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Subject: Bond and F-I FAQS Part 3: Tradable Bonds Date: 1/16/2006 2:38 PM
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Tradable Bonds
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So, in General, How Are Tradable Bonds Different from Savings Bonds, CDs, and so on?

----The basic difference between Tradable Bonds and the “fixed income” options we have talked about so far is that they are bought and sold on the bond market, instead of cashed in with the issuer.
----This means you have the opportunity to make a profit by buying a bond trading at a lower value than you later sell it for. On the inverse side, you can lose money.
----You don't have to sell tradable bonds—you may chose to hold to maturity (unless “called”). The reason, then, for buying tradable bonds is the hope of getting a higher yield than what is available from any of the “cash in” options.

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United States Treasury Bills, Notes, Bonds (“Treasuries”) and TIPS
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What Are Treasuries?

-----To finance the national debt, the United States Treasury issues debt obligations of various maturities, collectively called simply Treasuries.
-----As debt guaranteed by the United States Government, Treasuries are considered, around the world, as safe debt obligations as are available (the scope of the national debt and deficit notwithstanding). US Savings Bonds, also issued by the government, along with FDIC or NCUA insured savings accounts, money markets, and CDs would be considered to have the same very low risk.
-----The currently available maturities are 13 Week (3 month) and 26 week (6 month) Treasury Bills, T-Bills for short, 2, 3, and 5-year Treasury Notes, and 10-year Treasury Bonds. 30-year bonds, once a staple of the bond market, were discontinued in 2002, but will be reintroduced in February 2006.
-----Regular Treasuries (excluding TIPS) pay dividends at a fixed coupon (interest rate) multiplied by the face value; dividends are paid semi-annually for Treasury Notes and Bonds.
-----The coupon is set at the time the Treasuries are auctioned by the government and that is the interest that will be paid no matter how often the bond gets traded or for what price.
-----Usually, longer maturities have higher coupons (because the government doesn't have to pay back the loan for a long time). Sometimes, however, there is “an inverted yield curve,” during which shorter maturities have higher yields than longer ones.
-----You can find information on the original coupon rate, but daily and historical data for interest rates on bonds are posted as current yields, the coupon multiplied by the premium or discount at which the bond is trading (e.g., a 4% coupon that is trading for $1010 for $1000 face value has a yield of 3.96%). Yields provide a more accurate picture of where interest rates are at a given moment, although they refer to the bonds sold at the most recent auction of that maturity, which will actually have a shorter time until they matures than their designated maturity (usually just a little shorter, unless the issue has been discontinued).
----One place to see daily yields on Treasuries and TIPS is Bloomberg
http://www.bloomberg.com/markets/rates/index.html
-----Historical data on yields for different maturities and for TIPS can be found on this link to the Federal Reserve (look at the various maturities for US Government Securities/ Treasury Constant Securities and Inflation Indexed Securities)
http://www.federalreserve.gov/releases/h15/data.htm

What Are TIPS?

