Thursday, February 01, 2007
Buy bonds
Buy bonds
Bonds are the hot investment right now, but what are bonds?
Bonds are essentially debt. When a bond is purchased, the buyer is entitled to be returned the amount of the bond (debt to the issuer) along with an interest rate specified when the bond was sold. It is made with the understanding that the issuer will have enough money to repay the purchaser at a set end date, although some bonds can be redeemed early. Obviously, this cuts into future interest rate returns but also lowers the risk the issuer might go broke before your investment is returned.
The bond market is hard to understand because everyday investors have been hidden from it. Much like the options market, the bonds markets are full of jargon that would only make sense to someone very familiar with the trading of said bonds. MBAs really like to sound intelligent 
When bonds are first “created” or generated they are sold to investors in amounts that would make sense, round numbers if you will. Lets say Disney wants to raise $1M for a new ride at Disney world. The corporation could issue 1000, $1000 bonds in order to raise enough money. The bonds are sold to the buyers with an attached interest rate, we’ll say 5% a year. Each year 5% of the $1000 ($50) is returned to the investor, this may also take place in monthly or quarterly payments, semi-annually is another time period that is used but more rare than monthly or quarterly. At the maturation date the bond is cleared by a $1000 payment back to the investor. At this point the bond terminates, its no longer existent. The investor has received his or her dividend each year along with their original investment and the corporation received a cheap loan. The difference between a bond and a loan is that a bond can be easily traded in unit sizes (in the previous case, $1000) and typically the bond has a standard contract form.
There are many types of bonds:
1 The US treasury bonds, or any countries federal borrowing system.
2 Corporate bonds
3 Municipal bonds
4 Junk bonds
1 The US treasury issues bonds to fund the federal government’s interesting practices. The treasury has a very big advantage in borrowing over that of a corporation because the treasury can essentially print however much money is needed in order to make good on payments. Regardless of what you heard in your High School economics classes, the US can print money whenever it desires, this doesn’t mean it isn’t bad on the economy, its terrible. The federal government has this right but using it will come to be a loss for anyone in possession of US dollars. A few other countries borrow from themselves but usually, especially in developing nations with debt issues, the countries borrow foreign money. (Foreign money is always better because it increases the overall worth of the nations economy) Foreign money comes at a price however. As I have mentioned before, borrowing from one country to deposit in another can be financially devastating if the exchange rates are volatile.
If the economy of the borrowing country falters, the value of its currency falls and the payments to the lender are more than before because the new exchange rate. Developing nations have come up with a system to beat this terrible cycle by holding masses of US dollars to pay for loans when their own currency loses value. The holding of the dollar by foreign countries is also helpful to the United States. Less money in circulation means its worth more!
2 Corporate bonds are another form of bonds. These bonds are much like my Disney scenario above where bonds are issued to fund the company’s operations. These bonds usually carry more rules and stipulations such as “call rights” that allow a company to buy back the bonds for the debt amount at certain times, such as two years into the debt issuance. Some corporations also allow a bondholder to convert the value of the bond into shares of stock. This only happens on rare occasions.
3 The municipal bond is offered by local offices to fund things such a new football stadium or to make a new bike trail in the city. These bonds offer additional tax benefits that greatly increase their value. The value of municipal bonds isn’t in its interest as much as it is in its tax benefit to the individual investor.
4 Junk bonds. Junk bonds are basically like the credit card debt of lower class America. Junk bonds are just that, junk bonds. These bonds are labeled as junk bonds because they do not fit investment grade like corporate or US treasury bonds. These bonds often pay double digit returns because of their extreme risk and the possibility the issuer may go bankrupt. Junk bonds are not an investment I would recommend to any investor. Most junk bonds are funding start ups with no income or established companies just waiting to go bankrupt.
It is important to understand that interest is only paid on the base price of a bond. When bonds are sold on the open market, a $100 bond may sell for $102, although the interest payments will be calculated on a $100 investment, not $102. It is also true that bonds may sell for a discount such as $98 for a $100 bond, in which case interest will be calculated on the $100 issue amount. Buying a $100 bond means you are buying $100 in debt to a company, it is possible that you could pay just $1 for $100 in debt. Granted, a bond at $.01 to the dollar will probably not pay interest next due time because the company is most likely going under.
The yield on a $1000 bond purchased for $900 will be considerably higher than the original yield. If I were to purchase a $1000 bond at 9% for $900, I would receive $90 per year or 10% on my investment. This relationship makes most sense on US treasuries.
US treasuries are known for being virtually lossless investments because the government will always have the ability to make good on payments via printing more money. The rates are extremely important because the rates are THE number for how much money is available to the government. The rates not only affect the federal government but they also trickle down to affect even credit cards or a student loan. This interest rate is IT!
The term used to describe the change in return due to a price change of a bond is known as duration for whatever reason. The duration is not how long a bond is valid, do not get these two mixed up. The duration is simply an equation used to determine the interest rate in regards to a price that differs from the original issue. Basically, the duration tells you what you’re going to get on your money. Important, no?
If you own treasury bonds with a duration of 7, duration is the multiplier of course, and the interest rate rises .1%, expect the price of your bonds to DROP by .7%. Interest rates never really change, they just adjust to the price of the bond. When the bond drops in price, the effective interest rate goes up because the interest is still paid on the original issue, NOT the new value.
This is the bonds way of equilibrium. In loans, money market accounts or various other forms of interest, the interest rate is adjusted. In bonds, the value is adjusted by the markets to raise or lower the interest rate. $20 is 10% on 200 while it is 50% on a $40 bond.
It is important to remember though that duration is a word that is changed in and out of financial texts. One day you will find it as a “multiplier” or a “interest multiple.” Investors don’t like to make anything simple, although the most simple things often yield the most money.
Another, semi-complicated piece to bond investing is the Bond Rollup. See as your bond ages it goes from a 10 year bond to a 9 year bond to a 8 and a half year bond (half year was a hyperbole) but you get the picture. If I buy a 10 year bond right now, in 5 years it will trade on the market as a 5 year bond, and thus, receive 5 year interest rates. For the first few years of the bond’s life is when it pays the best interest rate. Any time after this the rate will slowly deteriorate because the longevity of the bond is also decreasing.
In normal scenarios, long term lending pays the highest rate. Right now and at various points throughout history the yield curve will go upside down and short term is cheaper than long term. As the bond ages it becomes a short term bond and more people are willing to invest in such a bond as people don’t like to lock up funds for a decade at the time. This means that the interest rate will probably drop but the price of the bond will also rise as you have a greater market to sell your bonds.
Everything in the markets is equal. Buying short term bonds means low rates, long term bonds means you lock up capital for longer but this time in exchange for a slightly higher rate of return.
Another drop in the bond bucket is the ability to invest in overseas bonds with cheaply borrowed capital. For example, in forex, borrowing from Japan to loan to Brazil at an 18% yearly interest rate. This is very risky because the exchange rate can go up or down and further add to the amount made or lost.
There are many different types and grades of bonds. Bonds have grades but not like that of school. An A grade bond is the best corporate bonds can be. I would not suggest investing in B grade bonds, leave these for the professionals even though a B really isn’t that bad schoolwise.
The bond market can be fun and rewarding. The best way to get into bonds would be through a mutual fund that specializes in bonds. Picking individual bonds can be a tricky task so leave it up to a manager to do it for you. Bonds have a lot more variables than just a PE ratio or trendmapping.