Investing in Bonds For Dummies. Russell Wild
investing
▶ Meeting the major bond issuers
▶ Considering individual bonds versus bond funds
Long before I ever knew what a bond is (it’s essentially an IOU), I agreed to lend five dollars to Tommy Potts, a blond, goofy-looking kid in my seventh-grade class. This was the first time that I’d ever lent money to anyone. I can’t recall why Tommy needed the five dollars, but he did promise to repay me, and he was my pal.
Weeks went by, then months, and I couldn’t get my money back from Tommy, no matter how much I bellyached. Finally, I decided to go to a higher authority. So I approached Tommy’s dad. I figured that Mr. Potts would give Tommy a stern lecture on the importance of maintaining his credit and good name. Then, Mr. Potts would either make Tommy cough up my money, or he would make restitution himself.
“Er, Mr. Potts,” I said, “I lent Tommy five bucks, and – ”
“You lent him money?” Mr. Potts interrupted, pointing his finger at his deadbeat 12-year-old son, who, if I recall correctly, at that point had turned over one of his pet turtles and was spinning it like a top. “Um, yes, Mr. Potts – five dollars.” At which point, Mr. Potts neither lectured nor reached for his wallet. Rather, he erupted into mocking laughter. “You lent him money!” he bellowed repeatedly, laughing, slapping his thighs, and pointing to his turtle-torturing son. “You lent him money! HA … HA …HA …”
And that, dear reader, was my very first experience as a creditor. I never saw a nickel from Tommy, in either interest or returned principal.
Oh, yes, I’ve learned a lot since then.
Understanding What Makes a Bond a Bond
Now suppose that Tommy Potts, instead of being a goofy kid in the seventh grade, were the U. S. government. Or the city of Philadelphia. Or Procter & Gamble. Tommy, in his powerful new incarnation, needs to raise not five dollars but $50 million. So Tommy decides to issue a bond. A bond is really not much more than an IOU with a serial number. People in suits, to sound impressive, sometimes call bonds debt securities or fixed-income securities.
A bond is always issued with a specific face amount, also called the principal, or par value. Most often, simply because it is convention, bonds are issued with face amounts of $1,000. So in order to raise $50 million, Tommy would have to issue 50,000 bonds, each selling at $1,000 par. Of course, he would then have to go out and find investors to buy his bonds.
Every bond pays a certain rate of interest, and typically (but not always) that rate is fixed over the life of the bond (hence fixed-income securities). The life of the bond is the period of time until maturity. Maturity, in the lingo of financial people, is the period of time until the principal is due to be paid back. (Yes, the bond world is full of jargon.) The rate of interest is a percentage of the face amount and is typically (again, simply because of convention) paid out twice a year.
So if a corporation or government issues a $1,000 bond, paying 4-percent interest, that corporation or government promises to fork over to the bondholder $40 a year – or, in most cases, $20 twice a year. Then, when the bond matures, the corporation or government repays the $1,000 to the bondholder.
In some cases, you can buy a bond directly from the issuer and sell it back directly to the issuer. But you’re more likely to buy a bond through a brokerage house or a bank. You can also buy a basket of bonds through a company that sells mutual funds or exchange-traded funds. These brokerage houses and fund companies will most certainly take a piece of the pie – sometimes a quite sizeable piece.
In short, dealing in bonds isn’t really all that different from the deal I worked out with Tommy Potts. It’s just a bit more formal. And the entire business is regulated by the Securities and Exchange Commission (among other regulatory authorities), and most (but not all) bondholders – unlike me – wind up getting paid back!
Almost all bonds these days are issued with life spans (maturities) of up to 30 years. Few people are interested in lending their money for longer than that, and people young enough to think more than 30 years ahead rarely have enough money to lend. In bond lingo, bonds with a maturity of less than five years are typically referred to as short-term bonds. Bonds with maturities of 5 to 12 years are called intermediate-term bonds. Bonds with maturities of 12 years or longer are called long-term bonds.
In general (sorry, but you’re going to read those words a lot in this book; bond investing comes with few hard-and-fast rules), the longer the maturity, the greater the interest rate paid. That’s because bond buyers generally (there I go again) demand more compensation the longer they agree to tie up their money. At the same time, bond issuers are willing to fork over more interest in return for the privilege of holding onto your money longer.
It’s exactly the same theory and practice with bank CDs (Certificates of Deposit): Typically a two-year CD pays more than a one-year CD, which in turn pays more than a six-month CD.
The different rates that are paid on short, intermediate, and long bonds make up what is known as the yield curve. Yield simply refers to the annual interest rate. In Chapter 2, I provide an in-depth discussion of interest rates, bond maturity, and the all-important yield curve.
Let’s consider again the analogy between bonds and bank CDs. Both tend to pay higher rates of interest if you’re willing to tie up your money for a longer period of time. But that’s where the similarity ends.
When you give your money to a savings bank to plunk into a CD, that money – your principal – is almost certainly guaranteed (up to $250,000 per account) by the Federal Deposit Insurance Corporation (FDIC). If solid economics be your guide, you should open your CD where you’re going to get FDIC insurance (almost all banks carry it) and the highest rate of interest. End of story.
You would expect the highest rate of interest to be paid by RadioShack. Why? Because lending your money to RadioShack, which has been busy closing stores left and right, involves the risk that company HQ may close, as well.. In other words, if the company goes belly up, you may lose a good chunk of your principal. That risk requires any shaky company to pay a relatively high rate of interest. Without being paid some kind of risk premium, you would be unlikely to lend your money to a company that may not be able to pay you back. Conversely, the U.S. government, which has the power to levy taxes and print money, is not going bankrupt any time soon. Therefore, U.S. Treasury bonds, which are said to carry only an infinitely small risk of default, tend to pay relatively modest interest rates.
If Tommy Potts were to come to me for a loan today, needless to say, I wouldn’t lend him money. Or if I did, I would require a huge risk premium, along with some kind of collateral (more than his pet turtles). Bonds issued by the likes of Tommy Potts or RadioShack – bonds that carry a relatively high risk of default – are commonly called high-yield or junk bonds. Bonds issued by solid companies and governments that carry very little risk of default are commonly referred to as investment-grade bonds.
There are many, many shades of gray in determining the quality and nature of a bond. It’s not unlike wine tasting in that regard. In Chapter 2, and again in Chapter 11, I give many specific tips for “tasting” bonds and choosing the finest vintages for your portfolio.
Aside