Chapter 7

Exploring Bonds and Other Lending Investments

In This Chapter

Getting the most from a bank

Selecting the right type of bonds for you

Choosing among individual bonds and bond mutual funds

Understanding other lending investments

Lending investments are those in which you lend your money to an organization, such as a bank, company, or government, which 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. However, even the most aggressive investors should consider placing some of their money into lending investments. The following table shows when such investments do and don’t make sense.

Lending investments are everywhere — through banks, credit unions, brokerage firms, insurance companies, and mutual fund companies. Lending investments that you may have heard of include bank accounts (savings and certificates of deposit), Treasury bills and other bonds, bond mutual funds (and now exchange-traded bond funds), mortgages, and guaranteed-investment contracts.

In this chapter, I walk you through these investments, explain what’s good and bad about each, and discuss situations in which you could consider using (or not using) them. I also tell you what to look for — and look out for — when comparing lending investments.

Banks: Considering the Cost of Feeling Secure

Putting your money in a bank may make you feel safe for a variety of reasons. If you’re like most people, your first investing experience was at your neighborhood bank, where you established checking and savings accounts.

Part of the comfort of keeping money in the bank stems from the fact that the bank is where your parents may have first steered you financially. Also, at a local branch, often within walking distance of your home or office, you find vaults, security-monitoring cameras, and barriers in front of the tellers. Most of these things shouldn’t make you feel safer about leaving your money with the bank, however — they’re needed because of bank robberies!

Bank branches cost a lot of money to operate. Guess where that money comes from. From bank depositors, of course! These operating costs are one of the reasons the interest rates that banks pay often pale in comparison to some of the similarly secure alternatives I discuss in this chapter.

Facing the realities of bank insurance

Some people are consoled by the Federal Deposit Insurance Corporation (FDIC) insurance that comes with bank accounts. It’s true that if your bank fails, your account is insured by the U.S. government up to $250,000. So what? Every Treasury bond is issued and backed by the federal government — the same debt-laden organization that stands behind the FDIC. Plenty of other equally safe lending investments yield higher returns than bank accounts.

Just because the federal government stands behind the banking FDIC system doesn’t mean that your money is 100 percent safe in the event of a bank failure. Although you’re insured for $250,000 in a bank, if the bank crashes, you may wait quite a while to get your money back — and you may get less interest than you thought you would. Banks fail and will continue to fail. During the 1980s and early 1990s, and again in the late 2000s, hundreds of insured banks and savings and loans failed annually. (Between the early 1990s and late 2000s, only a handful of banks failed annually.)

Any investment that involves lending your money to someone else or to some organization, including putting your money in a bank or buying a Treasury bond that the federal government issues, carries risk. Although I’m not a doomsayer, any student of history knows that governments and civilizations fail.

Online banking: More for you?

With the continued growth of the online world, you can find more and more banking options online. Of particular appeal are higher-interest online savings accounts. The best of them do pay higher interest rates than their brick-and-mortar peers and money market funds.

Online banks don’t generally have any or many retail branches; they conduct most of their business over the Internet and through the mail. By lowering the costs of doing business, the best online banks may offer better account terms, such as paying you higher interest rates on your account balances. Online banks can also offer better terms on loans.

Online banking is convenient, too. It’s generally available 24/7. You can usually conduct most transactions more quickly on the Internet, and by banking online, you save the bank money, which enables the bank to offer you better deals.

Here’s the issue that I have with online banks: With many online accounts, you face fees and hassles to actually access your money. Also, if you’re looking to park a major chunk of money for a long time, you can do better, for example, with safe bond funds.

Technology allows you to do more and more banking online. But remember to protect yourself and your money. You need to put on your detective hat when investigating online banks and be ready to do some searching for the best and safest deals. Never pick a bank simply because you saw one of their ads or because you know a coworker who uses that bank. These sections tell you what you need to do to evaluate an online bank and how to make the most of banking online.

Evaluating FDIC coverage

So what do you look for in an online bank? First you need to select a bank that participates in the U.S. government-operated Federal Deposit Insurance Corporation (FDIC) program. Otherwise, if the online bank you chose fails, your money isn’t protected. The FDIC covers your deposits at each bank up to $250,000.

