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Author: 2old4bs Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35392  
Subject: FAQ1 Final: Intro,Terminology,Interest,Risk Date: 2/18/2006 1:15 PM
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Bonds and “Fixed” Income Investing: Introduction
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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:
http://www.bondsonline.com/Educated_Investor_Center/Bond_Basics.php
http://www.bondsonline.com/Educated_Investor_Center/Types_of_Bonds.php
http://www.bondsonline.com/Educated_Investor_Center/Buying_Selling_and_Trading.php

The “learn more” section from investinginbonds.com has similar information
http://www.investinginbonds.com/
Also see Vanguard's glossary
http://flagship5.vanguard.com/VGApp/hnw/content/Glossary/IndexPages/GlossaryIndexPageNumContent.jsp

For comments and recommendations about books on investing in bonds, see this thread
http://boards.fool.com/Message.asp?mid=23489486&sort=whole

What is “Fixed Income Investing”?

“Fixed-Income” investing is a misnomer. It's 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) from the money when you need to use it as the money 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) being a reasonable goal, based on historical returns.

Typical options, such as 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 are usually subject to a penalty if cashed in early. Tradable bonds may serve as principal preserving options if held until maturity, not sold before 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 (“dividend,” “yield”) 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 within the fund.
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.

Unlike stock mutual funds, which, except during bear markets, have over time seen NAVs steadily increase, bond fund NAVs consistently fluctuate up and down, depending on prevailing interest rates, which affect the tradable value of the bonds held by the fund.
Many people assume investing in bond funds is a principal preserving strategy, but it is not, as your principal in the form of NAV is subject to fluctuation. Although over time your total return on a fund (dividends plus or minus value of sold fund shares) may make bond funds a good alternative to true principal preserving choices.

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 will provide the best return. Not all of these options may be available through some retirement accounts (for the reason just noted).

The income (interest, dividends) from most bonds or other principal preserving investments are fully taxed at your marginal rate, not at the lower rate for long term capital gains, so when there are no reasons why you need to have access to money earmarked for principal preserving investments, it makes sense to hold principal preserving assets in tax-advantaged accounts.

Since most of the current participants on this board are not bond traders, the FAQs are aimed primarily at 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 ought to know a lot more than what can be explained in FAQs.

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What Kinds of Principal Preserving Investment Options are There?
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Savings Accounts
Money Market Accounts
CDs (Certificates of Deposit) (of various maturities)
US Savings Bonds (I-Bonds and EE-Bonds)
US Treasury Bonds and Notes and Bills (of various maturities)
US Treasury Inflation Protected Securities (TIPS) (of various maturities)
US Government Backed Mortgage Securities (GNMA)
US Government Agency Securities
Federal Tax-Exempt Municipal and State Bonds (“Munis”)
Corporate Bonds (Investment Grade, “High-Yield” or “Junk”)
International Bonds (Corporate or Government)
Fixed and Inflation-Adjusted Annuities
Bond Funds
---Indexed versus Selected Funds
---Passive versus Actively Managed (trading, leveraged) Funds
---Short, Intermediate, Long (or mixed)
---Corporate, Treasury, Inflation Protected Securities, GNMA (or mixed)
---Municipals (Munis)
---“High-Yield” (“Junk”)
---International
---Mutual Funds versus Exchange Traded Funds (ETFs)
---“Closed-End” Funds
---“Terminal Trusts”

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In a Nutshell, what are the major factors that need to be weighed in choosing between these options?
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As with any investment, you are trying to maximize your “real” return (after taxes, expenses, and inflation), in this case “income” (yield/interest/dividends) and (sometimes) capital gains. Factors to take into consideration that may interfere with seeking the highest possible available returns include:

---Risks to preserving your original principal (defaults, or rising interest rates decreasing the tradable value of bonds or fund share price).
---Taxes (the idea is to get the best after-tax return).
---Liquidity: Having access to income and principal when you want it, which means paying attention to maturity dates, penalties and restrictions on cashing in, and the potential for having to sell at a loss.
---Minimums: Many options require minimum investments of $1000 or more.
---Costs: Fees, trading costs, loads, expense ratios, etc.

