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Bonds, Corporate Bonds

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February 27, 2009 – Comments (6) | RELATED TICKERS: LQD

Yes James Bond is cool, that's not what this post is about.  I actually am going to talk about corporate bonds.  I have been posting about bonds a lot lately.  Whenever I do, there is usually several comments from CAPS community members who say that they don't invest in bonds because they don't know how they work.  Bonds really aren't that complicated.  Kiplinger's has a great article on how bonds work in this month's issue.  It is a great introductory piece for anyone who is considering dipping their toe in the sector.

Anatomy of a Bond

In the article, the author outlines a series of important questions that one needs to answer before purchasing a corporate bond.  Here they are, but with commentary from yours truly instead of the article's author:

Who's the issuer?  This one is simple.  Essentially this question asks, "Who are you lending money to?"  Just like when lending someone money in real life, there's a big difference between lending money to your deadbeat compulsive gambler friend and to your responsible, fully-employed son.  The same goes for corporate bonds.  There's a huge difference between lending money to a messed up company like Citigroup and to a solid one like Wal-Mart.

What's the interest?  This one is pretty self-explanatory.  What yield does the bond that you are considering purchasing pay?

What does it cost?  Here's where things get a little trickier.  Bonds trade on the open market, just like stocks do.  They generally sell in increments of $1,000.  A lot of factors go into what price a $1,000 face value bond is trading for at any given moment.  Is the company in better or worse shape than it was when the bond was originally issued?  Is the economy in better or worse shape than when it was issued?  Are interest rates higher or lower in general right now than when it was issued?  How close is the bond to maturity? 

When does it mature?  This question is related to the issue that I just touched upon.  The closer the bond is to its maturity date, the more expensive it is (and in turn the lower the interest rate it pays) because you are assuming less risk by locking up your money for a shorter period of time.  The yield on a bond that has twenty years left before maturity will be a lot higher than the yield on a bond issued by the same company that has only a year or two left.

What does it earn?  The good old "yield to maturity" (YTM) is one of the most important things to look at when investing in this sector.  It essentially represents the real rate of return that you are receiving on your money when you buy a particular bond.  For example, if a company originally issued a $1,000 bond that pays 5% interest that is now trading at $0.50 on the dollar i.e. $500, the actual annual rate of return (in terms of the interest rate) that the person who buys it would receive is 10%. 

But wait, there's more to it than that because assuming that the company does not go bankrupt the person who bought it will eventually double their money at maturity because they will receive the full $1,000 value of the bond back from the company.  This 100% increase in the value of the bond needs to be added into the rate of return.  The impact that it has upon the bond's yield to maturity depends upon how long you have to hold the bond for.  For example, if there was only one year remaining on this bond, its (annual) yield to maturity would be a whopping 110% (not taking commissions into account).  Two years left, its YTM would be 60%.  Three years, the YTM would be 43.33%.  Four years would be 35%.  And so on...  You get the idea.  The YTM works in reverse as well for investors who pay more than face value for a bond.  Most brokers automatically calculate YTM for the bonds that they sell to keep things simple, but it's good to understand how it works.

What's the quality?   Here's the trickiest part of all.  Will the company that you are loaning money to survive until they are scheduled to repay you?  Even though most brokers provide the S&P and Moody's bond ratings for companies and they figure heavily into the prices of bonds, I generally ignore them.  We all know what idiots and scumbags the people at the ratings agencies are.  I look at the company's cash flow, debt level, cash on the books, business, assets, etc...  This is actually the beauty of bonds versus stocks.  With stocks, particularly ones that don't pay dividends, you often have to make sure that a company will thrive in the future to make a decent return in terms of capital gains.  Not so with bonds.  As the old saying goes, "I'd rather be generally right than specifically wrong."  One doesn't have to go wild with analysis using all sorts of assumptions about future earnings that may or may not ever come true with bonds like many people do with stocks.  If you plan on holding a bond maturity, you just have to ask yourself a simple "Yes / No" question: "Do you think this company will survive until it has to pay you back?"  If the answer is yes and you are getting an adequate return on your money.  Go for it.  If you aren't sure, look for a different bond.

