Bond Basics
By JERRY MORGAN, Newsday
<!-- MEDIUM RECTANGLE AD -->When you own stock, you own part of a company. If the company does well, the stock should go up; when it does badly the shares go down.
A bond, on the other hand, is an IOU from a company. It usually doesn't matter if the company performs well or poorly as long as it doesn't default. It owes you money that has to be repaid at a specified time and interest rate.
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</TD></TR></TBODY></TABLE>All this is spelled out in a document called an indenture that you, as a retail buyer, will probably never see. The indenture details the terms of the loans and who gets paid first, since there are often different levels of bondholders.
Despite that, if you're planning on buying bonds, you need financial advice. Bonds aren't easy.
Understanding yields, yields-to- maturity, the wide variety of bond types and the inverse ratio of prices to yields, as well as the difficulty of getting pricing information, puts more demands on an investor's knowledge than stocks do. For example, there are many more different bond issues than stocks, each with a different maturity, and finding prices is more difficult than getting a stock quote. Tens of thousands of municipal bonds are available, many of which trade rarely.
Bond prices and yields move in opposite directions. As bond prices rise, yields go down, and vice versa. If you buy a new bond paying 6 percent when it is issued at what is called par value or 100, you'll get 6 percent. But if rates drop a few years later, and you want to buy that same bond, it may be selling for a premium, and because you pay more, the yield will be lower.
Also, the longer the maturity of the bond, the more volatile its price will be as it continually reacts to the market.
Paying for individual bonds is another adventure for investors. Bonds are bought on a bid/ask basis and the difference, called the spread, is the commission. You'll know which is which immediately, explains author Annette Thau in "The Bond Book" because "it is not difficult to remember which is the bid and which is the ask. Just remember this: if you want to buy, you always pay the higher price. If you want to sell, you receive the lower."
If you prefer to buy a bond fund instead of a bond, you might pay a commission as well as continuing management expenses that affect the return.
So is it better to buy a bond or a bond fund? A lot depends on your savvy, and how much money you have to invest. The less capital you have, the more sense a bond fund makes --with a lot of caveats.
Many financial planners like to "ladder" bonds--that is, buy a selection of bonds that mature every year, so that principal is constantly being returned and reinvested.
They prefer that to the uncertainty of bond funds, which are very different from bonds. When you buy a bond, you get a guaranteed interest rate, a guaranteed maturity date and a guaranteed return of principal (barring the rare default).
You lose those guarantees when you buy a bond fund--once described by Michael Lipper, former head of Lipper Inc., as buying stock in a portfolio of bonds.
Open-end bond funds have no set interest rate, no maturity and no guarantee you will get your money back, as investors discovered the hard way in the 1994 and 1999 bear bond market debacles.
What you do get is professional management, the possibility of a higher total return than just the interest rate and liquidity--the ability to sell easily, which is not always the case with individual bonds.
Load bond funds, which charge a commission, are a dirty word to many planners. But an investor who pays a sales load could be getting good advice for that money.
Whether you're buying bonds or bond funds, you pay. How much varies greatly. Commissions on bond funds can be 4 to 5 percent. Expenses can take an annual .50 to 1 percent off the top. In some cases, you may find that the load plus the annual expenses leave you in a negative position the first year.
To compensate, you hope to have a fund manager who can buy bonds with different maturities and rates to offset market volatility, and perhaps provide capital gains that will give you a higher return than the interest alone would get.
If you want to buy Treasury bonds, you can use the TreasuryDirect program and buy bonds from the government at institutional rates, which is a very good deal. You can sell those bonds, if you don't hold them to maturity, through the SellDirect program for a fee.
If you want to buy a Treasury bond fund, experts say, don't pay a load, and find one with the lowest possible expenses because these are essentially generic funds.
But bonds, as we said, aren't easy. Web sites such as www.investinginbonds.com, run by trade group The Bond Market Association has generic explanations of what bonds are, as well as a glossary.
You can also get pricing information on some bonds on the site. Thau's book, "The Bond Book," is a complete look at bonds and bond funds, and contains resource information after each chapter.
