Fixed Income:
Inexperienced investors think the bond market goes up and down with all rates moving together. Everybody should know that bond rates of different maturities behave independently of each other. In fact, short-term rates and long-term rates even move in the opposite direction occasionally.
It is important to understand the yield curve and to keep a watchful eye on it. It's very important!
At any given time, the yield curve is a line chart that shows interest rates at a specific point for all securities having equal risk, but different maturity dates. It typically compares a government's short-term treasury bills with its mid-term and long-term bonds. The line begins on the left with the yield of the shortest maturity and ends on the right with the yield of the longest maturity.
The next day, as the different interest rates change to a different extent, the line between the various yields will shift.
What's important is the overall pattern of interest-rate movement -- and what it says about the future of the economy and the capital markets. The yield curve is an important tool for economists but it should also be one you use as well. It's probably the most important investment concept inexperienced investors could learn and apply.
Securities with longer maturities usually have a higher yield. This is the normal yield curve, which is sometimes called a positive yield curve. Note that if short-term securities offer a higher yield, then the curve is called "inverted".
So, if a situation in which long-term debt instruments have higher yields than short-term instruments, it follows that the opposite situation where long-term yields are lower than short-term interest rates (I referred to it as an inverted yield curve) is a negative yield curve. That doesn't often happen but when it does, it's a very clear sign that interest rates are expected to decline.
Early in the 4Q2004, the yield spread between the 3-month and 30-year U.S. Treasury debt instuments was well over 300 basis points (bp). By early 1Q2005, the spread is under 230 bp. That is a rapid flattening of the curve. At times, the yield curve will go fairly flat.
Ordinarily, short-term bonds carry lower yields to reflect the fact that an investor's money is under less risk. The longer you tie up your cash, as the theory goes, the more you should be rewarded for the risk you are taking. After all, who possibly knows what's going to happen over three decades that may affect the value of any 30-year bond?
A normal yield curve, therefore, slopes gently upward as maturities lengthen and yields rise. From time to time, however, the curve twists itself into a few recognizable shapes, each of which signals a crucial, but different, turning point in the economy. When those shapes appear, it's often time to alter your assumptions about economic growth.
When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward -- in the form of higher interest -- than those who risk their money for a shorter time period. Thus, as maturities lengthen, interest rates get progressively higher and the curve goes up.
To help you learn to predict economic activity by using the yield curve, we've isolated four of these shapes " normal, steep, inverted and flat-- so that we can demonstrate what each shape says about economic growth and stock market performance.
I found the educational tools at TD Waterhouse to be very good re the yield curve.
(1) Normal Curve: e.g., December 1984
When bond investors expect the economy to hum along at normal rates of growth without significant changes in inflation rates or available capital, the yield curve slopes gently upward. There would typically be about a 300 basis point spread between the three-month and 30-year U.S. Treasury debt instruments.
In the absence of economic disruptions, investors who risk their money for longer periods expect to get a bigger reward (in the form of higher interest) than those who risk their money for shorter time periods. So, as maturities lengthen, interest rates typically get progressively higher and the curve goes up.
December, 1984, marked the middle of the longest post-war expansion. Global economic growth rates were in a steady quarterly range of 2% to 5%. The major equity market indexes were posting strong gains. The yield curve during this period was normal and is kind of curve most closely associated with the usual comfort zone of an economic and stock market expansion.
(2) Steep Curve: e.g., April 1992
Typically the yield on 30-year Treasury bonds is three percentage points above the yield on three-month Treasury bills. When it gets wider than that -- and the slope of the yield curve increases sharply -- long-term bond holders are sending a message that they think the economy will improve quickly in the future.
This shape is typical at the beginning of an economic expansion, just after the end of a recession. At that point, economic stagnation will have depressed short-term interest rates, but once the demand for capital (and the fear of inflation) is re-established by growing economic activity, rates begin to rise.
Long-term investors fear being locked into low rates, so they demand greater compensation much more quickly than short-term lenders who face less risk. Short-term investors can trade out of their T-bills in a matter of months, giving them the flexibility to buy higher-yielding securities should the opportunity arise.
In April, 1992, the spread between short- and long-term rates was five percentage points, indicating that bond investors were anticipating a strong economy in the future and had bid up long-term rates to create a steep yield curve. They were right. The GDP, which is a measure of a country's economy, was expanding in the U.S. at 3% a year by 1993.
Short-term interest rates (which slumped to 20-year lows right after the 1991 recession) had, by October 1994, jumped two full percentage points, flattening the curve into a more normal shape.
Equity investors who had seen the steep yield curve in April 1992 and had bet on expansion were richly rewarded. The broad equity market had gained 20% over the next two years.
(3) Inverted Curve, e.g., August 1981
At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk? The answer is that long-term investors will settle for lower yields now if they think rates -- and the economy -- are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.
Look at the situation in August 1981. Earlier that year, the U.S. Federal Reserve had begun to lower the Federal Funds Rate in an attempt to forestall a slowing economy. Recession fears had convinced bond traders that this was their last chance to lock in 10% yields for the next few years. The collective market instinct was right.