-----TIPS are a kind of Treasury security that pays interest in two ways. Like regular Treasuries, there is a coupon (fixed rate) set at the original auction that is paid semi-annually to the bondholder. In addition, the Treasury pays an inflation adjustment, based on the Consumer Price Index, for the previous six months. However, the inflation adjustment does not get paid to the bondholder until the bond matures. Instead, it is added to the face value (principal) of the bond, and the next payment from the coupon rate, as well as the next inflation adjustment, gets multiplied by the new face value. (Basically, the inflation adjustment gets compounded into the face value, like a compounding CD or Savings Bond, whereas with regular Treasuries and the fixed coupon of TIPS, you get compounding by reinvesting the dividends elsewhere.) The net effect is that your principal has the same buying power (as measured by CPI) as when you invested it, plus you have gotten the coupon payments.
-----In the event of deflation, there is a deflation adjustment on the principal lowering the face value, but you are guaranteed to get back the original face value, so the worst you can do is receive the interest from the fixed coupon.
-----Because TIPS have the inflation adjustment, the fixed coupon will be lower than that of regular Treasuries of the same maturity. The difference is what bond traders are guessing inflation will be for the remaining life of the TIPS (so the totals for TIPS and Treasuries would come out even in the end). Inflation expectations change daily, so the differential in fixed yield for TIPS and Treasuries varies—from January '03 through July '05, inflation expectations for 10-year Treasuries and TIPS ranged from a high of 2.71% to a low of 1.61%. (See previous link on historical data.)
----Treasury Inflation Protected Securities (TIPS) are available in 5, 10, and 20-year Maturities, with some legacy 30-year TIPS, which were discontinued in 2002, available on the open market.
----Taxes on TIPS are paid each year on both the fixed coupon payment and the inflation adjustment (in a taxable account). What happens to compensate for previously paid taxes on inflation adjustments if there is deflation, only Alan Greenspan knows for sure, and he ain't telling. (Paying taxes on “phantom income” seems to upset some people, but it really isn't any different than paying taxes on money compounding in a CD until it matures or on money earning interest in a savings account you aren't using.)
----Treasury FAQs on TIPS
http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm

How Do I Buy Treasuries and TIPS?

----Treasuries and TIPS are purchased in $1000 increments, whether bought at auction or on the open market. Unlike US Savings Bonds, there are no limits as to how much you can buy.
----Treasuries are auctioned by the Treasury Department (to raise funds for the government) on a regular basis, with auctions for different maturities (and TIPS) occurring on different dates.
----Scheduled auction dates are listed on the Treasury Direct website, which also links you to a PDF file with a tentative schedule for future auction dates.
http://www.publicdebt.treas.gov/sec/sec.htm
----Anyone can buy Treasuries and TIPS at auction, either through the Treasury Department's Treasury Direct (you must have established an account with enough cash in it or enough cash in a linked bank account to cover your purchase) or through a brokerage account that offers auction purchases.
----Some brokerages (including Vanguard and Fidelity) don't charge a commission for Treasuries and TIPS purchased at auction, at least if you are a preferred customer.
----A recent change now makes it that small investors don't have the opportunity actually to bid at auction, but must settle for the average yield for bids by the big traders on the auction day.

Can Treasuries and TIPS Be Bought on the Open Market?

