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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35339  
Subject: Bond and F-I FAQs: Part 1 C Date: 2/14/2007 2:15 PM
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With all this talk about preserving principal, are there risks to Bond and Fixed-Income Investing?
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• Yes, there are many risks, some of them limited to active bond traders, others (covered here) of broader relevance.

• “Inflation Risk”:
---One of the biggest concerns with” fixed-income” investing is that the return on your investment may be so low your savings will buy less when you need to spend them than when you put the money away. This is because our costs for buying the same items usually increase due to inflation.
---The idea of a fixed income strategy is to preserve the buying power of your savings, not just the original principal.
---A return on your principal less than inflation puts you at risk of not having enough money to buy what you expected to be able to buy.
---One example of this is Passbook savings accounts, which notoriously have failed to keep pace with inflation.

• “Liquidity Risk”:
---When you need money, you need money, and if most of your money is tied up in investments that you can't liquidate quickly, you are at risk of having to sell at a bad time or of paying a penalty for cashing in before the specified date.
---Usually, to get greater liquidity, we have to accept a lower return, hence exposing ourselves to more “inflation risk.”

• “Interest Rate Risk/Trading Risk”:
---The value of tradable bonds depends on how the bond's coupon rate compares to prevailing interest rates (yields) for bonds of equivalent maturity and quality.
---If the prevailing yield is higher, the value of the bond for sale is less than its face value.
---More broadly, if the prevailing yield is higher than at the time you bought, the value of the bond will be less than you paid for it.
---This is called “interest rate risk.”
---If you hold a bond until maturity, you won't be subject to interest rate risk, because you won't be selling the bond, so its value doesn't affect you.
---With bond funds, however, you cannot escape interest rate risk, since the NAV (share price) of a fund is based on the tradable value of the bonds it holds. If the value of the bonds held by the fund is less than when you bought your shares, you will be forced to sell your shares for a lower share price than you paid.
---Interest rate risk is measured by multiplying the interest rate change in percentage points (or basis points divided by 100) by the “duration” of a bond or bond-fund. (Duration is an obscure measure, which will be discussed later.)

• “Default Risk”:
---There is always some risk the issuer of the bond will fail to continue to pay interest on its debt obligations and/or fail to pay off all or any of the face value of maturing bonds.
---This happens when companies or, sometimes, governments, are in deep financial trouble.

• “Reinvestment Risk”:
---When a bond or CD matures, or is called, you may not be able to reinvest the money for as high a yield as you have been getting.
---This is also true for income paid periodically by a bond, as opposed to instruments that compound internally.
---“Reinvestment risk” is an important consideration in choosing maturities (longer maturities lock in current rates for longer) and when looking at bonds with call dates (and mortgage securities).

• “Currency Risk”:
---This applies to foreign bonds.
---If the U.S. dollar increases in value compared to the foreign currency of the bond, the value of the foreign bond, though the same in its national currency, will decline in U.S. dollars.
---You will get fewer U.S. dollars when the bond matures, and your dividends in the foreign currency will convert to fewer U.S. dollars.

• “Call Risk”:
---If you purchase a bond with call provisions, there is risk that a bond will be called (and the principal paid off) before maturity.
---This may simply mean that a bond with an excellent coupon payment will have to be replaced in your portfolio with something paying much lower interest (“reinvestment risk”).
---However, if you bought a bond on the open market, you might be forced to accept a payoff of the face value (sometimes slightly more or less), before the coupon payments (higher than prevailing interest rates when you bought) have had time to compensate for what you paid for the bond. In some cases, especially if you bought at a premium, an early call could lead to a net loss.

• “Pre-payment Risk”:
---This is a variant of call risk for mortgage securities.
---When people sell or refinance a home, the mortgage owned by the security comes to an end; in effect, it is called, leading to the same concerns noted for “call risk.”
---For mortgage securities, refinancing risk is more or less continuous (callable bonds have specific call dates), with refinancing most common when interest rates come down, making “reinvestment risk” a problem.