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“'Income?'” Isn't This, Like, What Us Plain Folk Just Call Interest?
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Yup! But there is a jargon favored by the fancy folks of finance and, if you want to play with their toys, you should learn to talk their game. Here's some terminology:

---“Income”: A general word for cash that gets paid out by an investment on a regular basis (stock dividends, interest on a bank account, an annuity, rents from rental properties, dividends from bonds or funds, etc.). In some cases you may choose to have income reinvested or you may not have access to the income until some specified date.
---“Interest”: The colloquial word used to represent a % paid in cash on your invested principal or which you pay on money borrowed, now mostly used on the investment end on Savings and Checking Accounts.
---“Dividends”: The preferred word for “interest” paid not only by bonds and bond funds (as well as stocks and stock funds), but by such basic bank instruments as CDs and Money Market accounts.
---“Yield”: The rate of interest currently being paid on the principal you invested. Some investments have a fixed rate until they mature; others have a variable rate.
---“APY” or “Annual Percentage Yield”: The compound interest rate for a year (principally used with CDs), normally involving daily compounding—note that yields on bonds and bond funds are normally not listed as compounded, so compounding needs to be taken into account when making comparisons.
---“Fixed-Rate”: A rate of interest that applies to an instrument until it matures or you cash it in. Some instruments, such as I-bonds and TIPS, combine a fixed and adjustable component.
---“Adjustable Rate”: Some instruments adjust the rate of interest paid, based on prevailing interest rates (e.g., money markets and bond funds), on an inflation component (I-bonds, TIPS, some annuities), or on returns on investments by the bank or other institution.

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How About “Income” from Tradable Bonds?
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Here are some more terms that you need to know to understand how income gets paid from tradable bonds:

---“Face value”: The principal a bond returns to the investor when it matures (or is called), which may be more or less than the amount you paid to buy the bond.
---“Par”: Buying a bond at its face value.
---“Premium”: Paying more for a bond than its face value (also used for closed-end funds relative to the net asset values of their holdings).
---“Discount”: Buying a bond for less than its face value (also for closed-end funds)
---“Maturity”: The time left until a bond “matures” (i.e., when the issuer has to pay back the face value of the bond).
---“Call Date”: A date which the issuer of a bond has the right to pay back the face value (sometimes slightly more or less) of the bond, which may be long before the Maturity date. Bonds will typically get called if interest rates go down, because the issuer can then issue new bonds at a lower rate. Some bonds have more than one call date.
---“Coupon”: The interest rate a tradable bond pays based on its “face-value”—if you buy the bond on the open market for more or less than its face-value, your actual yield (the interest rate you get for the amount of principal you invested) will be more or less than the bond's coupon rate. If you buy at par, which usually only happens at a Treasury auction, you get the coupon rate.
---“Yield-to-Maturity”: The (annualized) yield you would get if you held a bond until maturity, factoring in the difference between the bond's face value and how much you paid for it, plus a compounding factor (estimated) from how much of a return you will get from reinvesting the dividends at prevailing interest rates. Though an approximation, this is the best basis for comparison with APY or other compounded interest on fixed-interest options. Yield to maturity is the total return on the bond divided by your investment (what you paid for it) averaged over the time between when you buy the bond and when it matures. Total return has three components: The total amount of dividends paid from time of purchase to maturity; the difference (plus or minus) between the bond's face value and what you paid for it; and the compounding from the dividends being reinvested. The compounding component is important because there may be a large difference between the bonds' coupon rates and prevailing interest rates (for CDs, etc.) at any given time. For example, a bond paying 12%, results in a lot more compounding than a bond paying 5%, even if dividends from both are reinvested at the same rate. The rub is that there is no way of knowing exactly at what rate dividends will be reinvested, since they get paid every six months over a number of years and prevailing interest rates change, sometime dramatically. So calculating YTM is pretty much of a crapshoot, and the YTMs listed when purchasing bonds are likely to be inconsistent and unreliable.
http://www.investopedia.com/university/advancedbond/advancedbond3.asp
---“Yield-to-Call”: Annualized yield, factoring in how much you paid, until the date at which a bond may be 'called,” plus a compounding factor. A variant of this is “yield-to-worst,” which is the worst yield you will get given different call dates (especially important if you are buying at a “premium”).

