Meridian Magazine :: MoneyWise: Want Investment Income? Bonds Might Be the Answer

Want Investment Income? Bonds Might Be the Answer
By Richard P. Halverson

Most people are familiar with investing in common stocks; fewer people are familiar with investing in bonds. For many people bond investing may make sense, because bonds generally provide higher income than stocks. For example, if you buy $10,000 of GE stock today, you can expect to receive about $276 back in dividends next year. If you buy $10,000 of a GE bond you can expect to receive $493 back in interest next year. For people who need income, bonds can make sense.

Briefly, investors who own stock in a company own part of the equity or ownership of the company. Investors who own the bonds of a company own part of the debt of the company. In other words the investor has made a loan to the company. This distinction means the entire rationale for investing in the company is different. Normally, an investor buying stock in a company believes the company will prosper and grow and that the investor’s stock will rise in value. The company may pay dividends to its shareholders but often the current dividend is a secondary consideration for the investor. The bond investor is primarily interested in the amount of interest being paid and whether the company will be able to pay off the bond in a timely fashion.

If you are interested in investments paying higher income, you may be interested in buying bonds. If you do you will almost certainly buy them through someone like a Merrill Lynch broker. Here are some of the characteristics of bonds you should know so that you can talk intelligently with the broker.

Instrument of indebtedness. Many types of institutions — such as corporations, governments (both foreign and domestic), and governments (both national and local) — issue bonds. The institution borrows money by selling the bonds. In return they agree to pay the bondholders interest every year and to repay the bonds when they come due.
Maturity.When the bonds are sold the seller agrees they will pay them back on a specified date for example 20 years from the date of issue.
Coupon rate. When the bonds are sold the market place will demand a certain rate of interest. This varies just like the mortgage market. At one time a homeowner can get a 5% mortgage and a year later the same homeowner might have to pay 6%. The coupon rate remains fixed for the life of the bond. If the coupon rate is 5% the institution will pay $50 a year in interest for every $1,000 bond. Usually, these payments are made every six months. There are a number of factors that determine what the market place will demand when a bond is sold.
- Time to Maturity. The longer the maturity the higher the rate. This reflects greater uncertainties of all types as the time for paying the loan off is extended. For example, the government must pay 3.92% today to borrow money for three months while it must pay 4.72% to borrow for 25 years. (Incidentally, this spread is historically very small right now.)
- Credit rating. Institutions, like people, have varying levels of credit worthiness. Most publicly traded bond offerings are rated by Standard & Poors and Moody’s. They use slightly different codings. The U S Federal Government is considered the safest of all creditors. Corporations like GE receive a AAA rating. This means as far as the rating agency is concerned GE is highly unlikely to default. Ratings go down to junk. As a practical matter most personal investors can feel O.K. about using Baa (Standard & Poors) or BBB (Moody’s) or above. These are considered investment grade bond ratings that can be purchased by banks. It stands to reason that the better the rating the lower the interest rate the borrower will be required to pay. For example, a ten-year AAA bond today will go for about 5.00% while a BBB bond sells for 5.50%. Incidentally, size of the corporation does not mean a good rating. At this time General Motors’ bonds are rated well below investment grade with a rating of B.
- Market place. Interest rates fluctuate all the time in the market. Today the federal government must pay about 4.50% interest to borrow money for ten years. In 1995 they had to pay 5.75%. (Incidentally, that ten year bond in 1995 is being paid off right now probably with money borrowed from the new ten year bond.)
- Tax exempt. A very important category of bonds is exempt from federal and usually local income taxes. These are municipal bonds issued by all types of local political entities from states and cities to school and water districts. Because of their tax exemption coupon rates are lower than a comparable bond issued by a corporation.
Certificates. The institution may be borrowing a large amount of money, say $50 million dollars. This amount will be broken up into bond certificates each worth $1,000. This allows investors of all sizes to invest in the bond offering. It also allows the investors to buy and sell their certificates in the market after the initial offering. Even though each certificate has a face value of $1,000 the last zero is dropped when giving market quotes. For example, a bond quoted for a price of $105 actually sells for $1,050.
Price fluctuations. After the investor has purchased the bond its price will fluctuate in the market. The key driver of fluctuation in price is the fluctuation of interest rates in the free market. For example, assume an investor bought a bond that had a 5.00% coupon. Assume the very next day interest rates in the market doubled to 10.00% for this bond. (Very extreme but it keeps the math simple.) The coupon on the bond does not change; that was fixed when the bond was sold. Consequently, the bond must decline in value so that its yield will reflect the new market reality. In this case the bond will decline by 50. This is because an investor can buy a brand new bond for $1,000 paying 10% or $100 a year or she can buy the old bond for $500 paying $50 a year and also get a 10% yield. While free market interest rates are the most important cause of bond price fluctuation bonds will also fluctuate in price if the credit rating of the issuer changes. Maturity does not change but the time to maturity is shorter every day, thus reducing the price volatility.
Current yield.This is the current price of the bond divided by the coupon. Because bond prices fluctuate the current yield fluctuates.
Yield to maturity. This is actually the most important yield for bond investors. It recognizes that despite day-to-day price fluctuations due to changes in the market the bond will someday be repaid in full. Consequently, if an investor could buy a five-year bond today selling for $500 he will get $1,000 when the bond matures. The market assumes that a portion of that $500 difference will be recovered every day or in this case $100 for each of the next five years. In this example, if nothing else changes, the price of the bond in the market place will rise from $500 to $600 in one year. The investor has received $50 in interest payments and $100 in accretion. This means the actual yield to maturity at the time of purchase for $500 was 30% ($150 of interest and accretion divided by $500 the cost of the bond.) This little example is very unrealistic and is used here just to keep the math simple. The actual calculation of yield to maturity is complex and requires a bond calculator. Despite complexity yield to maturity is what actually drives the price of a bond.

There are many other characteristics that influence the bond and its value. Some bonds have call privileges. This means that if interest rates fall to a certain amount the issuer can repay the investors early. It is the same idea as refinancing your mortgage. This certainly influences the price as interest rates fall. Liquidity is an important factor. A bond that only trades occasionally will generally sell for less than a comparable highly liquid bond. Some issues have sinking funds meaning the issuer is required to buy a certain number of bonds every year so that the entire issue is retired over the life of the bond. There are also convertible bonds that allow the bondholder to exchange her bonds for stock. Just about every kind of option imaginable has been hung on bonds.

Because there are so many different bond issues and because there are so many different characteristics it can be very difficult for ordinary investors to properly analyze a bond. Usually, it is a good idea to purchase bonds through a broker. It is just as good an idea to become acquainted with the lingo and characteristics of bonds so that you can understand what the broker is telling you.

Better yet for most investors it is a good idea to buy mutual funds that specialize in bonds rather than buying individual bonds. In this way you get professional managers and a diversified portfolio. Further, the mutual fund is almost certainly priced in a way that ordinary investors can buy shares and make on-going regular investments. Individual bonds are not very investor friendly when it comes to size. As indicated earlier a single bond sells for about $1,000 but few people buy just one. The size in these markets is just staggering. For example, it is actually easier to buy or sell $10 million of government bonds than it is to sell $10 thousand — if you happen to have the $10 million, that is.

Most people have enjoyed the low interest rates in recent years. It has allowed them to refinance their homes and enjoy low credit card rates. However, some investors need current income. Lower interest rates have been hard on them. Bond rates are still well below where they were ten or twenty years ago. But bonds do generate more current income for investors than stocks.