A chart of U.S. GDP demonstrates just how bad things got in 1981. Interest rates fell dramatically for the next five years as the economy tanked. Thirty-year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to below 6%. For equity investors, the 1981-82 bear phase was brutal. But investors who bought a long maturity bond definitely had success.
Inverted yield curves are rare and it pays never to ignore them. They are always followed by economic slowdown or outright recession as well as lower interest rates across the board.
(4) Flat Curve e.g., April 1989
To become inverted, the yield curve must pass through a period where long-term yields are the same as short-term rates. When that happens the shape will appear to be flat or, more commonly, a little raised in the middle.
Unfortunately, not all flat or humped curves turn into fully inverted curves. Otherwise all investors would get rich simply plunking their savings into 30-year bonds the day they saw long bond yields start falling toward short-term levels.
On the other hand, you shouldn't discount a flat or humped curve just because it doesn't guarantee a coming recession. The odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields. That's what happened in 1989 when 30-year bond yields were less than three-year yields for about five months. The curve then straightened out and began to look more normal at the beginning of 1990.
Was this a false alarm? No, because GDP charts show that the economy sagged in June and fell into recession in 1991. Equity market charts show that the stock market also took a dive in mid-1989 and plummeted in early 1991. Short- and medium-term rates were four percentage points lower by the end of 1992.
Applying your knowledge of the "Living" Yield Curve"
Here's how your new understanding of the yield curve can be used effectively. Say you inherited $10,000 and want to have it available in 10 years. You have these debt choices:
(1) A ten-year treasury bond to be held to maturity. This would be fine if you expected interest rates to stay high.
(2) A six-month treasury bill to be rolled over at maturity repeatedly over the ten years. This would be wise if you might need the money and if interest rates are high and expected to rise.
(3) A two-year treasury note that, at maturity, would be turned into an eight-year bond. This would be fine if short-term rates are high and expected to drop and long-term rates are low and expected to rise.
(4) A 15-year bond to be sold after ten years. This would be worth considering if you expect interest rates to fall. But it carries the greatest risk.
As with all technical indicators, the yield curve is not always correctly interpreted, but it's a useful tool in predicting future interest rates. It can aid investors to visualize the profit potential of various investments with different maturities.
But with a thorough understanding, the yield curve can do so much more. It can serve as the foundation of your entire investment approach, which is why I pay so much attention to it here.
General discussion about bonds:
When you buy a bond or debenture, you do so for income or security. Somebody else's debt is your asset " just like a stock except you don't hold any equity in their business. Your asset is limited entirely to the contract. Make sure you understand the contract.
With a bond, you are loaning your money to a corporation or government. In return, you receive a certificate or contract that states that the issuer will pay you interest at a specified rate, usually twice a year, until the debt is repaid, on a specified date that is 5, 10, up to 40 years hence.
Long-term fixed-income securities, such as bonds and debentures, represents debt of the issuer. A bond is a secured debt and a debenture is an unsecured debt. Obviously the quality of the debt is a prime issue to the fixed-income investor.
The bond certificate will contain a security agreement. In the case of a debenture, there will be no such security agreement. Therefore, bonds are typically more secure than debentures, but not always. A bond issued by Consolidated Moose Pasture is not as secure as a debenture from General Electric. Clearly, the strength of the corporation is a significant factor in determining the quality of the debt.
How interest is calculated and paid:
Interest on bonds is added to the sales price but does not include the day of delivery. It is calculated on a daily basis. For U.S. government issues other than Treasury bills, the base is the exact number of days in a 365-day year. With other bonds, it's a 360-day year or twelve 30-day months.From the:
(1) 1st to 30th of the same month = 29 days
(2) 1st to 1st of the next month = 30 days
(3) 1st to the 28th of February = 27 days
If interest is payable on the 30th or 31st, from the:
(1) 30th or 31st to 1st of next month = 1 day
(2) 30th or 31st to 30th of next month = 30 days
(3) 30th or 31st to 1st or 2nd of next month = 1 month, 1 day
To figure the yield superiority of 360-day bonds versus 365s, divide the interest rate by 360 to get the daily return, then multiply the result by 365.
For instance, with a 12% interest rate, the daily rate works out to 0.333%, so the annualized rate for 365 days would be 12.16%.
How bonds are rated:
Insert Table here
Ratings may also have + or - sign to show relative standings in class.
Prices for high-grade bonds, rated A or better, reflect money-market conditions and interest rates almost exclusively.
The lower the rating, the more that bond prices are more closely attuned to business conditions generally and to any changes in quality of the corporation.
Medium-grade Baa or BBB bonds are the lowest category that qualifies for commercial bank investment.
Any rating of Ba or BB or lower is speculative and you should not purchase these bonds as an investment without close analysis of current financial statements and considerations of industry prospects. Of course, if you want to speculate, Ba or BB-rated bonds pay well over 5% (1Q05) and B-rated junk bonds pay even more.
