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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 35363  
Subject: Bond and F-I FAQs: Part 3 B Date: 2/14/2007 2:25 PM
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Corporate Bonds
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What Are Corporate Bonds?

• When companies need more capital than is available to them through ongoing cash flow, they raise it either through selling new shares of stock in the company or by borrowing (or, sometimes a combination).

• Debt financing, usually with big investment banks acting as middlemen and taking a hefty cut, is in the form of corporate bonds.

• Most corporate bonds are available to the general public only through the secondary market.
---It is now possible to buy some newly issued corporate bonds directly. Vanguard, for example, has commission free new issues for its Voyageur clients.

• As with Treasuries, corporate bonds are issued with various maturity dates and with a fixed coupon rate.

• Typically, bonds with longer maturities and/or lower qualities at time of issue have higher coupons.
---Some corporate maturities stretch out to 50 years or more.

Why Would I Want to Invest in Corporate Bonds?

Corporate bonds have higher yields than Treasuries of similar maturities.

The higher yields are compensation for higher risk—even the highest rated companies have some risk of default in the future—with bonds from riskier companies paying higher yields.

If you buy a corporate bond for a good price, you have the opportunity to sell it for a capital gain.
---A good price may simply mean you bought when interest rates were higher (as with Treasuries).
---You may also have bought for a good price, because the rating of the company's bonds has improved or, at least, the perception of traders is that the company's default risk is less.
---Out-guessing or out-foxing the market is how serious bond traders try to make big money.

With many more corporate bonds than Treasuries, having a wide range of maturity dates, it is easier to find bonds that mature when you expect to need the cash.

How and Why Are Corporate Bonds Rated?

• Corporate bonds are rated for quality by independent institutions, most prominently S&P, Moody's, and Fitch.

• These ratings affect how much interest a company will have to pay to attract buyers at the time of issue and for how much existing bonds can later be bought or sold.

• The lower the quality, the more interest a company has to pay to borrow, because the company is considered to be at greater risk of default (failing to pay back the loan).
---The U.S. Government is treated as having essentially no default risk.

• When a rating agency downgrades or upgrades the quality of a company's bonds, it does not change the coupon rate on an existing bond, so if you hold until maturity, you will continue to get the same payment, unless the company defaults.

• An actual or anticipated change in rating does affect the sales value of a bond, since buyers assess the changed risk of default against the actual coupon rate (a downgrade means buyers will be willing to pay you less for the same bond).
---Traders reassess the default risk of bonds and build that into price on a daily basis, even without input from the rating agencies.

• Investment grade bonds are rated (with slightly different nomenclatures) from AAA to BBB, using S&P nomenclature.
---Moody's uses Aaa for AAA, Baa for BBB, etc.

• A rating of BB or below is considered a “high-yield,” or more colloquially, a “junk” bond.

• A downgrade from the lowest “investment-grade” to “junk” does not mean there is really a great leap in the likelihood of default.
---However, because some bond funds cannot legally hold “junk” bonds, the affect of a downgrade on sales value, especially in the short term, exacerbated by momentum traders, can be dramatic.

• Ratings are listed when you look at bonds being sold via your brokerage.
---They can also be found through various publications, such as Barron's.

• For no log-on quotes for Corporate Bonds, see NASD: http://www.nasdbondinfo.com/asp/bond_search.asp
---Also, snap shot: http://apps.nasd.com/regulatory_systems/traceaggregates/nasd/default.aspx



Where Do I Buy Corporate Bonds?

• Corporate bonds can be bought via bond desks or on-line through brokerages, typically for a slightly higher commission than for Treasuries, although there are now many discount brokerages that offer the same rate on all or most bonds.
--- Vanguard's commission on corporate bonds is $25 plus $2 per $1000 bond.

• Bonds are not sold through big, central, markets, like stocks, so you need to rely on the inventory available at your broker.
---Some people who would never use a full-service broker for stocks prefer one for bonds, because of larger inventories.
---Others use multiple brokerage accounts, in order to have a larger combined inventory and to choose whoever has the best deal for the same bond.

• Beware of mark-up costs (the difference between the price listed for a bond and what you actually pay for it), which vary considerably between brokerages and might more than make up for differences between commissions.