To see whether a bank is covered, never simply take the bank’s word for it or accept the bank’s display of the FDIC logo on its website or in its offices as proof. Instead, go to the FDIC’s BankFind page (http://research.fdic.gov/bankfind) to search the database of FDIC-insured institutions. You can search by bank name, city, state, or zip code of the bank. For an insured bank, you can see the date it became insured, its insurance certificate number, the main office location for the bank (and branches), its primary government regulator, and other links to detailed information about the bank. In the event that your bank doesn’t appear on the FDIC list yet claims FDIC coverage, contact the FDIC at 877-275-3342.

Beware that some online banks are able to offer higher interest rates because they’re based overseas and don’t participate in the FDIC program. Participating banks in the FDIC program must pay insurance premiums into the FDIC fund, which, of course, adds to a bank’s costs.

Other online bank issues to investigate

In addition to ensuring that a bank is covered by the FDIC, you should get answers to the following questions:

• What’s the bank’s reputation for its services? Reputation isn’t an easy thing to investigate, but at a minimum, you can conduct an Internet search of the bank’s name along with the word “complaints” or “problems” and examine the results.
• How accessible and knowledgeable are the customer service people at the bank? You want to be able to speak with a helpful person when you need assistance. Look for a phone number on the online bank’s website and call it to see how much trouble you have reaching a live person. Ask the customer service representatives questions (including the following) to determine how knowledgeable and service-oriented they are.
• What are the processes and options for withdrawing your money? This issue is important to discuss with the bank’s customer service people because you want convenient, low-cost access to your money. For example, if a bank lacks ATMs, what does the bank charge you for using other ATMs?
• What are the fees for particular services? You can typically find this information on the bank’s website in a section titled “account terms” or “disclosures.” Also, look for the “Truth in Savings Disclosure,” which answers relevant account questions in a standardized format.

Being wary of the certificate of deposit (CD)

Other than savings accounts, banks also sell certificates of deposit (CDs). CDs are an often overused bank investment — investors use them by default, often without researching their pros and cons. The attraction is that you may get a higher rate of return on a CD than on a bank savings or money market account. And unlike a bond (which I discuss in the “Why Bother with Bonds?” section later in this chapter), a CD’s principal value doesn’t fluctuate. CDs also give you the peace of mind afforded by the government’s FDIC insurance program.

The reason that CDs pay higher interest rates than savings accounts is that you commit to tie up your money for a period of time, such as 6, 12, or 24 months. The bank pays you 1 to 2 percent and then turns around and lends your money to others through credit cards, auto loans, real estate loans, business loans, and so on. The bank then charges those borrowers an interest rate of 10 percent or more. Not a bad business!

When you tie up your money in a CD and later decide you want it back before the CD matures, a hefty penalty (typically about six months’ interest) is shaved from your return. With other lending investments, such as bonds and bond mutual funds, you can access your money without penalty and generally at little or no cost.

In addition to penalties for early withdrawal, CDs yield less than a high-quality bond with a comparable maturity (for example, two, five, or ten years). Often, the yield difference is 1 percent or more, especially if you don’t shop around and simply buy CDs from the local bank where you keep your checking account.

High-tax-bracket investors who purchase CDs outside of their retirement accounts should be aware of a final and perhaps fatal flaw of CDs: The interest on CDs is fully taxable at the federal and state levels. Bonds, by contrast, are available (if you desire) in tax-free (federal and/or state) versions.

You can earn higher returns and have better access to your money when it’s in bonds than you can when it’s in CDs. Bonds make especially good sense when you’re in a higher tax bracket and would benefit from tax-free income in a non-retirement account. CDs make the most sense when you know, for example, that you can invest your money for one year, after which you need the money for some purchase that you expect to make. Just make sure that you shop around to get the best interest rate. If having the U.S. government insurance gives you peace of mind, also take a look at Treasury bonds, which I discuss later in this chapter. Treasury bonds (also known as Treasuries) tend to pay more interest than many CDs.

Swapping your savings account for a money market fund

Because bank accounts generally pay pretty crummy interest rates, you need to think long and hard about keeping your spare cash in the bank.

You can, if you so choose, keep your checking account at your local bank. But you don’t have to. I don’t, because I use a money market fund that offers unlimited check writing at a mutual fund company. I also don’t keep my extra savings in the bank.

Instead of relying on the bank as a place to keep your extra savings, try money market funds, which are a type of mutual fund that doesn’t focus on bonds or stocks. Money market funds offer a higher-yielding alternative to bank savings and bank money market deposit accounts.

