuries are callable, meaning that at the government's
option, the bonds can be called back to the Treasury at a fixed
price and at a fixed time which is stated in the bond's original
description. The bonds, if they are callable, will be called at
par or 1000. T-bonds pay semi-annually. By
the way, Treasury bills, notes and bonds are taxable by the
federal government, but they are free of state taxes. The
US government authorizes certain agencies to issue bonds. The
Federal Farm Credit Banks the Federal Home Loan Mortgage Corp.,
the Government National Mortgage Association, the Inter-American
Development Bank, they are all managed and backed by the US
government. The Federal National Mortgage Association, Federal
Home Loan Banks and the Student Loan
Marketing Association are run by private corporations but
they do have the quasi-backing of the US government. OK,
now for municipal bonds. Municipal or "muni" bonds are
securities that represent loans by investors to a state or a
municipality or a city or a legally constituted subdivision of a
state or a US territory (Puerto Rico or the Virgin Islands).
Munis are issued to finance public works and construction
projects or even loans to universities -- always something that
will benefit the public. Munis
vary in safety, and they are rated by a few rating agencies.
Munis range in maturies from a month to half a century. Munis
are usually exempt from federal taxation, and if you buy a muni
that is issued in your own state, the bond is usually exempt
from both federal and your own state's taxes. The
two types of munis are GOs or general
obligation bonds which carry the full faith and credit of
the issuer, and revenue
bonds which are backed by the revenue which comes from the
facility that is being financed. I'm
not going to go into corporate bonds, because I prefer either
government bills, notes, bonds (highest safety) or munis (tax
free). When
buying munis, I prefer buying munis that are rated AA or AAA on
their own. However, many
munis are insured by agencies, and if insured by a recognized
agency the rating companies usually gives them an AAA rating. I've
been asked, "How good are the agencies which insure these
bonds in the case of a national disaster?"
I don’t have the answer to that one.
Which is why I prefer muni bonds that are so solid that
they are rated AA or AAA on their own, based on their superior
credit worthiness. Remember,
bonds can advance sharply in an environment where interest rates
are dropping. But bonds can also hit the skids in an environment
where interest rates are rising. Bonds
are particularly sensitive to inflation or deflation. As a rule,
bonds do not do well in an inflationary environment. Since World
War II the US has tended to be on an inflationary path – thus,
the public's increasing affection for stocks over bonds. But
there are times when bonds will outperform stocks, such as
during the first half of 2001. Stocks
and bonds both have their place in portfolios. In bear markets,
you usually do best in high-grade bonds. In bull markets stocks
(if purchased at the right time) will almost always beat bonds. If
you want to buy bonds, you can buy them over the internet or you
can buy them through a broker. Personally, I prefer a broker,
but important
– he or she must be a broker who is thoroughly familiar with
bonds. Most brokerage office have one or more brokers who
specialize in bonds, and these are the brokers I would use (the
great majority of brokers sell stocks or funds – for this reason, most
brokers are not familiar with the specialized world of bonds).
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