Understanding bond issuers

A major dimension in which bonds differ is the organizations that issued the bonds. The issuer of a bond is actually borrowing money from the folks who buy the bonds when they’re originally sold.

Who issues a bond is hugely important. First, it determines how likely the bond issuer is to be able to pay back the bonds’ principal when the bonds mature. Second, the type of entity doing the bond issuance determines the taxation of the bond’s interest payments.

The following list covers the major options for who issues bonds (in order of popularity) and tells you when each option may make sense for you:

• Corporate bonds: Companies such as Boeing, Ford, Johnson & Johnson, and VISA issue corporate bonds. Corporate bonds pay interest that’s fully taxable at the federal and state levels. Thus, such bonds make sense for investing inside retirement accounts. Lower-tax-bracket investors can consider investing in such bonds outside a tax-sheltered retirement account. (Higher-tax-bracket investors should consider municipal bonds, which appear later in this list.)

• Treasury bonds: Treasuries are issued by the U.S. government. Treasuries pay interest that’s state-tax-free but federally taxable. Thus, they make sense if you want to avoid a high state income tax bracket but not a high federal income tax bracket. However, most people in a high state income tax bracket also happen to be in a high federal income tax bracket. Such investors may be better off in municipal bonds (explained next), which are both free of federal and state income tax (in their state of issuance). The best use of Treasuries is in place of bank certificate of deposits (CDs), as both types of investments have government backing. Treasuries that mature in the same length of time as a CD may pay the same interest rate or a better one.

  Bank CD interest is fully taxable, whereas a Treasury’s interest is state-tax-free.

• Municipal bonds: Municipal bonds (muni bonds, for short) are issued by state or local governments. Muni bonds pay interest that’s free of federal and state taxes to residents in the state of issue. For example, if you live in New York and buy a bond issued by a New York government agency, you probably won’t owe New York state or federal income tax on the interest. The government organizations that issue municipal bonds know that the investors who buy these bonds don’t have to pay most or any of the income tax that is normally assessed on other bonds’ interest payments. Therefore, the issuing governments can pay a lower rate of interest. If you’re in a high tax bracket and want to invest in bonds outside of your tax-sheltered retirement accounts, compare the yield on a given muni bond (or muni bond fund) to the after-tax yield on a comparable taxable bond (or bond fund).
• Convertible bonds: Convertible bonds are bonds that you can convert under a specified circumstance into a preset number of shares of stock in the company that issued the bond. Although these bonds do pay taxable interest, their yield is lower than that of nonconvertible bonds because convertibles offer you the potential to make more money from the underlying stock.

• International bonds: You can buy bonds issued by foreign countries. These international bonds are riskier because their interest payments can be offset by currency price changes. The prices of foreign bonds tend not to move in tandem with U.S. bonds. Foreign bond values benefit from, and thus protect against, a declining U.S. dollar; therefore, they offer some diversification value. Conversely, when the U.S. dollar appreciates versus most currencies (which happened during the early 1980s, from 1995 to 2002, and during the early 2010s), that lowers a U.S. investor’s return on foreign bonds.

  Foreign bonds aren’t vital holdings for a diversified portfolio. They’re generally more expensive to purchase and hold than comparable domestic bonds.

Considering credit (default) risk

Closely tied to what organizations are actually issuing the bonds, bonds also differ in the creditworthiness of their issuers. Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch rate the credit quality and likelihood of default of bonds.

The credit rating of a bond depends on the issuer’s ability to pay back its debt. Bond credit ratings are usually done on some sort of a letter-grade scale. AAA usually is the highest rating, and ratings descend through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on.

• AAA- and AA-rated bonds are considered to be high-grade or high-credit-quality bonds. Such bonds possess little chance of default (a fraction of 1 percent).
• BBB-rated bonds are considered to be investment-grade or general-quality bonds.
• BB- or lower-rated bonds are known as junk bonds (or as their marketed name, high-yield bonds). Junk bonds, also known as non-investment-grade bonds, are more likely to default; perhaps as many as 2 percent per year actually default.

To minimize investing in bonds that default, purchase highly rated bonds. Now, you might ask why investors would knowingly buy a bond with a low credit rating. They may purchase one of these bonds because the issuer pays a higher interest rate on lower-quality bonds to attract investors. The lower a bond’s credit rating and quality, the higher the yield you can and should expect from such a bond.

Poorer-quality bonds aren’t for the faint of heart, because they’re generally more volatile in value. I don’t recommend buying individual junk bonds; consider investing in these only through a well-run junk-bond fund. (Keep in mind that the volatility profile for a junk-bond fund is closer to stocks than it is for high-grade corporate bonds.)

Making sense of bond maturities

Bonds are generally classified by the length of time until maturity. Maturity simply means the time at which the bond promises to pay back your principal if you hold the bond. Maturity could be next year, in 7 years, in 15 years, and so on.