Rates for corporate bonds can be checked daily at Yahoo Finance, such as this table as at January 27, 2005:
Yahoo Finance obtains this data from ValueBond.com.
What attributes to look for in bonds:
(1) Quality. This is essential knowledge in choosing bonds for investment.
Since you buy bonds for safety, most investors ought to stick to quality and forget the small extra interest ($5 to $10 per year per bond), which can be obtained with the debt of a secondary corporation.
Most corporate and municipal (but not Federal Government) bonds are rated by statistical services in nine categories from gilt-edged to extremely speculative. These ratings represent carefully calculated estimates of the degree of protection for both principal and interest, based on past performance, current financial strength and future prospects.
The two top services, Moody's and Standard & Poor's, usually come up with about the same opinion.
(2) Changes in ratings. Upgrading is beneficial; downgrading signals future trouble.
(3) Terms. Serial bonds are redeemed at various dates over a period of years. This enables the buyer to select the exact maturity he desires: in seven years when daughter Delphinium starts college, for example. Usually, all of the debt comes due at once, but there's extra safety when there's a sinking fund (explained later).
(4) Corporate collateral. This is the property behind each bond. Secured bonds may be:
(i) First-mortgage bonds backed by the company's real estate, plants; trucks and so on or equipment trust certificates secured by railroad equipment-locomotives, freight cars, etc.
(ii) Bonds guaranteed, as to principal and interest, by another corporation or by the Government or a Government corporation or agency. Examples of the former are foreign bonds offered for sale abroad by foreign subsidiaries or affiliates of U.S. corporations and guaranteed by the parent company.
(iii) Unsecured bonds (debentures) are backed only by the general credit standing of the issuing company. The investor should translate this credit into the company's ability to pay annual interest and amortization plus the principal sum when due. The projection should consider recent historic ratios and trends and should apply to the total debt.
In practice, for most bonds, the ability of the corporation to pay is much more important than theoretical security because legal obstacles to investors collecting a bond's security in the event of insolvency are formidable and time-consuming, requiring litigation, which is the last thing you need in your life.
A rule of thumb for determining investment-grade industrial bonds is that interest charges should be covered over a period of 5 years. This is a handy table:
Insert Table here
(5) Type. Bearer or Registered Bonds. Historically, most bonds were issued in bearer form with interest coupons attached. Interest was paid, usually twice a year, by presentation of the detachable coupons to the paying agent. This is the origin of the phrase clipping coupons.
Going into debt makes most sense to an issuer when interest rates are low but cheap borrowing costs tends to lead to more borrowing by investors, corporations and governments, which at a point leads to inflationary pressures that push up interest rates.
Be Wary of the Negative Factors
There are some negatives to look for in bonds in addition to the broader issues of concern regarding all debt securities:
(1) Inflation. As fixed holdings, the dollars invested and the income received are worth less every year. With 10% inflation say, each $1,000, after 20 years, will buy only about $150 worth of the same goods and services.
(2) Lack of appreciation unless the bonds are bought at a discount and held to maturity (or, when traded, sold at a higher price). If you buy a new bond for $1,000, you will get back exactly $1,000 at maturity. The only chance for a profit is if interest rates decline sharply so that the bond value rises in the interim and you decide to sell before maturity. You could buy at a discount, say 970, which would produce a profit of $30 per bond at maturity.
(3) High taxes. All interest (except that of tax exempts) is taxable at the highest personal income-tax rate. With capital gains, the realized appreciation is taxed at a lower rate.
(4) Difficulty of compounding (earning interest on interest). Unless you buy shares in a bond fund, there can be no automatic reinvestment as with stock-dividend investment plans. The interest payments will have to be held in a low-yield savings account until there is money enough to buy a new bond: Over a couple of years, the difference between a 1.5% savings account and a 6.5% bond yield will add up to $50 per year per $1,000.
Government bonds:
Many investors believe the myth that U.S. government bonds are safer than U.K. or Canadian bonds for instance but I hardly think that is true. Wherever the highest interest rate exists would be the place I'd invest, assuming of course a liquid market exists and the returns are calculated on my net costs.
To my thinking, within a large group of countries, the bonds of one country are as sound as another. If there is any question, I'd turn to Moody's and Standard & Poor's, the independent agencies that give sovereign ratings to government bonds of all countries.
Before I'd make an investment in any bonds, I would first have a view on the trend and cycle picture for interest rates. The U.S. interest-sensitive related equity bellwethers are the Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) issues that trade on the NYSE.
You'll notice that January 2005 has seen the prices for FNM and FRE sharply down, which to me is an indicator of rising interest rates in the near future.