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Are there any calculators that might be useful in figuring out savings and returns and bond yields and values and so on?
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• Here are a few, and there are many others:
---How much will my savings be worth? http://partners.leadfusion.com/tools/motleyfool/savings02/tool.fcs
---How long will my money last? http://www.gummy-stuff.org/to_zero_explain.htm
---How much will my CD be worth? http://partners.leadfusion.com/tools/motleyfool/savings16/tool.fcs
---What difference does the rate make? http://partners.leadfusion.com/tools/motleyfool/savings08/tool.fcs
---Bond Calculators http://www.fool.com/calcs/calculators.htm#bonds http://gummy-stuff.org/bond-calculators.htm
---Savings Bond calculators http://www.treasurydirect.gov/indiv/tools/tools.htm
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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 26566 of 35339
Subject: Re: Bond and F-I FAQs: Part 1 C Date: 3/30/2009 12:09 AM
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• “Call Risk”:
---If you purchase a bond with call provisions, there is risk that a bond will be called (and the principal paid off) before maturity.
---This may simply mean that a bond with an excellent coupon payment will have to be replaced in your portfolio with something paying much lower interest (“reinvestment risk”).
---However, if you bought a bond on the open market, you might be forced to accept a payoff of the face value (sometimes slightly more or less), before the coupon payments (higher than prevailing interest rates when you bought) have had time to compensate for what you paid for the bond. In some cases, especially if you bought at a premium, an early call could lead to a net loss.


As before, the quoted material how the FAQ currently reads. Below is how I would re-write it.
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“Call-Risk”:
---If you purchase a bond with call provisions, you accept the risk that the bond might be called. In other words, you accept the “risk” (which is merely another term for “uncertainty”) that your principal will be repaid to you before its maturity. “Risk” can be a neutral term that does not necessarily imply loss. In ordinary speech and experience, however, “risk” is invariably associated with the potential for loss, which is unfortunate, because “call-risk” can be an opportunity. Let’s explore how.

Typically, investors who buy bonds intend to hold them to maturity. They are not looking for a quick turnover. They want to park their money, and they want to park it for a long time, somewhere safe that pays a reasonable return. But, meanwhile, interest-rates are constantly changing. The extent to which the investor bought the bond shrewdly in the interest-rate cycle (so that it pays an historically, above-average rate of return) is also the extent to which she does not want to see her carefully-made plans and already-counted-upon profits be disrupted by suffering the indignity of having her principal returned to her “prematurely”. This is especially so if interests rates have, meanwhile, fallen. So, the “downside” to call-risk is two-fold: #1, the disruption of plans, and #2, the genuine possibility of not being able to put the newly-received money back to work at as good a return as before.

Those who issue bonds, be they governmental entities, corporations, or whomever, know that investors are adverse to suffering call-risk. Therefore, issuers attempt to appease investors with two types of provisions: #1, newly-issued bonds typically cannot be called during the early years of the bond’s life. That provision buys the investor some “breathing room”. Typically, a bond won’t be called during the first 5-10 years of its life. #2, if the bond is called, the owner will typically be paid a slight premium to par for the bond. This premium is typically no more than 3 points, and it is typically scaled down and phased out as the bond approaches maturity. Higher call-premiums can be found, sometimes as much as 5 points, but they are typically attached to lower-quality bonds. The “safe” issuers know they have to make very few concessions to bond investors and, typically, the call-price is merely par.

There is another way in which investors can be rewarded for accepting call-risk, and that is through price. Typically, the secondary market offers a premium of ~25bps (aka, discounts the price by ~25 bps) for callable bonds of the same maturity as non-callable ones where all other features of the two are comparable. Sometimes, that premium is worth pursuing (alternatively, its associated risks are worth accepting).

The call-prices and potential call-dates are easily obtained when a bond is priced. It is not secret information that is hard to find. In fact, something even better happens. Investors who are considering a bond are warned that a call might happen by a column of the offering list that lists YTW (Yield to Worst), which is a term you need to look up. In essence, investors are warned that the fat return on the bond they are considering (if just the price, coupon, and maturity are considered) might not materialize after all, if the bond is called. OTOH, sometimes just the opposite is the case, especially when the bond is bought at a discount to par. It is not unusual for YTC (Yield to Call) to be 10-15%, compared to YTM (Yield to Maturity) of 6-8%. In such a case, an investor can be well rewarded for accepting call-risk.

The situation you do not want to accept is to buy the bond at price above call and then to suffer a call. That’s stupidity itself, and a likely loss that never has to be accepted. Find something else to buy.

However, depending on your sophistication as a bond investor and your ability to price the risks properly (to game the situation in terms of option theory), you might want to accept that particular call-risk. But if you’re that savvy, you wouldn’t be reading this FAQ, and you’d also know other ways to make call-risk work for you. But describing those strategies is also outside the scope of this FAQ.

(Rev. 02/28/08)
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