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- Bond Trading
Bonds are an excellent investment because they offer investors dependable income, a certain amount of safety and also portfolio diversification. Because bonds usually have an anticipated income stream of payments and repayment of principal investment, many people invest in bonds to preserve their capital, grow their capital and receive a consistent amount of interest income.
- A Basic Understanding of Bonds: Investing in bonds is a very easy way to conserve as well as increase your capital investment. Simply put, bonds are I.O.U.s that accrues interest over a period of time. Buying a bond means that you are loaning your money to a corporation, a government, a federal agency or any other municipality. Each bond is a loan for a defined time frame. When the bond reaches maturity (specified time frame has ended), then the bondholder can cash in the bond and be paid the amount they loaned plus any
accrued interest earned.
- Types of Bonds
There are a variety of bonds suitable for your specific needs. These range from agencies to zero coupon bonds.
- Secured bonds are bonds which are secured by specific collateral. The most common type of secured bond is the mortgage bond. This collateral (ie: mortgage bond) would then be transferred to the bondholder in the event of default. Secured bonds are backed by either real estate or actual physical equipment that can be sold. Secured bonds are believed to be high grade (A bond with a rating of AAA or AA, the two highest ratings)
and therefore safe investment bonds. Other bonds are secured by the revenues created by projects. If an issuer defaults and has secured and unsecured bonds outstanding, the secured bondholders are always paid first, then unsecured bondholders are paid. Unsecured bonds carry a larger risk than secured bonds. Larger risk bonds, for the most part, will pay higher yields and lower risk bonds will pay lower yields.
- Debentures are unsecured bonds, backed only by the general ability of the corporation to pay its outstanding debt. If the company goes bankrupt, then debentures can't be paid until secured bondholders are paid.
- Zero-coupon bonds can either be secured or unsecured. Zero coupon bonds are issued at a large discount from the face value. This is because zero coupon bonds pay all the interest at maturity, making no payments until they mature. Zero coupon bonds offer quite a few advantages to bond investors. A zero coupon bond has the advantage of being free of reinvestment risk, although there is no way to enjoy the effects of a rise in market interest rates. Zero coupon bonds are conducive to being sensitive to and fluctuations in interest rates, because there are no coupon payments to reduce the impact of interest rate changes. In addition, markets for zero coupon bonds are relatively illiquid. Under U.S. tax law, the assumed interest on a zero coupon bond is taxable as it accumulates, even though there is no cash flow.
- Municipal bonds are issued by state or city governments, or their agencies, and come in two principal varieties:
- General obligation bonds are backed by the full taxing authority of the government.
- Revenue bonds are backed only by the receipts from a specific source of revenue, such as a bridge or highway toll, and are not perceived to be as secure as general obligation bonds.
The interest paid to holders of both revenue and general obligation municipal bonds is exempt from federal income taxes and, usually, income taxes of the issuing state.
- U.S. Treasury bonds, which when issued in maturities of a year or less are called Treasury bills and in maturities of under ten years may be called treasury notes, are backed by the federal government. Treasury bonds are a negotiable, coupon-bearing debt obligation issued by the U.S. Government and backed by the U.S. Government, having a maturity of more than 7 years. On U.S. Treasury bonds interest is paid semi-annually. Treasury bonds are exempt from state and local taxes. These securities have the longest maturity of any bond issued by the U.S. Treasury, from 10 to 30 years. The 30-year bond is also known as the long bond. Denominations range from $1000 to $1 million. Treasury bonds pay interest every 6 months at a fixed coupon rate. These bonds are not callable, but some older Treasury bonds available on the secondary market are callable within five years of the maturity date. also called U.S. Treasury bond or T-bond.
- Callable bonds are issues that can be redeemed, or called, before they mature. A company might decide to call its bonds if interest rates fell so far that it could issue new bonds at a lower rate and therefore save money. This is obviously to the corporation's advantage, and not yours. Not only would you lose your comparatively high yield, but you'd also have to figure out where to invest the unexpected payout in a climate of lower interest
rates. And if the bond were called for more than you paid for it, you'd also owe taxes on the difference.
- Convertible bonds are corporate bonds that can be exchanged for the same company's common stock at a fixed ratio (a specified amount of bonds for a specified number of shares of stock). Convertible features make some companies' bonds more favorable by offering the possibility of an equity kicker: If the price of the stock rises enough after you purchase the convertible bonds, you can profit by exchanging your bonds for stock.
For example, suppose you purchase five convertible bonds issued at $1,000 each. The bonds pay 7% and each is convertible into 40 shares of stock. When you buy the bonds, the company is selling at $20 a share. Because break-even conversion price is $25, you've paid $5 a share for the conversion privilege. If the companies stock climbs above $25, you can make a profit by converting your bonds to stock. If the price were to go to $30, you could quickly turn your $5,000 bond investment into $6,000 worth of stock.
