Are Bonds For You?

First, let's define what a bond is, and then we can take a look at the more common types of bonds.

DEFINING BONDS

In general, bonds are long-term debt securities with a stated interest rate and fixed due dates for when interest and principal must be paid, issued by a corporation or a government. There are many variations, one of which is:

ZERO-COUPON BONDS

Zero-coupon bonds, often referred to as zeroes, make no periodic interest payments the way most other bonds do. So how do you make money on them? Instead of purchasing them at face value, you buy them at a discount. When the bond matures, you receive the face value of the bond regardless of what you paid for it. Thus, your gain is the difference between the discounted price you paid and the full face value. Some refer to this gain as interest, but in fact there is no interest paid to the purchaser, only the difference between the discount and face value. Zero bond prices are more volatile than interest-bearing bonds because there are no interest payments to offset changes in market interest rates.

The undistributed gains from zeroes are taxable, even though you don't actually receive any cash distributions. For this reason, zero-coupon bonds are ideal for IRAs and other tax-deferred retirement plans. When you purchase zero-coupon bonds within such a plan, you avoid paying tax on a payment you have not received. And then there's:

HIGH-RISK BONDS

It's no mystery -- the higher the risk, the greater the potential for gain, and also the greater potential for loss. If you want to invest a small portion of your bond portfolio in high-risk investments, consider high-risk bonds, commonly referred to as high-yield or, less charitably, junk bonds. These bonds are issued by companies with more credit risk.

How do you analyze junk bonds to minimize your investment risk? You use an approach similar to studying the fundamentals of equities:

1 If the company, not its bonds, is traded on the stock market, examine the stock price history. If you notice a steady decline in the stock price, it could mean the market thinks this sector and/or the company is a poor performer.

2 Calculate the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to annual interest. The higher the ratio, the better. An organization with an EBITDA-to-annual-interest ratio of five performs better in bad times than one with a ratio of three or less. EBITDA figures can be found on the Internet.

3 Compare earnings against annual capital expenditure costs. Again, such earnings figures can be found on the Internet. If a company needs significant capital expenditures to compete and grow, then it must have a strong revenue stream or cash flow.

EBITDA figures are available on the Internet, but you can find additional information from Value Line and Standard & Poor's listings, as well as your local library. Your broker can also be of help. A good investment strategy is to find a junk bond that is likely to be upgraded to investment grade. Then there's:

CONVERTIBLE BONDS

Another type of bond issued by corporations is the convertible bond (CV), which can be converted to either common or preferred shares of the company issuing the bond. That may make it sound like an ideal investment, but there are a few pitfalls to watch for.

Because convertibles allow you to convert the CV bond to stock, the interest of the CV is slightly lower due to the potential capital gain if the stock price increases. If the bond rating is low (as stated by Moody's, Standard & Poor's, or Fitch), then the company can pay less interest on the bond by issuing a CV. This doesn't mean that a company with a high bond rating will not issue a CV. It just means that you should be aware of the rating of the company issuing the CV because it is a tactic used by higher credit-risk companies to get lower interest rates.

When a CV is initially issued, the conversion to stock carries a premium. This premium can increase the price of your stock anywhere from 5% to 20%. The cost for each share of stock is based on the conversion rate. Before purchasing convertible bonds, be aware of the conversion premiums. Another type of bond is:

MUNICIPAL BONDS

Cities, towns, counties, regional municipalities, school districts, water and sewer districts, and port, highway, and bridge authorities also issue bonds. These are known as municipal bonds and commonly referred to as munis. Municipal bonds are exempt from federal taxes, and if you buy those issued by your state, you don't have to pay state or local taxes (in most cases).

The biggest advantage of owning munis is the tax incentive. Here's how it works. Suppose that someone gives you a choice between a municipal bond paying 6% and a corporate bond paying 8%. Assuming you are in a 20% tax bracket, do the following calculation:

1 Subtract your tax rate from 100 (100 - 20 = 80).
2 Divide the municipal rate by the result of step 1 (6/80 = 7.5%).
3 Determine how the result of step 2 compares against the corporate yield.