----Existing Treasuries and TIPS (ones that have been previously auctioned and are now being resold) may be purchased or sold on the open market.
----The Treasury lets you sell through “Sell Direct,” for a $45 commission.
http://www.publicdebt.treas.gov/sec/secselld.htm
-----If you hold Treasuries in a brokerage account, you can sell through that, as well as purchase Treasuries others are selling. Vanguard, for example, charges $40 per order for its preferred (Flagship) customers and a minimum of $40 (for $1000) to a maximum of $75 to others. https://flagship5.vanguard.com/VGApp/hnw/content/AccountServ/Brokerage/ATSIntegrityValueContent.jsp
----Obviously, if you are buying on the open market in small increments, the commissions will substantially reduce your actual yield ($12,500 for $40 commission would be about the expense ratio of a Vanguard bond fund), so you need a pressing reason for making small market purchases, instead of waiting for the next auction.
----When you buy or sell existing Treasuries of TIPS, you normally will not be selling for the face value of the bond, but at a premium of discount determined by the variation of the coupon rate from prevailing interest rates on bonds with the same time remaining until maturity. In other words, to buy a bond with a face value of $1000 (the amount you will get back when the bond matures), you will pay the current owner more or less than $1000 (e.g., $1005.64, $973.17), depending on how the bond's coupon rate compares with current interest rates and the amount of time left until the bond matures.
----The way this works conceptually is: when a bond matures you get back its face value (e.g. a $1000 Treasury). Between now and when it matures you get periodic payments (typically semi-annually) based on the bond's coupon rate times the face value. So, the total amount you get from the bond from now through maturity is the face value plus the dividends. There is also compounding to consider, which is a crap shoot to estimate, since you would be reinvesting the dividends at whatever the prevailing interest rate is at the time, not the original coupon rate. Anyway, the sales value on the bond has to match what someone would get as a grand total, face-value plus dividends and compounding, at the same maturity date for a bond with a different coupon.
---Bonds with different maturities (remaining time until they mature) sell at different premiums or discounts for the same change in interest rates because the dividends (plus compounding) extend for different times. Here's a simple example: Suppose I buy a $1000 4% 10-year Treasury today and sell it a year from now when 10-year Treasuries are yielding 5%. Over the following 9 years, my 4% Treasury would provide $360 in dividends plus about another $20 in compounding, then pay back $1000 in principal for a total of $1380. The new Treasury would provide $450 in dividends over 9 years, plus about $25 in compounding, for a total of $1475 (including the face value). This means I would have to sell my $1000 Treasury for $1380/1.475=$936 or a 6.4% loss.
----For the same situation and yields with a 5-year Treasury, we have $160 in dividends over the 4 remaining years plus about $7 in compounding, while the new 5-year Treasury would provide $200 in dividends over 4 years plus about $11 in compounding, so I would have to sell for $1167/1.211=$964 or a 3.6% loss.
----We can do the calculations the other way to look at selling a bond at a premium. For a $1000 10-year Treasury with 5% coupon sold 1 year later with 4% prevailing interest rates, after 9 years, my Treasury would have grossed about $1475 while a new 4% Treasury would gross $1380. Therefore, I could sell my Treasury for $1475/1.380=$1068.84. For a 5-year Treasury, the result would be $1211/1.167=$1037.70.
----With TIPS, the tradable value depends on how the fixed-coupon rate relates to current fixed yields. However, this gets complicated because the face values of TIPS change over time as the inflation adjustment gets added.

What Are The Advantages and Disadvantages of Treasures and TIPS

----Dividends paid by Treasuries and TIPS are exempt from state and local taxes, in taxable accounts, so comparisons with other fixed-income options, such as CDs, need to look at the after-tax yields. (As usually, in tax deferred accounts, all interest, dividends, and capital gains are treated as ordinary income and taxed to the max when you take your distributions.)
----Treasuries and TIPS are secured by the US Government, which is generally considered to make them the lowest risk category investment, along with federally insured bank and credit union accounts and US Savings bonds.
----Treasuries and TIPS can either be held until maturity or traded, so you have some flexibility. However, if you have to trade into rising interest rates, you will sell for a loss (with falling interest rates you would have a gain).
----Treasuries and TIPS can be bought at different maturities and used to build ladders. With longer maturities available than typically can be found on CDs, this allows for longer ladders, though to build a complete instant ladder requires buying on the open market.
----Longer maturities on Treasuries and TIPS allow you to lock in higher interest rates, when these are available, for a longer time than with CDs. Deciding what is a high interest rate, that is the chance that the rate you are getting will be higher over the long term than rolling over shorter maturities at a new rate, is at best an educated guess. (Looking at historical yields, as well as analyzing the macroeconomic situation, is what allows for the guess to be educated.)
-----If bought at auction, Treasuries and TIPS can be had for no extra cost; bought on the open market, they may be cost prohibitive, especially in small amounts.
----TIPS are difficult to assess, because the inflation adjustment is not predictable, so there is a lot of guesswork involved as to whether TIPS are a better or worse choice compared to Treasuries of the same maturity or CDs. If you are convinced you have a better crystal ball than the traders and that the inflation component they are factoring in is too low, TIPS would be a good choice.
----TIPS may also be a good choice, if your long term planning requires a certain return above inflation on “fixed-income” investments and TIPS are providing that return as their fixed yield. In other words, you can use TIPS to cover the risk of unexpectedly high inflation. However, remember the inflation adjustment for TIPS is the CPI, which does not necessarily correspond to inflation, as you personally will experience it.