But for my analysis, I'd also run through all the futures charts in the following table:
10 Year Interest Swap (CBOT)
Canadian Bankers Acceptance - 3 Month (BAX, MFE)
Euro Dollar (CME)
Euro Yen (CME)
Gilts Long (GS, LIFFE)
Federal Funds 30 Day (FF, CBOT)
LIBOR - 1 Month (EM, CME)
Municipal Bonds (CBOT)
Treasury Bonds (CBOT)
Treasury Bonds E-Mini
Treasury Bills (CME)
Treasury Notes - 2 Year (CBOT)
Treasury Note - 5 Year (FV, CBOT)
Treasury Notes - 10 Year (CBOT)
This list includes muni's, but I'm not going to get into the tax-benefits to Americans of investing in municipal government bonds because that's a market I'm not familiar with.
In small amounts, for asset allocation purposes, U.S. government bonds are best bought through the Exchange Traded Funds (ETFs). There is the Lehman 1-3 year Treasury Bond Fund (AMEX: SHY), the 7-10 year Treasury Bond Fund (AMEX: IEF) and the 20+ year Treasury Bond Fund (AMEX: TLT).
You will find that management fees on the Exchange Traded Funds, including government bond funds, are much less than the bond mutual funds, and your commission costs through a discount broker are virtually nil, so that is the best way to buy government bonds, given that you really don't need advice to invest in government debt.
Corporate bonds:
Corporate bonds might be safe but they are not as safe as the government bonds of the major countries. Just a couple months after Enron Corporation was widely reputed to be one of the world's strongest corporations, it was bankrupt.
Corporate bonds are debt to a corporation. When you buy a bond, you are loaning them money. In return, you receive a certificate that states the corporation will pay interest at a specified rate, usually twice a year, until the debt is repaid, at a specified date, 5, 10, up to 40 years in the future.
Bonds are a relatively inexpensive way for corporations to obtain funds for capital improvements and expansion. The interest is a tax-deductible business expense, so the cost of a 10% bond for a company in the 40% tax bracket is 6% (.10 x 60%).
They do mostly provide steady income for the investor and you're almost always sure to get your money back but, in recent years, their values have fluctuated as much, or more than, those of common stocks.
In less than nine months, the price of top-quality AT&T 8.75% bonds fell from 98 ($980) down to below 68 ($680). Of course, Enron bond prices fell much faster as the world came to see signs of that corporation's impending doom.
Obviously, corporate bonds are no longer the secure and solid securities they used to be.
It's now unwise, given the extreme market moves in capital markets, to buy bonds and forget them until maturity. To be a profitable strategy, a corporate bond portfolio must be closely managed like any other investment.
What this means is that investors who buy bonds today must (i) do so with an eye on total returns, which is interest income plus appreciation, and (ii) be willing to trade, not hold until maturity.
You can follow the daily bond market in the Wall Street Journal, either the print or Internet edition, and you can trade all these bonds on the New York Stock Exchange just like a stock:
Investors can also trade fixed-income ETF's on the American Stock Exchange (AMEX).
Exchange Traded Funds that track corporate bonds are perfect for the small investor as they represent a basket of bonds that have different ranges of maturities and credit risk.
The cost of buying such a diversified basket of bonds would be huge but the ETF allows you to buy it inexpensively through any broker.
Very popular is the iShares iBoxx Euro Liquid Corporates ETF that trades on the London Stock Exchange under the ticker symbol IBCX.L. This particular ETF tracks a basket of investment-grade bonds issued by European corporations.
About prices and yields of bonds:
If you need a primer on how to read quotations and figure yields from the bond tables in the Wall Street Journal, Barron's or Investor's Business Daily, try InvestingInBonds.com.
Your Google browser has no shortage of other places to look for information on how to get bond quotes and read tables. It's pretty simple when you get the hang of it.
The interest rate is the most important factor in the price of bonds, not supply and demand as with common stocks.
Bond values rise when interest rates decline. Conversely, bond values fall when interest rates go up.
Yields on short-term issues tend to fluctuate more than those on equal-quality, longer-term bonds.
Short-term yields react more quickly to business cycles and monetary changes, and move to greater extremes in both directions. Shrewd traders take advantage of this differential.
For example:
(1) In easy money markets, when interest rates are relatively stable, short-term issues typically yield less than long-term ones.
(2) In tight money markets, short-term interest rates are usually appreciably higher than long-term ones.
By contrast, prices of long-term bonds fluctuate more than those of short-term issues. The reason is that ‘time is money'.
A change in interest rates calculated for a few weeks or months involves a lesser change in price than the sama change projected for years ahead.
A rise of 1 % in the interest rates will mean a drop of about $10.00 for a $1,000 short-term T-bill but it can force a decline of $100 or more for a bond with 20 years to maturity.
How to figure bond yields:
Your investment objective will require an understanding of the different types of yield. Yield is a matter of definition, for example:
(1) Nominal or coupon yield. This is the interest rate stated on the bond: 8%, 10.5%, etc. It depends on the quality of the issuing corporation and the prevailing cost of money at the time the bond is issued.
(2) Actual yield on the purchase price. This is the rate of return per year that the coupon interest rate provides on the net price (without accumulated interest) at which the bond is purchased. It is higher than the coupon yield if you buy the bond below par, lower if you buy the bond above par.