The corporate bond yield of 8% beats the municipal bond by 0.5% (8.0 - 7.5). If your tax bracket had been 25%, then the two would be equal. Or would they? If this corporation is heavily in debt and revenues are falling, it may be in the category of high risk, or a junk bond. On the other hand, counties have been known to fail as well. If you're leery about risk, there's always:

US TREASURIES

US Treasury instruments are debt instruments issued by -- as you might have gathered -- the US Treasury to raise money for operating the federal government and to pay off debts. Backed by the full faith and credit of the United States, Treasury bonds are extremely secure. If you combine the short time to maturity of a six-month Treasury bill and the low risk of a T-bond, you get the benchmark low rate for a bond.

Treasury bills are issued for one year or less and offered at three-, six-, or 12-month terms. T-bills are zero-coupon bonds. Treasury notes are interest-bearing bonds that range in maturity from one year to no more than 10 years, and are currently offered for two, five, or 10 years. Treasury bonds are interest-bearing bonds and are currently offered for 30 years only.

READING BOND TABLES

If you are interested in investing in bonds, you must be able to read bond yields and prices that appear in newspapers and other financial publications. Take a look at Figure 1, which is an example of what you'll see under "New York Bonds" under "US Exchange Bonds"in the financial pages. Bond issues are separated into rows, and each column provides information about the corresponding bond. The first column displays the name of the bond itself. Sometimes, the name is preceded by a credit rating. The interest rate is displayed next. In this particular example, this particular bond, At&t, pays 55/8% interest. Further, one issuing company is listed several times. This is because bonds issued at different times will have different rates.

FIGURE 1: Keep track of your bonds by reading the bond tables.
The last two digits after the interest represent the year the bond matures. This particular bond from AT&T will mature in 2004. Sometimes, instead of the last two digits, you will see the standard format for month, day, and year as MM/DD/YY or MM-DD-YY.

The column heading "Current yield"represents what the bondholder will earn in interest if he or she bought it at its current price. Yields are usually stated as "current year" or "yield to maturity."

The "volume" represents the dollar value of bonds traded (in thousands). In this example, $139,000 worth of bonds was traded the previous trading day.

The "close" refers to the price at which the bond closed the previous trading day. Bond prices are quoted in terms of points or fractions. Each point is worth $10 and each eighth of a fraction is worth $1.25. Thus, if a bond closed at 971/4, it means that the closing price was $972.50.

The "net change"is the change in price from the previous trading day. This could be a percentage change in price, a basis point change (100 basis points = 1%), a change in price, or a change in spread.

Because bonds are traded, you may see columns with headings such as high, low, bid, or ask. "High" and "low" refer to the bond price, with high being the highest price paid for the bond and low being the lowest price paid for the bond during the trading day. Bid is the offering price -- that is, what a buyer wants to pay for the bond. The ask is the asking price, or what the seller wants to sell the bond for. The difference between bid and ask is sometimes referred to as the spread. When brokers don't charge commissions for buying and selling bonds, they sometimes get the spread in return for their effort instead, which is in fact equivalent to a commission. Don't forget to ask your broker about his fees and commission structure.

BUYING BONDS

If you want to purchase individual bonds instead of bond funds, the Treasury issues -- bills, notes, and bonds -- can be purchased directly by mail, telephone, or the Internet. To do this, you will need to set up a Treasury Direct Account. Fill out forms with your closest Federal Reserve bank or branch. Call 800 722-2678 or go to www.treasurydirect.gov for information on purchasing Treasury securities. The government also has a sell-direct program that you can take advantage of when you are ready to sell your bonds.

If you opt to purchase bonds through a broker, it is worth your while to shop around. The commission structure plus the investment devices that brokerages offer can vary greatly.

You may prefer to own bonds via mutual funds. This would involve the same buying process as purchasing a traditional mutual fund.

SUMMARY

Bonds have a reputation for being a stodgy, slow-moving instrument in which to invest. But they have various uses, even though they may not be as glamorous as stocks or even mutual funds. Bonds can be used as a safety net, especially during a bear market. If you are approaching retirement, you may want to consider moving a sizable portion of your investment into bonds, bond funds, or balanced funds. Bonds can also provide tax relief, and some investors prefer the interest payments to dividends from common or preferred stock.

Are bonds for you? To find out for sure, talk to your financial planner or broker and study personal finance books that discuss bonds.

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

RELATED READING

Peterson, Dennis D. [2001]. "Gentlemen (And Ladies!) Prefer Bonds," Working Money, Volume 2: April.