Money market funds, which are offered by mutual fund companies (see Chapter 8), are unique among mutual funds because they don’t fluctuate in value and because they maintain a fixed $1-per-share price. As with a bank savings account, your principal investment in a money market fund doesn’t change in value. If you invest your money in a money market fund, it earns dividends (which are just another name for the interest you’d receive in a bank account).

Money market fund advantages

The best money market mutual funds offer the following benefits over traditional bank savings accounts:

• They provide higher yields. The best money market mutual funds historically have paid higher yields because they don’t have the high overhead that banks do. The most efficient mutual fund companies (I discuss them in Chapter 8) don’t have scads of branch offices. (Here’s an exception to the higher-yields rule: The extended period of ultra-low interest rates following the severe recession of 2008 took away the yield advantage of money funds.)

  Banks can get away with paying lower yields because they know that many depositors believe that the FDIC insurance that comes with a bank savings account makes it safer than a money market mutual fund. Also, the FDIC insurance is an expense that banks ultimately pass on to their customers.

• They come in a variety of tax-free versions. So if you’re in a high tax bracket (see Chapter 3), tax-free money market funds offer you something that bank accounts don’t.

Another useful feature of money market mutual funds is the ability they provide you to write checks, without charge, against your account. Most mutual fund companies require that the checks that you write be for larger amounts — typically at least $250. They don’t want you using these accounts to pay all your small household bills, because checks cost money to process.

However, a few money market funds (such as those that brokerage cash management accounts at firms like Charles Schwab, TD Ameritrade, Vanguard, and Fidelity) allow you to write checks for any amount and can completely replace a bank checking account. Do keep in mind that some brokerage firms hit you with service fees if you don’t have enough assets with them or don’t have regular monthly electronic transfers, such as through direct deposit of your paycheck or money transfer from your bank account. With these types of money market funds, you can leave your bank altogether because these brokerage accounts often come with debit cards that you can use at bank ATMs for a nominal fee.

Money market funds are a good place to keep your emergency cash reserve of at least three to six months’ living expenses. They’re also a great place to keep money awaiting investment elsewhere in the near future. If you’re saving money for a home that you expect to purchase soon (in the next year or so), a money market fund can be a safe place to accumulate and grow the down payment. You don’t want to risk placing such money in the stock market, because the market can plunge in a relatively short period of time.

Just as you can use a money market fund for your personal purposes, you also can open a money market fund for your business. I have one for my business. You can use this account to deposit checks that you receive from customers, to hold excess funds, and to pay bills via the check-writing feature.

Money market fund disadvantages (if you’d really call them that)

Higher yields, tax-free alternatives, and check writing — money market funds almost sound too good to be true. What’s the catch? Good money market funds really don’t have a catch, but you need to know about one difference between bank accounts and money market mutual funds: Money market funds aren’t insured (however, they were for a one-year period during the 2008–2009 financial crisis).

As I discuss earlier in this chapter, bank accounts come with FDIC insurance that protects your deposited money up to $250,000. So if a bank fails because it lends too much money to people and companies that go bankrupt or abscond with the funds, you should get your money back from the FDIC.

The lack of FDIC insurance on a money market fund shouldn’t trouble you. Mutual fund companies can’t fail, because they have a dollar invested in securities for every dollar that you deposit in their money market funds. By contrast, banks are required to have available just a portion, such as 10 to 12 cents, for every dollar that you hand over to them (the exact amount depends on the type of deposit).

A money market fund’s investments can decline slightly in value, which can cause the money market fund’s share price to fall below a dollar. Cases have occurred where money market funds bought some bad investments (this happened more during the 2008–2009 financial crisis). However, in nearly every case, the parent company running the money market fund infused cash into the affected fund, thus enabling it to maintain the $1-per-share price.

The only money market funds that did “break the buck” didn’t take in money from people like you or me; in one case, the fund was run by a bunch of small banks for themselves. This money market fund made some poor investments. The share price of the fund declined by 6 percent, and the fund owners decided to disband the fund; they didn’t bail it out, because they would have been repaying themselves. In another case, a money market fund that took in money from institutions declined by 3 percent.

Stick with bigger mutual fund companies if you’re worried about the lack of FDIC insurance (or consider an online bank savings account with FDIC and reasonable fees). These companies have the financial wherewithal and the largest incentive to save a foundering money market fund. Fortunately, the bigger fund companies have the best money market funds anyway. You can find more details about money market funds in Chapter 8.