Bonds classifications are as follows:

• Short-term bonds mature in the next few years.
• Intermediate-term bonds come due within three to ten years.

• Long-term bonds mature in more than 10 years and generally up to 30 years.

  A small number of companies (such as Coca-Cola, Disney, and IBM) issue 100-year bonds. I don’t recommend buying such bonds, however, especially those issued during a period of low interest rates, because they get hammered if long-term interest rates spike higher.

You should care how long a bond takes to mature because maturity gives you some sense of how volatile a bond may be if overall market interest rates change. If interest rates fall, bond prices rise; if interest rates rise, bond prices fall. Longer-term bonds generally drop more in price when the overall level of interest rates rises.

If you hold a bond until it matures, you get your principal back unless the issuer defaults. In the meantime, however, if interest rates rise, bond prices fall. The reason is simple: If the bond that you hold is issued at, say, 4 percent, and interest rates on similar bonds rise to 5 percent, no one (except someone who doesn’t know any better) will want to purchase your 4 percent bond. The value of your bond has to decrease enough so it effectively yields 5 percent.

Most of the time, long-term bonds pay higher yields than short-term bonds do. You can look at a chart of the current yield of similar bonds plotted against when they mature — a chart known as a yield curve. At most times, this curve slopes upward. Investors generally demand a higher rate of interest for taking the risk of holding longer-term bonds.

Finding uses for bonds

Because their value fluctuates, you’re more likely to lose money if you’re forced to sell your bonds sooner rather than later. In the short term, if the bond market happens to fall and you need to sell, you could lose money. In the long term, as is the case with stocks, you’re far less likely to lose money.

Following are some common situations in which investing in bonds can make sense:

• You’re looking to make a major purchase. This purchase should be one that won’t happen for at least two years. Examples include buying a car or a home. Short-term bonds may work for you as a higher-yielding and slightly riskier alternative to money market funds.
• You want to diversify your portfolio. Bonds don’t move in perfect tandem with the performance of other types of investments, such as stocks. In fact, in a poor economic environment (such as during the Great Depression of the 1930s or the 2008 financial crisis), bonds may appreciate in value while riskier investments such as stocks decline.
• You’re interested in diversifying your long-term investments. You may invest some of your money in bonds as part of a long-term investment strategy, such as for retirement. You should have an overall plan for how you want to invest your money (see Chapter 2). Aggressive younger investors should keep less of their retirement money in bonds than older folks who are nearing retirement.
• You need income-producing investments. When you’re retired (probably much later in life) or not working, bonds can be useful because they’re better at producing current income than many other investments.

I don’t recommend putting your emergency cash reserve in bonds. That’s what a money market fund or bank savings/credit union account is for (see Chapters 6 and 7).

Don’t put too much of your long-term investment money in bonds, either. Bonds are generally inferior investments for making your money grow. Growth-oriented investments — such as stocks, real estate, and your own business — hold the greatest potential to build real wealth.

Comparing other lending investments with bonds

As I explain in Chapter 1, lending investments are those in which you lend your money to an organization, such as a bank, company, or government, that typically pays you a set or fixed rate of interest. Ownership investments, by contrast, provide partial ownership of a company or some other asset, such as real estate, that has the ability to generate revenue and potential profits.

Lending investments aren’t the best choice if you really want to make your money grow, but even the most aggressive investors should consider placing some of their money in lending investments.

In this chapter, I focus on bonds, but I’d be remiss if I failed to point out that lending investments are everywhere: banks, credit unions, brokerage firms, insurance companies, and mutual fund companies. Lending investments that you may have heard of include bank accounts (savings and CDs), Treasury bills and other bonds, bond mutual funds and exchange-traded bond funds, mortgages, and guaranteed-investment contracts (GICs).

Bonds, money market funds, and bank savings vehicles are hardly the only lending investments. A variety of other companies are more than willing to have you lend them your money and pay you a relatively fixed rate of interest. In most cases, though, you’re better off staying away from the investments described in the following sections.

Too many investors get sucked into lending investments that offer higher yields and are pitched as supposedly better alternatives to bonds. Remember: Risk and return go hand in hand, so higher yields mean greater risk, and vice versa.

One of the allures of nonbond lending investments, such as private mortgages, GICs, and CDs, is that they don’t fluctuate in value — at least not that you can see. Such investments appear to be safer and less volatile. You can’t watch your principal fluctuate in value because you can’t look up the value daily, the way you can with bonds and stocks.

But the principal values of your mortgage, GIC, and CD investments really do fluctuate; you just don’t see the fluctuations! Just as the market value of a bond drops when interest rates rise, so does the market value of these investments — and for the same reasons. At higher interest rates, investors expect a discounted price on a fixed-interest-rate investment because they always have the alternative of purchasing a new mortgage, GIC, or CD at the higher prevailing rates. Some of these investments are actually bought and sold, and behave just like bonds, among investors in what’s known as a secondary market.

