The Bare Necessities: Chapter Three

Chapter Three: The World of Bonds Fact: The bond market is the largest investment market in the world. Its world wide value, as of March 2009, is $82 trillion. Compare that to the stock market; its world wide value is approximately $36 trillion. Yet, even with its huge valuation in the world, very people fully understand how a bond works. In this chapter, I hope to give the average investor a better understanding of the bond market, how you decide to invest in them is up to you. The first thing you need to know is that a bond is just a loan sold by the government or a corporation. Governments or companies may sell bonds to raise money to pay for infrastructure, equipment, investments, or to take advantage of low interest rates. You may also hear the term "debenture." Debenture is a term to describe bonds sold by companies, however, it is not wrong to call a corporate bond a bond. It is taboo to call a government bond a debenture, so try not to make that mistake. Because they are loans, there is no guarantee that you will receive all your money back. Therefore, there are risks involved with bonds. All bonds will have a grading. BBB+ is considered investment grade and are safe. A, AA (or double A), AAA (or triple A) with the last being safest. The value of safe bonds will be higher, and bonds with more risk will be lower in value. If that part doesn't make sense, think of it this way. In reality, you don't charge your friends interest, so you would rather lend $1,000 to a friend who has a higher chance of paying you back. With bonds, if you have a higher chance of getting paid back, you would pay a little more today for that safety net. The next feature of bonds are its three key elements: maturity date, par value, and coupon payment. A maturity date is the day the bond expires. That is, this is when the company or government will re-pay the loan, similar to a friend borrowing $100 from you. The par value is always $1,000 and is the amount you receive. Bonds are always quoted in 100, but pay in $1,000. Lastly, the coupon payment is the amount of interest you receive for lending your money. This is quoted in a percent. For example, you may hear somebody say, "A 5-year US Steel bond paying 4% is worth 109.80." This means that the bond's coupon is paying you 4% a year based on the par value, which is always $1000. This equals $40 a year per bond. (Note, the term per bond is not proper, but I will use it for simplicity). However, if you want the 4%, you must pay 109.80 or $1098.00 (as explained above). Therefore, the amount you actually earn is less than 4%. That is where the term yield and yield-to-maturity arise. A common misunderstanding with bonds are the coupon and the yield. This is because bond quotes will always show the coupon in the bond name, but also show a yield next to it. For new investors, this can be confusing. In the above example, the real yield is simply the coupon ($40) divided by your original investment ($1098.00) which equals 3.64%. The yield-to-maturity (YTM) calculates the amount of cash you receive over the lifespan of the bond. So, if the bond matures in 4 years from today, you should determine how much you receive as a total yield through the steps below. 1. Calculate the amount you gain (or lose) on the purchase of the bond. This is -$98. 2. Calculate all the coupons you would recieve. This is $40 x 4 years = $160. 3. Divide that number by your original investment. So, [160-98]/1098 = 5.65% 4. Take the total earnings in percent and divide by the amount of years left. 5.65%/4 years = 1.41%. As you can see, there is a drastic difference between the coupon, the yield, and the YTM. When investing in a bond, the goal is to receive a YTM higher than the free-interest rate. If a money market is paying 1.5%, then why take on the risk of a bond which pays you less? In reality, bond YTM's will never be lower than the free-interest rate. If this were to happen, bond values would decrease due to massive selling, and allowing YTM's to go back to normal. Other tidbits of bonds that you should know is that longer term bonds will have a higher yield. Again, this is because of the risk factor. If a bond matured in one month and another matured in ten years, the one maturing in ten years has a higher probability of defaulting (not paying you back) and therefore, should have a higher yield. As discussed earlier, the higher the risk, the higher the reward. Government bonds are also considered safer than corporate bonds. You will normally see government bonds values much higher than an equal corporate bonds. Treasury bills, although not actually called a bond, is essentially a short-term bond maturing in less than a year. Because of the varying features of bonds, nobody really day trades bonds. Bonds are not traded on an exchange, but done through institutions. This presents problems for those who want a specific bond, but may not be offered or available at a brokerage. However, many good brokerages will look in their inventory to find bonds with similar yields, investment grades, coupons, and time. So, when opening an account highly fixed on bonds, consider if the company have dedicated representatives for bonds. Another problem that arises from a lack of an exchange are the pricing. When you purchase a bond, you pay a little more than the bond is actually worth, and when you sell, you receive a little less. This is known as the spread. With bonds, the more you buy/sell, the smaller the spread will be. Well, I think that's all I can write about bonds. There's a lot more to bonds than what I have described, but this should give you a better understanding. I would also highly suggest you consistently review yields and coupons so that you do not make rookie mistakes.