For more on bond prices and yields see:
http://personal.fidelity.com/products/funds/content/browse.shtml.cvsr?refpr=ipmf1

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What are “Interest Rates” and why doesn't what they say on the News make any sense?
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“Interest Rates”: A vague term referring to various rates of interest that are currently being charged by lenders or paid to investors. These range from the “Discount Rate,” proposed as a target by the Federal Reserve (a very short term rate) that gets a lot of press, to different mortgage rates to yields on Treasury Bonds of different maturities. It is important not to confuse what you hear about “interest rates” with the specific interest rate that applies to a particular bond, bond fund, or other investment or debt. For example, the Federal Reserve rate does not directly determine mortgage rates or yields on Treasury Bonds. It typically does have a stronger indirect impact on short-term rates than on long-term rates.

“Basis Points”: A term used when speaking of changes in interest rates that, once you understand it, is less confusing than “percentage.” It is the change in percentage points measured in hundredths (100 basis points = 1 percentage point; 25 basis points = 0.25 percentage points). Note that we are not referring to the change as a percent of the original rate, but changes in percentage points (from 4% to 5% is a change of 1 percentage point or 100 basis points, even though it is a change of 25% from the original rate).

If it isn't just the Federal Reserve, how are Interest Rates set?

Interest rates are determined by supply and demand for debt financing. Supply and demand is specific for different maturities and qualities, though there is a finite supply of capital available for debt financing.

The supply of capital comes from various sources: Individuals putting money into banks or buying bonds or savings bonds or shares in bond funds; institutions (insurance companies, pension plans) buying bonds; foreigners, foreign institutions, or foreign governments buying bonds; surplus contributions to Social Security (and some other US government surpluses); the Federal Reserve printing money to loan to banks for less than they loan the money out to those seeking debt financing, etc.

Demand for debt financing comes from the US Government, other national governments, state and local governments, agencies, large corporations, small businesses, and of course, individuals (including mortgages, credit cards, and big ticket items).

The amount of capital available for debt financing not only depends on how much total capital is available (nowadays, on a world-wide basis), but also on what percentage of that capital is made available for debt financing, as opposed to equities, commodities, real estate, etc.

The upshot is that it is very difficult to predict what will happen to interest rates, even if we can identify specific factors that contribute to supply and demand (such as foreign governments buying Treasury Bonds and mortgage securities, flight from stocks to bonds during panics, looming end of the Social Security surplus, government deficits, demand for mortgages, etc.).

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How do different "Qualities" and maturities affect yields?
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If we lend someone money, we expect to be paid back, and the higher the risk we won't be paid back, the more interest we will demand (as any self-respecting loan-shark will tell you). Also, since tying up money for a longer time involves more risk of default as well as risk of the principal shrinking against inflation and the likelihood we will need to draw on the principal, we normally would demand to be paid more interest for waiting longer to get our principal back.

Quality is the general term used for the risk a bond will default. This risk is assessed by various bond-rating agencies (Moody's, Fitch, S&P), using slightly different letters in their rating schemes, but more or less they range from AAA (highest) down to C.
---Investment Grade: Anything rated above BB. The higher the rating, the less likely the bond is considered to be a default risk.
---High Yield/Junk: Anything rated BB or below.
---Risk Premium refers to the amount of yield paid by lower rated bonds compared to bonds of similar maturities of lower risk. We can compare the current risk premium on different instruments (e.g., the yield on a 10-year Treasury Bond with the yield on a 10-year BB- rated bond).
---“Short-term Interest Rates” refers to the yields on bonds of shorter maturities, sometimes restricted to maturities of under 1-year but applied, with bond funds, to anything under about 3-years.
---“Long-term Interest Rates” refers to yields on bond of longer maturities, generally over 5-years, though bonds maturing within 5-10 years are usually considered “intermediate.” (The reintroduction of the 30-year Treasury Bond will probably make it become the reference point for a “long” maturity.)
---Usually, long-term rates will be higher than short-term rates for the reasons outlined above.
---“Yield Curve” refers to the relative amounts of interest paid by the same type of bond of different maturities. A “flat” yield curve means both long and short-term interest rates are quite close. An “inverted” yield curve means short-term interest rates are higher than long-term interest rates (historically, this has often happened shortly before a recession, but not always).

