Gentlemen (And Ladies!) Prefer Bonds

How big is the marketplace for bonds? Really big. Municipalities issue bonds (these are referred to as municipal bonds, or munis). There are about 1.5 million municipal issues outstanding. If your local newspaper listed all of them, it would take 90 pages.

You can buy some bonds directly, such as US Treasury securities (either a bill, note, or bond, depending on the length of time to maturity), but most are sold through a broker or underwriter, such as a bank. You can buy a new issue or a bond that has already been issued. When you buy or sell a bond that has already been issued, you are dealing in the secondary market, which is the common way to buy and sell bonds.

Why would you even consider investing in bonds? Unlike investing in stocks, for which there is always some risk that your original investment will suffer a loss, bonds can provide the closest to a guarantee of profit as you will find for an investment. For example, the US government has never in its history defaulted on a US Treasury security. Not all governments are equal, however, and some do default on loans; one example would be the Russian debt default of 1998.

BONDS IN THEORY

There are two parts to a bond. First, there is the amount of money you get back when the bond matures. A bond originally issued for $1,000 has a face value, or par, of $1,000. Second, there's the interest rate or coupon rate.

Why use a phrase like "face value" when what you mean is "principal"? That is what you mean, right? Well, consider this example. You need some money, so you decide to get a loan from your cousin Vinny. You agree to pay Vinny back in five years at the current market interest rate of 10%. You agree to make interest payments every six months. But one day, Vinny decides that he can make more money in the stock market and sells the loan, or bond, to someone else. Since he's anxious to get the bond off his hands, Vinny has to sweeten the deal, so he offers to sell the bond to another person not for $1,000 -- face value -- but for $900.

The bond is now selling at a discount, $100 below the face value of $1,000. Then, time goes by and for one reason or another, market interest rates start to fall, going from 10% to 8%. The new owner now has a bond that pays 10%, while the market is paying only 8%. A bond at 10% is obviously worth more than a bond at 8%. What do you think someone would be willing to pay for the bond now?

I will leave the details for later, but it's obvious potential new buyers of the bond would be willing to pay more than $1,000. So who made money on this deal? The second purchaser, the one who bought the bond from Vinny. If that second purchaser were to get $1,100 for the bond, or anything more than the face value of $1,000, the bond would be referred to as selling at a premium. Meanwhile, what are you, the debtor, going to pay at maturity? The face value, or $1,000. What interest rate are you going to pay? What you promised to pay when you issued the bond, or loan, in the first place -- 10%.

BONDS IN REAL LIFE

In my example, Vinny gave you the current market interest rate of 10%, but suppose he doubted your ability to repay the loan. When credit risk increases in real life, the interest you are charged also increases. You could end up paying more than 10% per year. Bonds with more risk must pay higher interest; junk bonds, for example, have higher interest rates because there is an increased risk of late payments or default.

When market interest rates drop, older bonds with higher interest rates return more money. When interest rates move down, the prices of older bonds move up, as in my example of the bond price going up to $1,100. When interest rates move up, bond prices move down.

When a government or corporation wants to borrow money, an underwriter (such as a brokerage, a bank, or an entire government) issues a bond. Your cousin Vinny might feel confident that you can repay the loan because he knows you; he needs no formal statement about your financial health. However, a newly issued bond must include a security's offering statement or prospectus. And althoughVinny might have sold the bond to someone else based on a simple exchange of money, in real life, bonds are bought and sold in the over-the-counter (OTC) market. (The New York Stock Exchange lists some corporate bonds.)

Bonds that sell for less than face value are selling at a discount. Those that sell for more are selling at a premium. The bond's coupon rate describes the interest paid by the bond. Most bonds make semi-annual interest payments, which may or may not be taxable, depending on the type of bond.

Bonds can also be callable. This means the debtor can decide to pay before the actual maturity date the principal and interest to date. (Sometimes there are specific dates for calling a loan back, though.) The debtor may find that he or she can refinance his or her loan at a lower rate and decide to call in loans at higher rates. High-yield bonds are more likely to be callable than low-yield ones. Some bonds offer call protection; that means that these bonds cannot be redeemed for a certain period. The call price is the price the issuer must pay to retire the loan. Check with your broker or the issuer to see if call protection is available.

YIELD TO MATURITY

When the second buyer purchased the $1,000 bond from Vinny for $900, the income he derived would not only be from the semi-annual payments, but also the additional $100 for the discount. Is there one number that can accommodate both interest and the discount? There is; the market has devised such a measure, called yield to maturity (YTM), because it incorporates both the interest and the discounted bond price. Thus, it is a way to compare bonds at different discounts and interest rates.