(3) Current yield. This is the rate of return on the current market price of the bond. This is higher than the yield on the purchase price if there has been a decline in the price, lower if there has been a rise in the market value of the security.
(4) Discount yield. This is the percentage from par or face value, adjusted to an annual basis, at which a discount bond sells. It is used for zero coupon bonds and for short-term obligations maturing in less than one year, primarily treasury bills. Roughly, this is the opposite of YTM. If a discount bond with one year to maturity sells at a 12% yield, its cost is 88 ($8,800). The discount yield is 12 divided by 88 or 13.64%.
(5) Yield to maturity (YTM). This is the rate of return on a bond held to redemption. It includes the appreciation to par from the current market price when bought at a discount from par, or the depreciation to par when bought at a premium.
To approximate the Yield-To-Maturity for a Discount Bond:
(i) Subtract the current bond price from the face amount.
(ii) Divide-the difference by the number of years to maturity.
(iii) Add the annual interest.
(iv) Add the current price to the face amount and divide by two.
(v) Divide (3) by (4) to get the YTM.
Example: a $1,000, 5% coupon bond, due in 10 years, is selling at 57 ($570). The coupon yield is 5% hence the current yield is 8.8% (5 / 57) and the YTM is 11.8%.
(i) $1,000 - 570 = 430
(ii) 430 / 10 = 43
(iii) 43 + 50 = 93
(iv) 570 + $1,000 / 2 = 785
(v) 93 / 785 = 11.8%
This is approximate, as an exact figure would have to include the accrued interest and number of days to maturity.
Trading bonds for capital gains:
In my view, sticking to the common myth that bonds should be bought and then stored in a safety deposit box is a foolish way to invest. Bonds are investment instruments that must be traded like you would trade a stock.
To most of you, a bond is a secure, mostly stagnant investment that provides a fixed annual income and can be redeemed at maturity for the same amount of dollars used to purchase it when issued.
But there are plenty of conservative opportunities, with all kinds of bonds, to attain capital gains or to increase total returns from income plus appreciation.
A straight bond almost always reflect the cost of money, which is reflected by the interest rate. Capital gain opportunities result from changes in interest rates.
Nowadays, with the extreme volatility in interest rates, bonds should be bought for trading, not holding, unless you are willing to swap the ultimate security for interim paper losses or actual profits.
As a rule of thumb:
(1) buy short-term, high-coupon bonds when there is a probability of higher interest rates
(2) buy long-term, low-coupon bonds when there is good reason to anticipate a decline in interest rates in the next six to twelve months.
Since you are giving up some current income when you buy discount bonds, always look for a higher-than-current yield.
It pays to know the history of certain bonds before you buy them. For instance, U.S. Steel Corp had long faced financial crises, which caused chaotic conditions for the bond holders. Prices were all over the board. A 4 3/8's U.S. Steel bond, issued at $1,000, sold at 55 when the interest rate was 8%. When the cost of money went below 7%, its value moved up to about 59. But, later, when interest rates soared to over 18%, its price fell to 39. When they started to fall again, the price jumped to about 66.
Discount bonds are excellent investments for a Subchapter S corporation (which is basically a family holding company in the U.S. where profits are funneled through the corporation to the individual shareholder).
Discount bond investments can earn tax-deferred or tax-free income for shareholders because only 40% of long-term capital gains are taxable to an individual. Hence, the result is to convert part of the investment income into tax-exempt income.
They are excellent for offshore corporations and trusts that pay little or no tax on income.
Recommended reading includes these (old and probably out-of-print) books by "Dean of Bond Street," Sidney Homer:
(1) History of Interest Rates
(2) Great American Bond Market
(3) Inside the Yield Book: Tools for Bond Market Strategy
(4) Price of Money, 1946-1969: An Analytical Study of U. S. & Foreign Interest Rates.
In his books, mostly written in the 1970's, Homer advised investors to recognize the value of reinvesting bond interest. Over a 20-year period, he pointed out that more than half the total return of a bond comes from interest on interest.
Such is the magic of compounding interest.
So, to build capital and boost your income over the years, always reinvest the semi-annual interest into more bonds. If your coupon income is relatively small, Homer would advise you to hold the money in a savings account until you can add savings and buy more bonds. Today, of course, you would put that money into a money market fund.
In his 1977 "Inside the Yield Book", Homer explains that all bonds do not act the same when there is a change in interest rates.
Other things being equal, the volatility of bonds is greater (i) the longer the maturity, (ii) the lower the coupon and/or (iii) the higher the starting yield. Thus, 20-year 8's are more volatile than 30-year 12's; 15-year 10's are almost as volatile as 30-year 12's, etc.
If you have substantial holdings in bonds, it will pay you to ask your broker to discuss your portfolio with an experienced bond analyst and/or trader. Not being a bond specialist myself, that's would I would do.