How Do I Figure Out What I Will Pay for a Bond?

• What you will pay is:
---Price (after mark-up) multiplied by the face value (typically $1000) times the number of bonds;
---Commission;
---Interest accrued since the last coupon payment.

• If yield-to-maturity is listed without commission, you will need to recalculate it.
---As a short cut, just divide the commission by the price times the number of bonds, then divide again by the years to maturity and subtract from the listed YTM. (For example, if you buy $20,000 of bonds with 10 years to maturity at par for a $65 commission, you subtract about 3 basis points from the YTM.)

What Else Do I Need to Know About in Deciding Whether to Buy a Corporate Bond?

• When you buy a corporate bond, you are basically weighing whether the higher yield is worth the added default risk.

• Bond funds mitigate default risk by holding a diverse portfolio of corporate bonds.
---For individuals, it requires quite a lot of money to build a diverse portfolio, and if you buy only a small number of corporate bonds, you won't have much diversification to spread out the risk.

• If you are looking to buy a corporate bond as a fixed-income investment, with idea of holding to maturity (active traders have additional concerns), what you really want to know from a listing is: how long until the bond matures, its quality, call provisions, and its “yield-to-maturity” (usually listed).

• The YTM can then be compared with that of other corporate bonds or Treasuries bought for a premium or discount or with the annualized yield of a CD or a bond bought at or near par (e.g., new auction issue).
---Annualized yield is the compounded interest over the remaining life of a debt instrument, divided by the remaining time. Annualized yield can also be extrapolated by assuming the CD or bond will be rolled over into one with the same simple yield or coupon
---If the coupon on the bond is not too different (within 100 basis points or so) from prevailing yields, it is probably sufficient for decision making purposes to use the bond's “current yield” (coupon divided by price, including commission) or “adjusted current yield” (coupon divided by price plus or minus the difference between price and face value divided by time till maturity) for comparison with the simple yield of a CD or a bond bought at par.

• The basic questions (from a buy-and-hold perspective) are:
---Is YTM is attractive enough to warrant the added risk compared to the other options?
---Is the YTM attractive enough to warrant locking in the yield for the length of time until maturity?

• Inexperienced bond investors need to pay careful attention to the maturity date, not just the yield.
---A yield on a bond maturing in 25 years may look attractive compared to current yields on bonds maturing in 5 years, but might seem much less attractive when you realize you are locking in that yield for 25 years.
---Owning a bond with a longer maturity than you can handle in terms of your need to get the principal back is a big problem if you have to sell for a loss.

• Inexperienced (and experienced) bond investors also need to understand that weighing default risk against YTM is not as simple as looking at bond ratings, at least for anything below high investment grade (AAA and AA).
---Investors need to go beyond the ratings and to learn how to evaluate the company's default risk for themselves.

• Moody's has an analysis of historical default rates that may be helpful: http://72.14.203.104/search?q=cache:rXQ250X78EIJ:www.lesechos.fr/info/medias/200050753.pdf+Default+Rate,+Corporate+Bonds&hl=en&gl=us&ct=clnk&cd=3&client=safari

• Another issue with corporate bonds is the “call date.”
---Most companies reserve the right to buy back the loan at a call date (or call dates) long before the maturity date, when they must pay back the loan.
---If interest rates drop, it is to the company's advantage to take out a new loan at the lower rate (like refinancing a mortgage when rates go down), as long as the costs of doing so don't exceed the benefits.

• For a bondholder, the consequences of calls vary.
---If you bought the bond at par (i.e., for its face value), you will get back what you paid for the bond, but will then have to find a new investment in the lower interest rate environment. (Some calls pay back somewhat more or less than face value, so you need to check to be sure.)
---If you bought the bond at a discount (i.e., for less than its face value), you will get back the full face value (or promised % of face value), which means your yield to call will be higher than your yield to maturity (the difference between what your paid and the face value gets averaged in over a shorter period of time), but again, you will need to reinvest in a lower interest rate environment.
---If you bought at a premium, your loss will get averaged in over a shorter time, making your yield to call less than yield to maturity, possibly even resulting in a negative total return.
---Yield-to-Worst, the worst result if there are several call dates, is usually listed when you buy or research a bond.
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