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Investing/Strategies / Bonds & Fixed Income Investments
|Subject: Bond and F-I FAQs: Part 1 A||Date: 2/14/2007 2:08 PM|
|Author: Lokicious||Number: 19761 of 35498|
Bonds and “Fixed” Income Investing: Introduction
What are Bonds?
• Bonds are “debt securities” (IOUs) issued by governments, agencies, or corporations to institutional or individual investors from whom they borrow money.
• They pay periodic dividends (usually semi-annually) until they mature or are “called.”
• They may be held until their maturity-date (unless they get “called” or liquidated during bankruptcy), at which point they pay back the “face-value” of the bond.
• They may also be traded on the bond market, i.e., sold prior to maturity, typically for more or less than face value.
• A good source for terminology and “bond basics” is bondsonline:
• The “learn more” section from investinginbonds.com has similar information
• NASD on buying bonds:
• Also, see Vanguard's glossary
• For comments and recommendations about books on investing in bonds, see this thread
What is “Fixed Income Investing”?
• “Fixed-Income” investing is a misnomer. It is actually a financial strategy in which you put money into investment or savings instruments with the intent of having at least as much buying power (after inflation) when you need to use the money as it had when you put it away, while minimizing the risk of losing the principal. “Principal preserving” is a better term. Income (interest, dividends) is often not, in fact, at a fixed rate.
• Except for money you need to have available for very short-term purposes, you should be able to find “principal preserving” financial instruments that will at least keep pace with inflation, with 2-3% above inflation (pre-tax) as a reasonable goal. (Historically, average “real returns,” over time, from a combination of CDs, Intermediate and Long Term Treasuries, and Investment Grade Corporate Bonds, have been in the 2.75%-3.75% above inflation range, but inflation adjusted returns have been lower during the 2001-2006 period.)
• This link has data on annual “real returns” (above inflation) for 5 and 10-year Treasury Bonds, with a 2.8% average (both median and mean). Other options, with little risk to principal, typically provide slightly more income. http://boards.fool.com/Message.asp?mid=23212071
• US Savings Bonds, Money Market accounts, CDs (Certificates of Deposit), and traditional Savings accounts, are cashed in, not traded, thus avoiding the risk of selling at a loss, although Savings Bonds and CDs may be subject to a penalty if cashed in early.
• Tradable bonds may serve as simple principal preserving vehicles, if held until maturity, not sold on the open market prior to the maturity date. (This includes buying on the open market, then holding to maturity.)
• A starting point for a principal preserving strategy is to find the option with a true fixed rate (a CD, a US Treasury Bond or Note) that is currently paying the highest interest for the length of time in which you are interested. Then, use this as the basis against which to compare options with variable rates or options that depend on total returns (income plus or minus principal), even though the comparisons will inevitably involve estimates and guesses.
How About Bond Funds?
• Bond funds are mutual funds that invest in bonds.
• Individuals buy shares in these funds then receive dividends, based on the dividends paid by the bonds held by the fund. Sometimes funds also distribute “realized capital gains” from bonds they sell for more than they cost.
• When individuals sell their bond fund shares, they will get back more, less, or the same as they paid for the shares, depending on the prices (“Net Asset Value,” a.k.a. “NAV”) at which the shares were bought and sold.
• Bond fund share prices (NAVs) should be expected consistently to fluctuate up and down, depending on prevailing interest rates, which affect the tradable value of the bonds held by a fund. This is different from the expectation for stock mutual funds, which, except during bear markets, over time have seen NAVs steadily increase (along with realized capital gains),
• Many people assume investing in bond funds is a “buy and hold,” principal preserving strategy, but it is not, since your principal, in the form of NAV (plus realized capital gains), is subject to fluctuation.
• However, your total return on a fund (dividends and realized capital gains plus or minus the value of fund shares) may make bond funds a good alternative to “buy and hold” principal preserving choices. You just need to understand there is no guarantee you will be able to sell your shares (minus realized capital gains) for what you paid for them, no matter how long you wait.
Any provisos, before we get started?
• As with stocks, the finance industry, including most of advice givers, brokerages, and fund families, have a vested interest in selling product, so you won't hear much about options, such as US Savings Bonds and CDs, which don't make them money, even though, in many cases, these may provide the best return for the risk.
• Unfortunately, not all of these options may be available through some retirement accounts (for the reason just noted), so it is important to understand all options, even less desirable ones.
• The income (interest, dividends) from most bonds, bond funds, and other principal preserving investments is fully taxed at your federal marginal rate (tax bracket), not at the lower rate for long term capital gains and “qualified dividends” in taxable accounts.
---Even though they are called “dividends,” they do not qualify as “qualified dividends”—most stock dividends, except for from REITs, are “qualified dividends.”
---So, when there are no reasons why you need to have access to money earmarked for principal preserving investments, it makes sense to hold these assets in tax-advantaged accounts (and stock assets in taxable accounts).
• Be careful when comparing different options, that you are making a fair comparison.
---This means factoring in taxes and, where relevant, all commissions and other trading costs.
---It also means comparing simple yield with simple yield, compound yield with compound yield of the same kind.
---For example, “yield to maturity” for tradable bonds and “SEC yield” on funds are “annualized” yields, where the total return, including compounding, is averaged over the time until maturity. The APY on a CD is the compound yield for one year, so if you want to use the equivalent measure as “yield to maturity” you would need to take the total compounded return over a number of years for the CD and divide by the number of years. (A 5% APY 5-year CD has an annualized yield of around 5.3% to maturity.
---Or, when comparing a bond that pays semi-annual dividends with a CD that compounds internally, you need to factor in compounding from reinvesting the dividends (at some unknown rate). (A 5% bond with semi-annual dividends has a 5.06% APY, if dividends are reinvested at 5%.)
• These FAQs are aimed primarily at those interested in principal preserving investing (limiting risks to principal, while aiming to get the best total return possible within such limits).
---Bond trading is discussed as a practical matter, but anyone seeking to become an active bond trader or looking to pick bonds with more risk of default than high investment grade corporate bonds ought to know much more than what can be explained in FAQs.
---There are participants on this board who are knowledgeable about bond trading and bond picking, and these topics are discussed on a regular basis.
---Active bond traders and junk-bond pickers often aim to get returns on par with historical stock market returns.
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