Because their fate is so closely tied to that of the stock price of the issuing firm, convertible bonds tend to be more closely in sync with the stock market rather than the bond market.
- Junk Bond: A high-risk, non-investment-grade bond with a low credit rating, (usually BB or lower); as a consequence, it usually has a high yield. Junk bonds are the opposite of investment grade bonds.
- Bond Rating is a measure of the quality and safety of a bond, based on the issuer's financial situation. More specifically, an evaluation from a rating service indicating the possibility that a debt issuer will be able to meet scheduled interest and principal repayments. Typically, AAA is highest (best), and D is lowest (worst).
- Bond Equivalent Yield is a restating of the yield on a debt instrument in terms of semiannual interest, in order to facilitate direct comparison to an interest-bearing coupon security.
- How to Buy Bonds - How to Invest
There are multiple ways to invest in bonds. You can purchase individual bonds, bond funds or unit investment trusts.
- Individual Bonds
There is a large variety of individual bonds to choose from. Your financial planner can help you find a bond that matches your investment needs and your investment expectations. Most individual bonds are bought and sold in the over-the-counter (OTC) market, although some corporate bonds are also listed on the New York Stock Exchange.
If you’re interested in purchasing a new bond issue, your investment advisor will provide you with the security’s offering statement, or prospectus—the official document that explains the bond’s terms and features, as well as any risks that investors should know about before investing.
You can also purchase and sell bonds which have already been issued. This is known as the secondary market. Many dealers keep inventories of a variety of outstanding or previously issued bonds.
Bond prices normally include a markup, which constitutes the dealer’s costs and profit. If a broker or dealer has to seek out a specific bond that is not in their inventory for a customer, a commission may be added to compensate for the costs and efforts of serving the customer’s specific needs. Each firm establishes its own prices within regulatory guidelines, which can vary depending upon the size of the transaction, the type of bond you are purchasing and the amount of service that the firm provides.
There are a number of services to help investors compare current prices of bonds. For municipal bond prices, benchmark yields are available on the Internet and in some newspapers. The Bond Market Association offers recent and historical price data on corporate and municipal bonds through their web site.
For U.S. Treasuries, corporate and other bonds, there are also a number of Internet sites, media sources and vendors that provide current information on new issues.
- Bond Funds
Bond funds offer bond investors another way to invest in the bond markets. Bond funds, like stock funds, offer professional selection and management of a portfolio of securities. Bond funds allow an investor to diversify risks across a wide range of issues and offer a number of other conveniences, such as the option of having interest payments either reinvested or distributed periodically.
Because a fund is actively managed, with bonds being added to and eliminated from the portfolio in response to market conditions and investor demand, bond funds do not have a specified maturity date. With open-end funds, you are able to purchase or sell your share in the fund whenever you want. Because the market value of bonds fluctuates, a fund’s net asset value will change from day to day, reflecting the cumulative value of the bonds in the portfolio. Therefore, when you sell, the value of your investment could be higher or lower,
depending upon how the fund has performed since you bought your share. Closed-end bond funds have a specific number of shares that are listed and traded on a stock exchange. Because the fund managers are less concerned about having to meet investor redemptions on any given day, their strategies can be much more aggressive.
- Bond Prices
Most funds charge annual management fees averaging 1%, while some also impose initial sales charges (some up to 5%) or fees for selling shares. Because the annual management fees will lower returns, investors need to be aware of the total costs when calculating their overall expected returns. The minimum initial investment is usually between $1,000 and $2,500, and $500 for retirement accounts.
- Bond Unit Investment Trusts
Bond unit investment trusts offer a fixed portfolio of investments in government, municipal, mortgage backed or corporate bonds, which are professionally chosen and remain constant throughout the life of the trust. The benefit of a unit trust is that you know exactly how much you will earn while you’re invested in it, because the composition of the portfolio remains stable. Also, since the unit trust is not an actively managed pool of assets, there is generally no management fee, but investors do pay a sales charge, plus a small annual fee to cover
supervision, evaluation expenses and trustee fees. The minimum initial investment is usually between $1,000 and $5,000. As an investor, you can earn interest income during the life of the trust and recover your principal as securities within the trust are redeemed. The trust typically ends when the last investment matures.