Guidelines for finding profits in the bond markets:
To find profits in trading bonds, you have to be able to accurately forecast interest rate direction. Here is a way to predict future interest rates that is used by some bond traders:
After you follow a money market fund's interest rate tables for a couple of months, you'll start to see some obvious signals:
(i) When the average rate of maturity moves within a narrow range, interest rates are likely to remain stable.
(ii) When the maturity jumps, say, from 35 to 40 days, there will probably be a sharp decline in returns.
Check the 7-day data but focus on the 30-day figures. These funds are so huge that it takes time to make shifts.
The interest rate table also shows how to check the composition of the portfolios.
The most conservative funds are those that buy primarily U.S. government obligations; the most aggressive are those that hold European instruments and U.S. dollar CDs. If you invest a large sum, always ask for the minimum standards for Commercial Paper and be extra cautious with any fund that invests in ratings that are less than an A-rating.
If you feel you have an indication of the direction of rates (remembering that even the best experts often get it wrong), here is a rule of thumb:
(1) If you anticipate higher interest rates, buy short-term bonds. If you're right, reinvest the redemption proceeds in high-yielding long-terms.
(2) Be cautious about locking in high yields unless you are happy with income alone. Over a period of years, the prices of these bonds can swing widely and their total returns will always run behind inflation.
(3) If you anticipate lower interest rates, buy low-coupon long-term bonds and sell when you have an adequate capital gain. The percentage gains would be higher if you used margin.
(4) With bonds, don't worry about "wash" sales, i.e., selling and buying back similar securities within 30 days (see notes on taxes). With stocks, these losses are not tax deductible but with bonds, there are no such limitations.
(5) Beware of maintenance fees if you leave the bonds with your bank as custodian. Typically, the charge will be about $5.00 per month. This will lower your net rate of return considerably because $60 a year is quite a dent in the $600-a-year interest on ten 6%-coupon bonds.
Buying bonds on margin:
Most broker-dealers limit margin accounts with bonds, which is usually about 33% for long positions and 50% for short selling. But banks are more liberal and will lend up to 80% on quality corporate bonds and over 90% on U.S. government securities. So check with your broker as their policy.
A few years ago when the cost of money was higher and the interest rate on bonds higher than that of a loan, it was usually not profitable to buy bonds on margin. But in today's market environment (1Q05), with borrowing rates still at or near historic lows, the income from the bond pays the loan cost.
If, as and when interest rates grow in future and the price of bonds start to fall, you could sell for a low-taxed, long-term capital gain. Or, if you a speculator, you could sell short today and cover your position at a profit in the future. Such speculations only work well in periods of low interest.
For high rate taxpayers, a 45% annual rate of return is possible:
If in a high-tax jurisdiction you pay taxes at a 70% rate and are willing to borrow heavily, bonds bought at the right time can provide after-tax returns of over 45%. This is possible because of a combination of deductions for interest and low 3% to 8% margins on the loan. The benefits may even be worthwhile at a somewhat lower tax bracket.
Mr. Smith, in the 70% tax bracket, bought $1 million 7%-coupon bonds, due in 13 months, at 94.4375 ($944,375). He put up $29,540 in cash and arranged a fixed-interest loan for the balance. (For tax purposes in his jurisdiction, everything had to be over one year). His interest payments were $44,710. In the 70% tax bracket, this meant an after-tax expense of $13,414. His total investment was $42,954. When the bonds are paid off at par, the capital gain will be $45,625. Since his capital gains will be taxed at a 28% rate (40% at 70%), the after-tax net will be $19,437. On the investment base of $42,954, that's a net return of 45.25%.
The danger here, of course, is that the price of the bonds drop during the remaining 13 months of this bond, so that Mr. Smith will have to come up with more cash on the margin loan. With such a short maturity this is not likely but if it should happen, it could be expensive.
Every rise of 1% in the cost of money would mean an extra $10,000 in margin. So, before you try such a deal, be sure to check with your tax adviser and be confident that interest rates are likely to rise in the interim.
High-yield bonds:
Be very cautious with high-yield securities, and with trying to stretch the income from a bond. It should be obvious that the higher the yield, the higher the risk.
Occasionally, however, you will find a special situation in the junk bond market.
High-yield bonds are of two types:
(1) There are those of well-established corporations that have run into temporary trouble, usually not entirely of their own making. Under normal conditions, such securities would be safe investments.
(2) Then there are those of highly leveraged companies whose issues are of questionable quality (usually unrated) and not suitable for institutional portfolios.
Currently, both types are selling at low prices (and thus high yields) because investors can get somewhat comparable returns with much less risk.
The second type is classified as "junk" bonds. Generally, corporations use these bonds to dress up their balance sheet.
A bond exchanged for common stock, for example, provides leverage for the company to produce an instant earnings increase. This is because the after-tax interest cost is always less than the earnings attributed to the common stock they buy back from the market.
During 2002, with interest rates at historic lows, there were a lot of corporations up to that trick.
To cover stock that is selling at five times earnings, the company must earn 40% before taxes. By swapping for a 10% bond, it can save three quarters of that cost. Shrewd speculators take advantage of this situation and obtain high yields and, with a little luck, appreciation as well.
