Published on November 3rd, 2010 | by Leonard Jackson0
The Bond Mystery
The other day, after I had been strapped in the chair, my mouth filled with various appliances and my face and gums totally numb, as is always the case, my dentist began asking me questions about investment securities. He was particularly puzzled by bonds and afraid to step into that market. It seemed so risky to him. Why should you buy bonds instead of stocks or other investments? Why does the price go up when the yield goes down? How do you know how to select a bond suitable for your portfolio? I’ve never been able to understand why bonds are such a mystery to people who are above average intelligence and who should be considered sophisticated investors.
Actually it is the simplest and most straightforward of all investment securities. For example let’s use municipal bonds. The basics of all bonds are pretty much the same and since I spent almost thirty years dealing with munis primarily, maybe I can explain some of the features more clearly.
First, a bond is a loan – plain and simple. When you buy a bond you have loaned the issuer of that bond money to build a school, a bridge, a road or fund any one of a thousand uses that a political entity may have. No matter from whom you bought the bond or how long ago you bought it or what price you paid, you hold a promise from the issuer (the name on the bond) to repay you the face value written on that bond on a certain date. In the meantime every six months until the maturity date you will receive an interest payment again stated on the bond for half of the annual interest promised by the issuer. On the date on the bond (the maturity date) you can walk in any accredited bank or financial institution and upon surrender of the bond you will be paid the face value plus any accrued interest. That’s about as simple as you can get.
A bond issue must be voted on by the tax paying citizens of this particular entity (since they are ultimately responsible for the repayment). After the offering is approved a sale date is announced and on this date bids are accepted from all interested parties. The winning bidder is the one who offers the lowest interest rate and most attractive terms to the issuing (borrowing) party. That’s about as deep as we need to get into this area unless you have an interest in participating in the sale which I somehow doubt.
So let’s use this example. On October 31, 2010 you purchase a bond for $10,000 (most all municipal bonds are now issued in increments of $10,000). The bond is described on its face as a general obligation bond issued by, we’ll say, the city of Overland Park, KS. It will mature on January 1, 2015 and it will pay a rate of interest of 3% (again stated on the face of the bond). You will receive 2 payments $150 on January 1 and July 1 of each year until the bond matures. So you would pay $10,000 plus accrued interest through October 31, 2010 an amount of $100 which you will recapture on the next interest payment date – in this case January 1, 2011 when you cash the coupon on the bond for $150. The math on the accrued interest: your purchase was on 10/31/2010; at this time the seller had earned 2/3 of the semi-annual interest due or $100 (2/3 of $150 is $100); On June 1, 2010 you will present a coupon to the issuer and receive the full semi- annual interest amount of $150. Thus you have earned 3% for the time you owned the bond which was two months ($150 – $100 or a net $50).
That’s the basics of bonds and how they are structured and how you get paid. Now let’s look at how to determine a bond’s place in your portfolio, what to look for and when to buy and sell.
Bonds are fixed income securities and therefore provide the stable portion of the portfolio. No matter what markets are doing or what outside forces or world events occur, good quality general obligation bonds will pay that set amount of interest until they mature and then can be redeemed for their face value. They are as close to risk-free investments as you can purchase in the market place. There is a market risk, of course, but if you hold the bond to maturity you will receive the face value and all interest owed.
When determining what bonds to buy you should look for bonds with the strongest “collateral”. Remember they’re loans. You look for the bonds that are the least likely to have a problem collecting property taxes and hence repaying you. As for as the maturity, it really doesn’t make a great deal of difference what you choose. I once had an old bond salesman tell me that the only reason the maturity was considered was because it had one. You can actually say that the maturity of all bonds is the same as stocks – three business days or the time it takes to get your money if you sell them. Some folks try to “ladder” their maturities which allows them to have bonds rolling over on a scheduled timeline strategy. That’s neat and well organized for those to whom that matters, but I would never sacrifice any amount of return in choosing between two similar bonds to get them on the proper rung of the “ladder.” Always look for the strongest bond with the best yield to maturity.
Now for all those folks that were unable to understand bonds and the bond market, that was simple enough wasn’t it. It was a lot less painful than that dentist is going to be next week.