- A Premium Bond is a bond issued by the United Kingdom government's National Savings and Investments. The government promises to buy back the bond on request for its original price. The popularity of Premium Bonds has grown dramatically. Around 23 million people hold Premium Bonds, issued by NS&I. Every month more than a million premium bond numbers are chosen at random and two bond-holders pocket £1 million. Other premium bonds range from around a million at £50 to four at £100,000. Each person may own up to
£30,000 in Premium Bonds. Bonds are currently sold in multiples of £10, with a value of £1 per bond and a minimum purchase of 100 bonds.
- U.S. Series EE Savings Bonds
More and more taxpayers are investing in U.S. Savings Bonds. The popularity of series ee savings bonds is due in large part to their safety, relatively low cost, and tax deferral advantages. Since 1990, the Bonds have had an additional feature that will allow owners to entirely exclude interest accrued on the series ee savings bonds if used to pay for qualified educational expenses.
- Series EE Savings Bonds are purchased at half their face value. When a bondholder holds series ee savings bonds for five years or more, the interest on series EE Bonds becomes market based, retroactive to the first day of purchase. The series ee bonds currently receive interest at either 85% of the average return during that time on marketable Treasury securities with five years remaining to their maturity or a guaranteed minimum of
four percent.
Some bond investors purchase Series EE Savings Bonds bacause of their tax benefits under current tax code which gives owners a choice in reporting interest. Taxpayers may pay tax on interest as it accrues or defer paying tax on the interest until the bond matures. Interest on Series EE Bonds escapes state and local income tax completely.
The tax treatment of Series EE Bonds makes them an popular investment for saving for college education for children. Starting in 1990, there has been an alternative method for using Series EE Bonds for college savings plans. The interest on qualified U.S. Savings Bonds issued after 1989 is entirely free from federal tax if the money is used to pay for higher education costs.
- General Features of I Bonds
I Bonds are a new type of bond designed for bond investors trying to protect the purchasing power of their investment and earn a guaranteed real rate of return. I Bonds are an accrual-type security, which means that interest is added to the bond monthly and paid when the bond is paid. I Bonds are sold at face value, meaning you pay $50 for a $50 I Bond, and the IBond grows in value with inflation-indexed earnings for up to 30 years. The Treasury is offering the I Bond to encourage more Americans to save for their future. The I Bond offers
bond investors a bond with a fixed rate in addition to semiannual inflation adjustments that will help protect purchasing power. The I Bond will not replace Series EE bonds; both will be available to give investors a choice.
The earnings rate of an I Bond is a combination of two separate rates: a fixed rate of return and a variable semiannual inflation rate. The fixed rate remains the same throughout the life of the I Bond, while the semiannual inflation rate can vary every six months. The semiannual inflation rate is combined with the fixed rate of an I Bond to determine the I Bond's earnings rate for the next six months.
I Bonds increase in value each month, and interest is compounded semiannually. I Bonds increase in value on the first day of the month. An I Bond's issue date is the month and year when the full issue price is received by an I Bond issuing agent.
I Bonds are U.S. Treasury securities backed by the U.S. Government. I Bonds even protect you from the effects of deflation. In the rare event that the CPI-U is negative during a period of deflation and the decline in the CPI-U is greater than the fixed rate, the redemption value of your I Bonds will remain the same until the earnings rate becomes greater than zero. I Bonds earn interest for up to 30 years.
Earnings are exempt from state and local income taxes. Federal income taxes can be deferred for up to thirty years, or until redemption or other taxable disposition, whichever comes first.
If you qualify, you can exclude all or part of the interest on I Bonds (and on eligible EE bonds) from income as long as the proceeds are used to pay for tuition and fees at eligible post-secondary educational institutions
- Investing in and redeeming I Bonds:
On September 1, 1998, six denominations ($50, $75, $100, $500, $1,000, and $5,000) were made available for purchase through financial institutions across the country. Two additional denominations ($200 and $10,000) were added in May 1999.
I Bonds fit all budgets. They are sold at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. This makes it easy to keep track of the growth of your bond's value.
You can only buy up to $30,000 worth of I Bonds each calendar year. The purchase limitation for Series I Bonds isn't affected by purchases of Series EE Bonds.
You can cash an I Bond anytime six months after the issue date to get the original investment plus the earnings. However, I Bonds are meant to be longer-term investments. So, if you redeem an I Bond within the first five years, there is a 3-month earnings penalty. For example, if you redeem an I Bond after 18-months, you'll get 15 months of earnings.
- Bond Calculator:
A bond calculator can help you determine whether or not you are better off investing in taxable or municipal bonds. Yields on municipal bonds, though lower than those on taxable bonds, are many times higher than they would need to be to fully account for their tax-exempt status.
Reference:
www.Meanwhile.com
Cite this as:
YouSigma. (2008). "Investing in Bonds." From http://www.yousigma.com.
