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Robert Abbott
Robert Abbott
Articles (661)  | Author's Website |

Higher Returns From Safe Investments: Bond Basics, Part 1

The essentials you need to know before investing in bonds or bond funds

July 18, 2019

In his book, "Higher Returns from Safe Investments Using Bonds, Stocks, and Options to Generate Lifetime Income,” Marvin Appel argued it was possible to have your cake and eat it too. In his case, that meant buying safe investments for retirement without sacrificing too much return.

Bonds represent the first of several categories which he recommended, and in chapter two he explored the essentials of bond investing.

When an investor lends money to a government or company, the loan is considered a bond. Bonds are structured so the borrower makes regular interest payments (income) to the person who made the loan, but, unlike consumer loans, does not pay down the principal. Instead, after a specified period, the borrower returns the exact amount of the loan by making a lump-sum payment.

The interest rate received by the investor is called the coupon rate or coupon yield. This reflects an earlier age when bonds were pieces of paper with coupons attached; when it was time for an interest payment, the investor (or bondholder) would submit a coupon and be presented with the cash amount due. Generally, American bond interest payments are made every six months.

Most bonds are sold in denominations of $1,000 and may be bought in multiples, but not in fractions. So a 5% bond will pay $50 per year, since 5% of $1,000 equals $50.

When the bond is redeemed or reaches its maturity date, the principal amount must be repaid; the redemption amount is known as the par value.

One of the fundamental ways in which bonds are categorized is by the term to maturity:

• Short-term bonds mature in three years or less.

• Intermediate-term bonds mature in three to 10 years.

• Long-term bonds mature in 10 years or longer.

In this book, Appel focused on short- and intermediate-term bonds, saying, “Most of the time, short- and intermediate-term bonds will be the suitable maturities for you because they offer the best balance between the level of investment risk and return.”

The safety of bonds arises out of the characteristics of the borrowers. First, they are governments, and in the case of federal governments, they can print more money if necessary to make their interest and principal payments. Lower levels of government do not have access to printing presses, but do have taxation powers.

They are also corporations and are rated by independent agencies, so you an objective and independent assessment of their riskiness. In addition, risks are lower because you know:

  • The dates and amounts of interest payments are stipulated in advance.
  • The same is known about the return of your principal.

Interest rates vary, according to the type of bond. Three-month Treasury bills (a form of bond known as T-bills) have virtually no risk and pay the lowest interest rate. Longer-term Treasury bills also pose no default risk, but their prices are affected by interest rates (thus, you can buy a $1,000 bond for more or less than $1,000).

Corporate bonds are loans to businesses, and since they cannot print new money, there is always a risk of failure or default. The amount of risk involved is normally rated by independent agencies. Because of this risk, corporations pay more than governments.

Municipal bonds, or munis, refer to those issued by state and local governments, as well as government agencies. They are popular because they are usually exempt from federal and state income taxes. These are generally safe, but “if you look back to the 1970s, you can see that this type of bond too has had its periods of significant risks. With many state and local governments facing revenue shortfalls in 2010, you should not take the safety of municipal bonds for granted.”

Risk among bonds is referred to as drawdown, i.e. the biggest investment loss from a peak to a following low point. It is expressed as a percentage. Appel provided the following chart to show the risks and returns of four different types of bonds between 1973 and 2008:

Marvin Appel Risk Return Table

Note that these returns reflect the period before the 2008 crisis and are not representative of risks and returns that might be expected now. With very low interest rates since 2008, bond investors have suffered proportionately lower returns. Appel wrote, “Investors today are looking at better return prospects from buying corporate or municipal bonds than from buying Treasury debt provided that they can address the question of the added risk.”

Earlier, we categorized bonds by a couple of criteria, but there are still important distinctions if investors want to make informed decisions. There are taxable versus tax-exempt bonds, for example. In the United States, those issued by for-profit corporations are taxed most heavily. Treasury bonds are taxed federally, but not at the state or local level.

And the income from municipals is not taxed at all, subject to this important caveat: If they are held by a resident of the state that issued the bonds.

Also, investors should consider their own situations. For example, someone in a high tax bracket will gravitate to municipal bonds, while those in a low tax bracket might be indifferent to a bond’s tax status. Investors who hold bonds in tax-advantaged accounts, such as IRAs, can buy taxable bonds without undue concern.

The next categorization comprises investment-grade versus high-yield. Most corporate and almost all government bonds are considered investment grade, which is to say there is little risk they will default on their interest or principal payments.

High-yield bonds, which are also known as junk bonds, carry higher default risks and, therefore, their issuers need to pay higher interest rates.

Next Appel turns to interest rate risk, asking rhetorically, what happens if you bought a bond last year and now interest rates are going up? Will the rate on your bond also go up? No, the interest rate is locked in for the life of the bond, no matter what happens with interest rates. In the same vein, the principal repayment you receive at the end of the term remains fixed.

Interest rates pose two types of problems for investors: opportunity risks and price risks. The first, for example, might be a situation where you bought a bond at, let’s say, 5% and then interest rates go up; in this case, you’re stuck with a lower interest rate (anyone want to buy a 30-year bond today?).

Price risk occurs when you want to buy or sell a bond between the time it is issued and when it reaches maturity. For example, you buy a 10-year, $1,000 bond at 5% and then the interest rate rises to 6%. At some point after you bought the 5% bond, you have an emergency and need cash now; you cannot wait for eight more years.

That means you’ll have to sell it on the secondary market (what Appel calls the “equivalent of eBay” for bonds). On the secondary market, an investor who buys your 5% bond will get $50 per year, but for the same price could get a new, 6% bond. Why would the investor buy your bond?

The simple answer is that you will have to discount your 5% bond, reducing the price below the $1,000 you paid, to the point where is of equal value or better value than new 6% bonds. Appel summarized this way:

“The take-home point is that there are two sources of investment returns from a bond: the interest you receive during the life of the bond and the difference between the price you pay for a bond and the $1,000 per bond you get when it matures.” And,

“When interest rates rise, the market value of existing bonds falls. When interest rates fall, the market value of existing bonds rises. If you hold individual bonds to maturity, changes in interest rates will not affect the returns you receive from your investment.”

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website

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