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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, that your savings will buy less when you need to spend it than when you saved it. 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 for bonds of equivalent maturity and quality. If the prevailing interest rate is higher, the value of the bond for sale is less than its face value. More broadly, if the interest rate is less than at the time you bought, the value of the bond will be less. 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. However, with bond funds, 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 might be forced to sell 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 together with interest rate risk, will be discussed later.)
---“Default Risk”: The risk the issuer of the bond will fail to continue to pay interest on its debt obligations and/or to pay off the face value of maturing bonds. This happens when companies or, sometimes, governments, are in deep financial trouble. They may delay paying bondholders or, even, declare bankruptcy and pay off bondholders at cents on the dollar of face value, if anything.
---“Reinvestment Risk”: This has to do with how much compounding we get on the income being paid. With CDs and other instruments that compound internally, you know what your compounded return will be. With tradable bonds and other instruments that pay regular dividends, you may not be able to reinvest those dividends at as high a rate as what the bond is paying. This is an issue especially if the coupon on a bond is much higher than prevailing interest rates at the time you need to reinvest.
---“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 foreign currency, declines in U.S. dollar terms. You will get less U.S. dollars when the bond matures, and your dividends in the foreign currency will convert to less U.S. dollars when received.
---“Call Risk” and “Pre-payment Risk”: The risk that a bond will be called or 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. If you bought a bond at a premium, you might be forced to accept a payoff of the face value (sometimes slightly more or less), which is less than you paid for the bond. This, in addition to not getting your expected high interest payments for an extended time, may lead to a substantially lower total return or even an overall loss.
“Pre-payment” is the risk of a bond being called by an issuer and is usually applicable to mortgage securities, when people choose to refinance their mortgages at a lower rate. Again, you might have to replace that bond in your portfolio with something paying much lower interest.
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Author: Mark12547 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15449 of 35392
Subject: Re: FAQ1 Final: Intro,Terminology,Interest,Risk Date: 2/18/2006 2:42 PM
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---“Interest”: The colloquial word used to represent a % paid in cash on your invested principal or which you pay on money borrowed, now mostly used on the investment end on Savings and Checking Accounts.

Actually, "Interest" is the dollars paid, "Interest Rate" is the percent paid in cash on invested principal.

I get bugged quite a bit over this on the Credit Card board when people talk about paying the debt with the highest interest when they really mean paying the debt with the highest interest rate, except that there are a few people who really do mean the debt with the highest interest. (Think about this: is it better to pay off my 10% interest rate credit card if I am being charged only $15 of interest a month, or pay down my 5.25% interest rate mortgage with a monthly interest payment of about $230? If one uses "interest" but means "interest rate", one would be targeting the wrong debt.)


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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: 15454 of 35392
Subject: Re: FAQ1 Final: Intro,Terminology,Interest,Risk Date: 2/19/2006 8:59 AM
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---“Interest”: The colloquial word used to represent a % paid in cash on your invested principal or which you pay on money borrowed, now mostly used on the investment end on Savings and Checking Accounts.

Actually, "Interest" is the dollars paid, "Interest Rate" is the percent paid in cash on invested principal.


Good pick-up Mark. Should probably read, ---“Interest”: The colloquial word for the amount paid in cash on your invested principal or which you pay on money borrowed, now mostly used on the investment end on Savings and Checking Accounts.

There's an awkwardness, here, in trying to talk about "interest" as the lay word that shows up as "dividends" in the financial jargon, and "rate of interest paid or owed," which is "yield" in financial jargon. I've been trying to avoid saying "interest rate," because that seems to have become this media flash that refers to what the Fed is doing. "Yield" gets confusing, too, because yields get listed in so many different ways, as we've learned with SEC yields on bond funds.




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