In part one of this discussion, which is based on Marvin Appel’s book, "Higher Returns from Safe Investments Using Bonds, Stocks, and Options to Generate Lifetime Income," we began reviewing the basics of investments in bonds.
Part two begins with this question: “How Much Is Your Bond Really Paying You?” As you may recall from part one, bonds always sell in units of $1,000. If you buy or sell a bond at any time between issuance and its maturity date, the price may not be exactly $1,000. In fact, it may be significantly higher or lower.
This happens because of changes in interest rates. If rates go up, then the bond will be worth less than $1,000 and if they go down, then it will be worth more than $1,000. If you hold a below-par bond (purchased for less than $1,000), then you will also cash in on the difference when it matures (roughly similar to a capital gain on stocks). Similarly, if you buy an above-par bond (purchased for more than $1,000), then you will suffer a loss at maturity.
When you buy a below-par bond, then the interest payments plus price appreciation will add up to the total return. That, in turn, leads to the yield to maturity, an important term in the bond market. Appel provided this example:
You buy a 10-year bond paying $45 per year for $904. The coupon rate (posted interest rate) is 4.5%, yet the yield is really 5% because you bought the bond at a discount ($45 divided by $904 = 5%). Thus, 5% is the current yield.
Because the bond will be worth $1,000 at maturity, then you will also have annual price appreciation of 1% per year. Adding this 1% to the 5% annual interest rate means your yield to maturity will be 6%.
Of the term yield to maturity, Appel wrote, “The yield to maturity is the most important piece of information you need to know about a bond when evaluating whether or not you find the returns attractive.”
With this number, a percentage, you can compare bonds when shopping. Brokers offer information on both the coupon yield and the yield to maturity; the second is obviously much more informative. With that information, you can predict how much your investment will return and when you will receive payments.
Next on Appel’s topics list is a categorization based on the holding period: long-term versus short-term bonds. As we’ve seen, prices of bonds vary in response to interest rate changes. Crucially, short-term bonds only vary a little while the prices of long-term bonds vary a lot (they are more volatile).
In practice, this means investors will favor short-term bonds when interest rates are expected to rise, and probably turn to money market funds. On the other hand, if you buy a 5% bond maturing in 30 years and rates go up to 6%, you are locked in for many years of substandard returns. Appel created this chart to show what happens to the value of three different bond maturities when interest rates rise from 4% to 6%:
Appel made this recommendation:
“Most of the time, the best balance between interest rate risk and reward (in the form of interest income) for individual investors is with intermediate-term bonds maturing in seven to 10 years, assuming that you are confident that the issuer of your bonds will be around that long.”
Appel wrote this book in the immediate aftermath of the 2008 financial crisis, a time when investors could take nothing for granted.
At a couple of points above, I’ve been tempted to refer to the lengths of holding periods as durations. But Appel warns that duration has a very specific meaning in the bond community. He wrote, “Duration is a measure of how much the value of a bond or bond portfolio changes when interest rates change by a fixed amount.”
Duration, therefore, varies every time interest rates change, unlike maturity, which stays constant (more on this subject later, particularly in our discussion of bond mutual funds).
The author also reported that bonds can be bought from most well-known stockbrokers. They will supply prices and other key information, including coupon yield, maturity date, price and credit ratings. As noted above, you can also check for yield to maturity.
There are no fixed commissions per bond trade. Instead, brokers build their profit into the price, making the buying and selling of bonds comparable with negotiating a price at a car dealership. Appel also advised that investors might find better deals by shopping for odd lots, which are bundles of bonds worth less than $10,000.
If you are buying, a listing may look like this one at T.D. Ameritrade’s website in 2009:
Here’s what those header items mean:
- CUSIP number: The unique number used to identify a publicly-traded stock or bond.
- Credit ratings: How one or more credit rating agencies view the bond’s quality.
- Quantity: The number of bond units available at the quoted price.
- Issuer: The name of the borrower.
- Coupon: The annual percentage paid to holders each year.
- Maturity date: When bond owners get back their principal.
- Yield to maturity: How much your return will be if you buy at the listed price and hold it through to maturity.
- Price: The dollar amount, based on $10 units; therefore, a quote of “100” means $1,000.
Finally, in chapter two, Appel explained how bond prices vary, according to the number of days before the next coupon payment. We might think we will buy a bond a day or two before the payment date and get the full coupon. However, payments are prorated; for example, if a bond pays $20 every six months, you will not get the full $20.
If you buy the bond three months before the six-month payment date, you will get $10. If you buy it the day before the payment date, then you will pay the seller the full coupon amount minus one day’s interest.
Read more here:
- Higher Returns From Safe Investments: Bond Basics, Part 1
- Higher Returns From Safe Investments: Finding a Happy Medium
- Learning to Think Like Charlie: Decision-MakingÂ
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