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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 middle-men and taking a hefty cut, is in the form of corporate bonds, mostly available to the general public through the secondary market (no cheap direct purchases, as with Treasury auctions).
-----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, and while 30-year Treasuries have been in hiatus, those seeking maturities longer than 10 years have turned to corporate bonds (or buying legacy 30-year Treasuries).

Why Would I Want to Invest in Corporate Bonds?

----Corporate bonds typically 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 do have the opportunity to sell it for a capital gain. A good price can mean either, or both, that interest rates are high or that the company was in better shape than the bond raters and bond market thought at the time you bought. Out-guessing or out-foxing the market is how serious bond traders try to make big money.

How and Why Are Corporate Bonds Rated?

----Unlike Treasuries, 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 resold.
-----The lower the quality, the more interest a company has to pay, because the company is considered to be at greater risk of default (failing to pay back the loan)—the US 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. However, a 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). If you own shares of a bond fund that holds bonds that have their credit ratings changed, this will affect the salable value of the bonds, therefore the fund's NAV.
-----Investment grade bonds are rated (with slightly different nomenclatures) from AAA to BB, using Moody's. 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” doesn't 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, of course, by momentum-trading, can be dramatic. (For those looking for high return/high risk opportunities, downgrades to junk may provide them.)
-----Ratings are listed when you look at bonds being sold via your brokerage. They can also be found through various publications, such as Barrons.

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, but there are now many discount brokerages that offer the same cut-rate on all or most bonds.
----Beware of hidden 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 may more than make up for differences between commissions.
----Junk bonds sometimes have higher commissions and/or mark-ups.

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 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 maturities, its quality, and its “yield to maturity.” The YTM can then be compared with other corporate bonds or with the annualized yield on a Treasury or a CD with a similar maturity date. (Annualized yield is the compounded interest over the remaining life of a debt instrument, divided by the remaining years, which can be calculated exactly with a CD, but is an approximation with a Treasury where you receive and reinvest the dividends periodically, just as YTM is an approximation).
-----The basic question is whether the YTM is attractive enough to warrant the added risk compared to the other options, or, if you are looking at a long corporate bond, whether the yield is attractive enough to want to hold the bond that long.
-----Inexperienced bond investors need to pay careful attention to the maturity date, not just the yield. 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 interest rates go up and you have to sell.
-----Another issue with corporate (and municipal) bonds is the “call date.” Most companies reserve the right to buy back the loan at a call date 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). For a bondholder, the consequences 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.

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Zero Coupon Bonds and “Strips”
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What Are Zero-Coupon Bonds?

----Most bonds pay dividends on a regular basis, which then need to be reinvested if you want to get compounding (and estimated for yield-to-maturity).
----If you don't need to spend the dividends and don't want to reinvest, there are some bonds that don't pay dividends and effectively let you compound interest within the bond until it matures, as with CDs or US Savings Bonds. This gives you a predictable return, without “reinvestment risk.”
----They way this works is, you buy the bond at a considerable discount to face value. When the bond matures, you get back the face value. In this way, you can have a precise idea of what your annualized return will be. For example, if you buy a bond that matures in 20 years at 50% face value, your annualized return will be 5% per year, about the same as a 3.5% (compounded) EE-bond.
----Although you won't receive any money until maturity, in a taxable account, the IRS does require you to pay taxes on “imputed interest” (as with inflation adjustment on TIPS).
----Without regular dividend payments, the salable values of Zeros are more sensitive to changes in interest rates than coupon bonds, making them popular with active traders.
----For more on “Zeros,” see
http://www.precision-info.com/bondsonline/tut-2081443166-1.html

Who Issues Zero-Coupon Bonds and Where Can I Buy Them?