Now that we have a general idea of how bonds work, the question is how does one go about buying them?  I purchase my bonds through Schwab.  I don't think that it is the best broker in the world, but it is a major brokerage that is not in danger of blowing up (as far as I know, HA) so does the trick and I don't feel like switching. 

One good thing about Schwab is that a few years ago it made its pricing on bonds much more transparent.  It used to scalp investors with huge fees that it did not even bother to break out.  Now everything is very, very clear and well laid out for investors.  Its bond commissions are around $10.

I suppose that it depends upon what your definition of a "large" portfolio is, but one certainly doesn't have to be a millionaire to buy individual bonds in their investment account.  You can buy most corporate bonds in $1,000 increments.  Of course, the smaller the increment you buy in, the higher the commission is on a percentage basis.  Still, a $10 commission on a $1,000 investment is only 1%, which is nothing if you hold on to the bond for a number of years.

There is a lot more to bonds than this in terms of the different types of seniority, whether they are callable, whether they are tax exempt, whether one expects interest rates to rise in the future, etc...but this is a general primer on how they work.  Please let me know if you have any questions and if you found this post helpful, give it a rec so it appears at the top of the list where others will see it.

Deej

6 Comments – Post Your Own

#1) On February 27, 2009 at 10:37 AM, BigFatBEAR (29.16) wrote:

A rec for the blog title (pure genius!), and of course its contents.

Thanks Deej.

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#2) On February 27, 2009 at 11:04 AM, anchak (99.84) wrote:

Abso genious with the title!

Incidentally, I pitched this ( similar ) idea on one of the Fool boards - and of course Michael(Everyday) pitched JNK right when it was troughing in Dec 2008.

Here's the link :  stinkyfeet board

My feeling is you can do it various ways

(1) Deej your method ie buy direct from broker (Schwab). Involves a lot more due diligence on the investor's part - but biggest thing - YOU CAN HOLD TO MATURITY. This is not true with ETFs or  Mutual funds - because they mark-to-market their bonds everyday.

(2) You can do it thru a good mutual fund - my thesis is thru Vanguard. They are doing some active judgement on their part - low cost and they are known for being conservative.

(3) Or take the ETF route. Broader exposure - LQD has also had a little run up.

Overall excellent pitch and I think timely!

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#3) On February 27, 2009 at 11:09 AM, Billullo (< 20) wrote:

Great post i just had Bonds 101 Thanks!

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#4) On March 10, 2009 at 6:04 PM, MICHAELSN (< 20) wrote:

When it comes to investing in bonds it's important to understand the covenants attached to the bond offering memorandum. Just like anything else it's the small details that need to be examined before investing in a specific bond issue. I am relatively new to this site but another important debt category are convertible bonds. Right now, most of them are busted considering how far the equity markets have fallen in value but hopefully some day not to far off they will have some relevance again.

     

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#5) On March 11, 2009 at 7:46 AM, Namirius (< 20) wrote:

Talking about hybrid bonds takes us to another important point that as far as I have seen has not been covered in the post: SENIORITY and embedded OPTIONS

 @ Seniority: A very general summary would be that there exist senior and subordinated bonds. In case of default senior bondholders get paid before subordinated ones see a single cent. Considering that the average historical recovery rate in case of default is somewhere close to 40% the buyer of a subordinated bond should prepare for not receiving anything in case of default. That's why these bonds tend to have much higher yields then senior ones of the same issuer. Hybrid bonds fall into that category. This is one of the major points making them much like equity. The other point would be their (theoretically) endless maturity. Theoretically endless because they use to be equipped with an embedded call option...

@ Embedded Options: A bond with an embedded call option can be redeemed by the issuer before their actual maturity date. With put options the bondholders have to possibility of early redemption. Call options are more frequently used then puts. Bonds equipped with a call should pay higher yields (the call has value to the issuer), puts will pay less (value to the holder).

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#6) On March 11, 2009 at 8:50 AM, jackcrow (88.88) wrote:

There is a great Bond board if anyone would like to discuss their ideas or lean different ways of researching bonds and different bond strategies. New blood is always welcome

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