By JERRY MORGAN, Newsday
<!-- MEDIUM RECTANGLE AD -->When you own stock, you own part of a company. If the company does well, the stock should go up; when it does badly the shares go down.
A bond, on the other hand, is an IOU from a company. It usually doesn't matter if the company performs well or poorly as long as it doesn't default. It owes you money that has to be repaid at a specified time and interest rate.
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</TD></TR></TBODY></TABLE>All this is spelled out in a document called an indenture that you, as a retail buyer, will probably never see. The indenture details the terms of the loans and who gets paid first, since there are often different levels of bondholders.
Despite that, if you're planning on buying bonds, you need financial advice. Bonds aren't easy.
Understanding yields, yields-to- maturity, the wide variety of bond types and the inverse ratio of prices to yields, as well as the difficulty of getting pricing information, puts more demands on an investor's knowledge than stocks do. For example, there are many more different bond issues than stocks, each with a different maturity, and finding prices is more difficult than getting a stock quote. Tens of thousands of municipal bonds are available, many of which trade rarely.
Bond prices and yields move in opposite directions. As bond prices rise, yields go down, and vice versa. If you buy a new bond paying 6 percent when it is issued at what is called par value or 100, you'll get 6 percent. But if rates drop a few years later, and you want to buy that same bond, it may be selling for a premium, and because you pay more, the yield will be lower.
Also, the longer the maturity of the bond, the more volatile its price will be as it continually reacts to the market.
Paying for individual bonds is another adventure for investors. Bonds are bought on a bid/ask basis and the difference, called the spread, is the commission. You'll know which is which immediately, explains author Annette Thau in "The Bond Book" because "it is not difficult to remember which is the bid and which is the ask. Just remember this: if you want to buy, you always pay the higher price. If you want to sell, you receive the lower."
If you prefer to buy a bond fund instead of a bond, you might pay a commission as well as continuing management expenses that affect the return.
So is it better to buy a bond or a bond fund? A lot depends on your savvy, and how much money you have to invest. The less capital you have, the more sense a bond fund makes --with a lot of caveats.
Many financial planners like to "ladder" bonds--that is, buy a selection of bonds that mature every year, so that principal is constantly being returned and reinvested.
They prefer that to the uncertainty of bond funds, which are very different from bonds. When you buy a bond, you get a guaranteed interest rate, a guaranteed maturity date and a guaranteed return of principal (barring the rare default).
You lose those guarantees when you buy a bond fund--once described by Michael Lipper, former head of Lipper Inc., as buying stock in a portfolio of bonds.
Open-end bond funds have no set interest rate, no maturity and no guarantee you will get your money back, as investors discovered the hard way in the 1994 and 1999 bear bond market debacles.
What you do get is professional management, the possibility of a higher total return than just the interest rate and liquidity--the ability to sell easily, which is not always the case with individual bonds.
Load bond funds, which charge a commission, are a dirty word to many planners. But an investor who pays a sales load could be getting good advice for that money.
Whether you're buying bonds or bond funds, you pay. How much varies greatly. Commissions on bond funds can be 4 to 5 percent. Expenses can take an annual .50 to 1 percent off the top. In some cases, you may find that the load plus the annual expenses leave you in a negative position the first year.
To compensate, you hope to have a fund manager who can buy bonds with different maturities and rates to offset market volatility, and perhaps provide capital gains that will give you a higher return than the interest alone would get.
If you want to buy Treasury bonds, you can use the TreasuryDirect program and buy bonds from the government at institutional rates, which is a very good deal. You can sell those bonds, if you don't hold them to maturity, through the SellDirect program for a fee.
If you want to buy a Treasury bond fund, experts say, don't pay a load, and find one with the lowest possible expenses because these are essentially generic funds.
But bonds, as we said, aren't easy. Web sites such as www.investinginbonds.com, run by trade group The Bond Market Association has generic explanations of what bonds are, as well as a glossary.
You can also get pricing information on some bonds on the site. Thau's book, "The Bond Book," is a complete look at bonds and bond funds, and contains resource information after each chapter.