In our example, the approximate YTM for a $1,000 bond discounted to $900 with a coupon rate of 10% for time to maturity of five years is:

Yield to maturity

$1,000 - $900 = $100, the gain you make at maturity

$100/5 years = $20 per year for the annual gain due to the discount

$20 per year + $100 per year of annual interest = $120 per year in annual revenue (may be taxable)

($1,000 + $900)/2 = $950, a rough estimate of the principal on which interest and the annual discount is being paid (even though you paid $900, your interest is paid on $1,000, but then the $20 per year gain from the discount is based on $900)

$120/$950 = 12.6% for yield to maturity

When I used the Internet calculator, I had to answer several questions. They are the same questions you'd be faced with when you buy a bond:

1  Is this a US Treasury security? US Treasury securities are exempt from state and local taxes.

2  What interest rate will you get with the bond interest paid semi-annually? I said 10%, which may be wishful thinking on my part.

3  What is your tax rate? The money received may be taxable. I said 0% to simplify matters. (If these are municipal bonds issued in the buyer's state of residence, then it is likely that no local, state, or federal tax is involved.)

Coupon yield: The coupon rate.

CREDIT RISK

The interest rate or coupon of the bond varies based on the debtor's ability to repay the loan and make interest payments in a timely fashion. Credit ratings are provided by a number of services (Figure 1). Anything that is rated speculative and lower is considered a junk bond, while anything with a rating of upper medium and above is considered investment grade.

FIGURE 1: BOND CREIT RATINGS. The best credit ratings are at the top (prime) and the worst at the bottom (default).

What are examples of corporations or governments that fit the credit levels? At the top or prime level are US Treasury securities (bonds, notes, and bills). At the excellent level are US government-supported activities such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae). At the upper medium level are investment-grade corporate and municipal bonds, and at the lower medium level are corporate bonds, somewhere between investment grade and junk.

PRICE RISK

While credit risk establishes the coupon rate, the price of the bond is at risk due to interest rate changes. When interest rates go up, bond prices fall, because older bonds will pay less and therefore are worth less. When interest rates go down, bond prices rise, because older bonds will pay more and therefore are worth more.

A new issue that has 30 years to maturity is more likely to have large price swings than one that has only six months to maturity. Bond price volatility increases as the time to maturity increases. In other words, the price of the bond will move up and down more the longer to maturity. The market is much more unsure about the state of the economy five years from now than six months from now.

However, there is one notable exception. The lower a bond is in credit rating, the more likely it is that the issuer's ability to repay surpasses time to maturity in importance. The biggest worry the market has when you deal with very speculative bonds is not the time to maturity, but the ability of the issuer to repay the loan and make the interest payments in a timely manner. So as interest rates change, you may end up seeing less of a change in junk bonds than in investment-grade bonds.

REINVESTMENT RISK

Not only does a bond have price risk, it also has reinvestment risk. When I used the YTM calculator at financenter.com, it asked what interest I would expect to get when I reinvested the semi-annual interest payments. I answered -- with some wishful thinking -- that the reinvestment would be at 10%, or the same as the coupon rate. Yield to maturity (YTM) assumes the same interest will be paid on the reinvested semi-annual payments until the bond matures. That's something of an assumption, since, after all, interest rates are continually changing. Bond duration takes reinvestment into account in a more sophisticated way.

To understand what this is, consider what happens when interest rates fluctuate. If interest rates rise, then your bond is not worth as much as a newer issue at the current higher interest rate. The price of your bond falls. You can, however, eliminate the potential loss from a bond price fall by simply holding onto the bond till maturity. The issuer will then pay the face value. What happens if interest rates fall? The bond price goes up because your older bond is worth more than a new issue, but now the semi-annual interest payments are reinvested at a rate less than your coupon rate. So in that case, holding the bond till maturity doesn't help.

Bond duration takes into account the reinvestment of interest payments. The price of a bond will roughly change in percentage terms by about the duration -- for example, a bond that has a duration of two years will see a 2% change with a 1% change in interest.

You can see volatility in action when you study bond duration. Vanguard uses the table in Figure 2 for bond funds, but it could apply to an individual bond as well. Bond duration gives you an idea of how much bond prices move with an interest rate change. As you can see in Figure 2, a bond with a duration of 10 years could see a price change of 20% with a 2% change in interest.

FIGURE 2: BOND DURATION. The longer the duration, the more volatile the bond price is to interest rate changes.

From an investment perspective, if you expect higher rates with lower bond prices, then invest in bonds with shorter durations to mitigate the loss from a lower price. If you expect lower rates, then invest in bonds with longer durations to take advantage of higher bond prices.

When you consider the billions of dollars currently invested in bonds, you can see why bond traders get nervous when the interest rates change just a quarter of a percent (0.25%), or 25 basis points. As an investor, you must ask the broker what the bond duration is. While bond duration will change as the market changes, it is still one of the best methods of comparison between bonds at any given point in time.

Dennis Peterson can be reached at DPeterson@Traders.com.

WEBSITE RESOURCES

www.financenter.com

www.vanguard.com