----Zero-Coupon Bonds are issued by corporations and municipalities, in lieu of, or in addition to, dividend-paying bonds. This allows them to delay any repayment until maturity.
----Because you are not receiving regular dividend payments, there is greater risk of loss if a company or municipality defaults, which should mean you can get a somewhat higher return (if they don't default) than on the analogous coupon bond.
----“Strips” are zero-coupon Treasuries sold by brokerages, who buy Treasuries from the government, strip off the coupons, then resell the stripped Treasury at a discount to face value.
----For more information on Strips, see
http://www.precision-info.com/bondsonline/tut-964763405-2.html
----Zeros and Strips can be bought and sold on the open market.

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Tax-Exempt Municipal (“Muni) Bonds
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What Are Municipal Bonds?

----Just like the federal government, state and local governments (municipalities) sometimes need to borrow money, usually to fund special projects where they want to spread out the costs over a number of years.
----The money is borrowed in the form of debt securities, known in the trade as Municipal Bonds (Munis).
----Munis are exempt from federal taxes and from taxes in the states and local communities from which they are issued.
----This tax advantage means Muni bonds can be issued with much lower dividend payments than Treasuries, Corporates, CDs, etc., because the effective after tax yields can still be better (which means state and local governments can borrow for less).

Oh Goody, I Won't Have to Pay Taxes. So, What's the Catch?

----Well, what we just said: lower dividends.
----The key is whether in your own, personal, tax situation, your after-tax return will by higher with Munis or with other options of similar risk and time till maturity.
----Assuming your tax situation remains constant, the calculation is easy. Multiply the yield on a Muni bond by 100% plus the % in taxes you would pay on the option with which you are comparing. Alternatively, multiply the taxable option by 100% minus % taxed to get after-tax yield.
----For example, a 4.8% CD with 25% federal bracket and 5% state tax is the equivalent of a 3.2% state tax exempt Muni. A 4.4% Treasury with 25% federal bracket (no state tax) is the equivalent of a 3.3% state tax-exempt Muni.
----Historically, Munis have been geared toward the well-to-do, with a wider applicability only where state and local taxes are very high. However, it is always worth crunching the numbers. (Also with Muni funds.)
----Caution: some Muni bonds are exempt from the Alternative Minimum Tax (AMT), some are not.

How Risky Are Munis?

----Like corporate bonds, Muni bonds are given credit ratings.
----Normally higher credit ratings translate into lower yields.
----Some Muni bonds are insured, which means the insurer (who usually is a much bigger financial institution than the bond issuer seeking insurance) guarantees the bond against default.
----Some Munis are low-rated, “high-yield” bonds.
----Historically, Muni bonds have been a better risk than corporate bonds of a similar rating.
----Caution: some states and municipalities have been under their greatest financial stress since the Great Depression, and many have future pension and retiree health obligations they cannot possibly pay.

Where Can I Buy Muni Bonds?

----Muni bonds are bought on the open market, through bond desks at brokerages.
----Muni bonds, especially if you are looking for ones that are exempt from state and local taxes, tend to be hard to find (also hard to sell), and may require help from a broker who specializes in this area.
----Because of their lack of liquidity, Munis tend to cost more to buy and sell than more liquid bonds.

Are There Muni Bond Funds?

----Yes there are bond funds devoted to Tax- Exempt Municipal Bonds.
----Some of these are national Muni Funds, where the focus is on exemption from federal taxes.
----There are also some state specific Muni funds, mostly for states with high income tax rates.
----Muni funds may be available with different maturities (short, intermediate, long) and with insured or uninsured Muni bonds.
----Some funds specialize on “high-yield” Muni bonds
----Be sure to check about AMT on the Munis held by a fund.
----Vanguard has an extensive set of no-load Muni Funds
http://flagship5.vanguard.com/VGApp/hnw/FundsByType#3
----For discussion of other issues about Muni Funds that apply across bond funds, see below.
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