If the normal volatility of a bond’s principal value makes you uneasy, try not to follow your investments so closely!

In the sections that follow, I explain common lending investments that are often pitched as bond alternatives with supposedly more stable prices. You can find information on CDs in Chapter 6.

Choosing between bond funds and individual bonds

Unless the bonds you’re considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you’re generally better off investing in bonds through a mutual fund or ETF. Here’s why:

• Diversification is easy with funds and much more difficult with individual bonds. You shouldn’t put your money in a small number of bonds of companies in the same industry or that mature at the same time. It’s difficult to cost-effectively build a diversified bond portfolio with individual issues unless you have more than $1 million that you want to invest in bonds.
• The best funds are cost-effective; individual bonds cost you more money. Great bond funds are yours for less than 0.5 percent per year in operating expenses (see Chapter 10). If you purchase individual bonds through a broker, you’re going to pay a commission. In most cases, the commission cost is hidden; the broker quotes you a price for the bond that includes the commission. Even if you use a discount broker, these fees take a healthy bite out of your investment. The smaller the amount you invest, the bigger the percentage bite. On a $1,000 bond, the commission fee can equal several percent.
• You have better things to do with your time than research bonds and go bond shopping. Bonds are boring, and bonds and the companies that stand behind them aren’t simple to understand. Did you know, for example, that some bonds can be called before their maturity dates? Companies may call bonds, which means they repay the principal before maturity, to save money if interest rates drop significantly. After you purchase a bond, you need to do the same things that a good bond fund portfolio manager needs to do, such as track the issuer’s creditworthiness and monitor other important financial developments. In addition to the direction of overall interest rates, changes in the financial health of the issuing entity company that stands behind the bond strongly affect the price of an individual bond.

Investing in Treasury bonds

If you want to purchase Treasury bonds, buying them through the Federal Reserve’s Treasury Direct program online is generally the lowest-cost method. The Federal Reserve doesn’t charge for buying Treasuries through these online accounts (www.treasurydirect.gov).

You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying Treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through the Federal Reserve is a hassle, as you must transfer the bonds out to a broker to do the selling for you.

The advantage of a fund that invests in Treasuries is that it typically holds Treasuries of differing maturities, thus offering diversification. You can generally buy and sell no-load (commission-free) Treasury bond funds easily and without fees. Funds, however, do charge an ongoing management fee. (See Chapter 10 for my recommendations of Treasury mutual funds with good track records and low management fees.)

Investing in non-Treasury individual bonds

Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying Treasuries. Here’s my advice for doing it right and minimizing the chance of mistakes:

• Buy quality, not yield. Yes, junk bonds pay higher yields, but they also have a much higher chance of default. Also, did you know what a subprime mortgage was before it was all over the news that defaults were on the rise? (Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default.) You’re not a professional money manager who’s trained to spot problems and red flags; stick with highly rated bonds so you don’t have to worry about and suffer through these unfortunate consequences.
• Diversify. Invest in and hold bonds from a variety of companies in different industries to buffer changes in the economy that adversely affect one industry or a few industries more than others. Of the money that you want to invest in bonds, don’t put more than 5 percent in any one bond. Diversification requires a large amount to invest, given the size of most bonds, and trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond fund.
• Understand that bonds may be called early. Many bonds, especially corporate bonds, can legally be called before maturity. In this case, the bond issuer pays you back early because it doesn’t need to borrow as much money or because interest rates have fallen and the borrower wants to issue new bonds at a lower interest rate. Be especially careful about purchasing bonds that were issued at higher interest rates than those that currently prevail. Borrowers pay off such bonds first.
• Shop around. Just like when you buy a car, shop around for good prices on the bonds you have in mind. The hard part is doing an apples-to-apples comparison, because brokers may not offer exactly the same bonds. Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating. Beware of using commission-based brokers. Many of the worst bond-investing disasters have befallen customers of such brokerage firms. Your best bet is to purchase individual bonds through discount brokers.

Evaluating individual bonds you currently hold

Perhaps you’ve already bought some bonds or inherited them. If you already own individual bonds, and they fit your financial objectives and tax situation, you can hold them until maturity, because you already paid a commission when you purchased them. Selling the bonds before their maturity would just create an additional fee. (When the bonds mature, the broker who sold them to you will probably be more than happy to sell you some more. That’s the time to check out good bond funds — see Chapter 10.)

Don’t mistakenly think that your current individual bonds pay the yield that they had when they were originally issued. That yield is the number listed in the name of the bond on your brokerage account statement. As the market level of interest rates changes, the effective yield (the interest payment divided by the bond’s price) on your bonds fluctuates to rise and fall with the market level of rates for similar bonds. So if rates have fallen since you bought your bonds, the value of those bonds has increased — which in turn reduces the effective yield that you’re earning on your invested dollars.