Marginally strong corporations often offer to swap high-yield bonds for lower-coupon CVs or preferred stock. But the replacements may be every bit as risky and they pay less.
Once in a while, because of unusual circumstances, a junk bond could be the debt of a high-rated corporation. Teledyne 10% subordinated debentures, 2004, had been selling at 825 to yield 12.1%. They were rated BB because they were subordinated to other corporate debt. But Teledyne's cash flow and credit facilities could have allowed the corporation to pay them off at any point.
Then in October 1996, Teledyne did redeem these high-yield debentures utilizing $250 million from their credit facilities and $115 million from cash on hand. As a result, an extraordinary loss of $22.3 million pretax was taken by Teledyne to expense the related unamortized original issue discount and the debenture holders profited nicely.
Bond swaps:
Swapping bonds is an important tactic in serious bond investing. The question is to swap or not to swap?
On the surface it would appear profitable to sell a bond yielding 6.5% to purchase a similar quality bond selling to yield 8%. In theory, this is a gain of 150 points a year to maturity. However, this would be an incorrect assumption.
The conventional yield to maturity assumes a reinvestment rate of 6.5% for one and 8% for the other. Actually, the reinvestment rate will be identical for both issues.
Thus the yield gain from the switch is narrowed and, depending on the time to maturity, may be almost eliminated.
There's the same problem you are going to have in relating present and future yields.
To calculate if its more profitable to accept $1 income today or $1.25 in four and a half years invested in a 6% bond, use this formula: 1 / (1 + R)T where
T = number of semi-annual interest periods R = interest rate per period, expressed as a decimal
The answer: It's better to take the $1 yield today because your return over 4 and a half years from the bond is only going to be $0.96.
$1.25 x 1 / (1 + .03)9 = $1.25 x 1 / 1.039 = $1.25 x 1 / 1.3048 = $1.25 x 0.766 = $0.96
Also, remember the Rule of 72 when deciding whether to swap or not: A $1,000 8% bond compounded semi-annually will grow to $2,000 in 9 years, whereas a 6% bond takes 12 years.
If you recall from compounding tables, the $1,000 8% bond with interest re-invested will continue to grow to $7,106 in 25 years and $50,504 in 50 years.
Guideline for considering bond swaps:
If you add a number of bonds to your portfolio, review them every six months, use the interest productively and consider swaps whenever there is a change of at least 1% in the prevailing interest rate.
If interest rates are falling, you may want to swap into longer maturity bonds and when they are rising, you would go to shorter maturities.
You can't go wrong with active management of your bond holdings.
Trading bonds on the NYSE:
The NYSE operates the largest centralized bond market of any U.S. exchange or other self-regulatory organization. It offers investors a broad selection of over 2,000 corporate (including convertibles), agency and government bonds and even foreign bonds.
NYSE-listed equity issuers can list their bonds free of charge on the NYSE.
In my opinion, the NYSE website is outstanding in many respects. For trading bonds at the NYSE, you'll find all the information you need.
NYSE-listed bonds trade through the Exchange's Automated Bond System (ABS), a terminal-based system for the trading of corporate, agency and government bonds. NYSE member firm subscribers use ABS to electronically trade bonds over a proprietary network. ABS maintains and displays prices and matches price orders on a strict price and time priority basis. ABS reports both quotes and trades, real-time, to market data vendors.
The large preponderance of NYSE bond volume is in corporate debt, with some 85% in straight, or non-convertible bonds, and 15% in convertible debt issues. Closing bond prices are available in the financial sections of major newspapers, as well as on-line.
A list of bonds traded on the NYSE is available at:
You can also get the daily bond tables from the online Wall Street Journal:
Here is a discussion of the table of ATT&T bonds trading on the NYSE with prices quoted in the Wall Street Journal at November 13, 2003, which was the last time I reviewed this material:
For the AT&T 6 and 3/4s of 2004, the current yield was 6.6. On that day, there was 35 bonds traded and the closing price was 101.53, down -.13 on the day.
It's really not difficult to call your broker with a list of bonds you'd like to pick up at a price you'd like to pay. Put in an open order, which you can change by the day depending on your fills and how interest rates are moving.
Selecting bond funds:
How can a small investor buy bonds? "- If you do not have the financial resources to buy a diversified block of bonds, say on the NYSE, take a look at bond funds or, preferably, bond ETF's (see my section on ETFs).
Bond Exchange Traded Fund investments are, in my view, highly preferable to bond mutual funds because the commission costs and ongoing management costs of the ETFs are almost nil, but the benefits are all there.
Costs of investing in bond mutual funds are comparatively high. Some loads are 8.5% (although that would be extreme); management fees are around 0.5% of assets plus 0.5% for operational expenses plus 2.5% of the fund's cash income. Thus, the yield to shareholders will be about 1.5% less than the return of a bond average portfolio holding or a bond ETF.
(A) Bond ETF's:
Exchange Traded Funds that track corporate bonds are perfect for the small investor as they represent a basket of bonds that have different ranges of maturities and credit risk.
The cost of buying such a diversified basket of bonds would be huge but the ETF allows you to buy it inexpensively through any broker.
Very popular is the iShares iBoxx Euro Liquid Corporates ETF that trades on the London Stock Exchange under the ticker symbol IBCX.L. This particular ETF tracks a basket of investment-grade bonds issued by European corporations.
(B) Bond funds:
To beat the competition, some bond fund managers look for income from trading or other non-investment tactics. They may buy high-yielding commercial paper, or lend part of their portfolio to major underwriters short of certain bonds. The underwriter pays a small fee and thus avoids bank borrowings or having to cover a short position in an erratic market.
If you are not overcome by the high cost, there are some positive attributes of bond funds. For example, they:
(i) provide competitive returns,
(ii) can be purchased for a minimum investment of $1,000 or so (usually with a sales commission), and
(iii) permit reinvestment of income for compounding.
These are the most popular types:
(1) Closed-end bond funds whose proceeds are invested in fixed-income debt securities and whose shares are publicly traded on the NYSE or OTC. They operate like regular mutual funds. Their yields are slightly less than those of new issues. The actual returns, of course, depend on the composition of the portfolio and the skill of the money managers.
(2) Open-end bond funds that invest either wholly or largely in Government notes and bonds. They are geared to the small and medium investor. They diversify their portfolios by maturities rather than by types of bonds. Sales charges are low, and often there are no redemption fees.
Since there are no maturity dates for the fund shares, an investor always takes an extra risk: that the spread will become greater rather than smaller. The discounts vary according to the type of bonds held and the management fee charged. Don't worry if you buy for income, but be cautious if you want capital gains.
(3) Bond mini-funds. These, I suppose, are a pitch by broker-dealers to cash in on retiree investor interest in fixed-income securities. Usually, the redemption of bonds is at the will of the issuer. But with these bond funds, which can be purchased for $1,000 with additions in $100 units, the bondholder may redeem part of the total each year at par plus accrued interest.
(4) High-yield bond funds. These specialize in low-grade corporate issues with extra high rates of return, up to 15% a year, and are designed to appeal to the younger conservative investor. High yield bonds, introduced by a former hero of mine, Michael Milken, are possibly better speculations than investments but, at possibly 15% compounded, they are still investments where you will double your money in about five years. Risk diversification in a high-yield bond fund, however, is probably a good thing. ;-)
Bond funds do have special features:
(i) Greater upside leverage as compared to typical bonds. When interest rates fall (and bonds rally), the funds get double pressure from (a) the rise of the overall bond market and (b) the enthusiasm of investors who bid up prices until they are almost equal to net-asset values.
(ii) Downside cushion in a down market. Shares of bond funds selling at deep discounts will decline less than the prices of individual bonds.
Guidelines in choosing bonds, bond ETFs and funds:
(1) Always check the portfolio and the policies of the bond fund or ETF before you invest. Special techniques may be profitable but they can be risky and the concept of a bond fund should always be ‘safety first'.
(2) Evaluate the portfolio and stay away from any fund or ETF that has large holdings of NR (Not-Rated) issues. (a) For safety, choose those with the most AA- and A-rated holdings. (b) For income, look for those that buy lower-quality issues.
(3) With junk-rated bond funds, be skeptical about claims of diversification. There's little chance of a failed corporation to pay interest or redeem the principal, which will severely hurt the overall fund returns.
(4) Check the repurchase price. If the fund buys only at the lower side of the price spread, you will lose a few dollars when you cash in. At redemption, Fidelity pays the bid side price. Morgan Stanley pays the offering price as long as the fund is one in which it makes a market.
(5) Look for frequent distributions. A fund that pays monthly assures a steady cash flow and, if the income is reinvested, compounds at a higher rate. Buy just before the distribution-declaration date.
(6) Calculate the average discount for a closed-end fund. When a closed-end bond fund is selling below its average annual discount from net-asset value, it's probably a good buy. If it's priced well above that average, be cautious. Usually, the discount will reflect the composition of the portfolio.
Summary:
This is a comprehensive yet superficial look at what is a deep capital market. I cover it on this website because (i) interest rates are a basic macro-economic influence on equity prices, and (ii) fixed income becomes more important to people as they get older.
Fixed income still entails risk (capital safety risk and market price risk), and so you have to have your wits about you.
A final piece of advice is that the sell-side and some other major players in the bond market, such as Bond King Bill Gross (PIMCO) all have axes to grind. Be extremely cautious when it comes to listening to these people.
It is more important to keep your focus on the actual price data, and try to link trend and cycles to other macro-economic factors like forex rates, corporate and retail spending data, government budgetary spending data, international trade and foreign reserves data, and commodity prices.
After a while, you'll get the hang of forecasting interest rate direction, and you won't pay as much attention to those "experts".
Posted by Bill Cara at January 27, 2005 11:54 AM