Why Bother with Bonds?

Conservative investors prefer bonds (that is, conservative when it comes to taking risk, not when professing their political orientation). Otherwise-aggressive investors who seek diversification or investments for shorter-term financial goals also prefer bonds. The reason? Bonds offer higher yields than bank accounts, usually without the volatility of the stock market.

Bonds are similar to CDs, except that bonds are securities that trade in the market with a fluctuating value. For example, you can purchase a bond, scheduled to mature five years from now, that a company such as the retailing behemoth Wal-Mart issues. A Wal-Mart five-year bond may pay you 5.25 percent interest. The company sends you interest payments on the bond for five years. And as long as Wal-Mart doesn’t have a financial catastrophe, the company returns your original investment to you after the five years is up. So in effect, you’re loaning your money to Wal-Mart (instead of to the bank when you deposit money in a bank account).

The worst that can happen to your bond investment is that the business goes into a tailspin and the company ends up in financial ruin — also known as bankruptcy. If the company does go bankrupt, you may lose all your original investment and miss out on the remaining interest payments you were supposed to receive.

But bonds that high-quality companies issue are quite safe — they rarely default. Besides, you don’t have to invest all your money earmarked for bonds in just one or two bonds. If you own bonds in many companies (which you can easily do through a bond mutual fund or exchange-traded fund) and one bond unexpectedly takes a hit, it affects only a small portion of your portfolio. And unlike CDs, you can generally sell your bonds anytime you want at minimal cost. (Selling and buying most bond mutual funds costs nothing, as I explain in Chapter 8.)

Bond investors accept the risk of default because bonds generally pay you more than bank savings accounts and money market mutual funds. But there’s a catch. As I discuss later in this chapter, bonds are riskier than money market funds and savings accounts because their value can fall if interest rates rise. Plus you’re forgoing the security of FDIC insurance (which bank accounts have). However, bonds tend to be more stable in value than stocks. (I cover the risks and returns of bonds and stocks in Chapter 2.)

Investing in bonds is a time-honored way to earn a better rate of return on money that you don’t plan to use within the next couple of years or more. As with stocks, bonds can generally be sold any day that the financial markets are open. Because their value fluctuates, though, 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 longer term, as is the case with stocks, you’re far less likely to lose money.

Don’t put your emergency cash reserve into bonds — that’s what a money market fund or bank savings account is for. And don’t put too much of your longer-term investment money into bonds, either. As I explain in Chapter 2, 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 wealth.

Here 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, such as buying a home or some other major expenditure. Shorter-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 tandem with the performance of other types of investments, such as stocks. In fact, in a terrible economic environment (such as during the Great Depression in the early 1930s or the financial crisis of 2008), bonds may appreciate in value while riskier investments such as stocks plunge.
• You’re interested in long-term investments. You may invest some of your money in bonds as part of a longer-term investment strategy, such as for retirement. You should have an overall plan for how you want to invest your money, sometimes referred to as an asset allocation strategy (see Chapter 8). Aggressive, younger investors should keep less of their retirement money in bonds than older folks who are nearing retirement.
• You need income-producing investments. If you’re retired or not working much, bonds can be useful because they’re better at producing current income than many other investments.

Assessing the Different Types of Bonds

Bonds differ from one another according to a number of factors — length (number of years) to maturity, credit quality, and the entities that issue the bonds (the latter of which has tax implications that you need to be aware of). After you have a handle on these issues, you’re ready to consider investing in individual bonds and bond mutual funds.

Unfortunately, due to shady marketing practices by some investing companies and salespeople who sell bonds, you can have your work cut out for you while trying to get a handle on what many bonds really are and how they differ from their peers. But don’t worry. In the following sections, I help you wade through the muddy waters.

Determining when you get your money back: Maturity matters

Maturity simply means the time at which the bond promises to pay back your principal — next year, in 7 years, in 15 years, and so on. A bond’s maturity gives you a good (although far-from-perfect) sense of how volatile a bond may be if interest rates change. If interest rates fall, bond prices rise; if interest rates rise, bond prices fall. Longer-term bonds drop more in price when the overall level of interest rates rises.

Suppose you’re considering investing in two bonds that the same organization issues, and both yield 7 percent. The bonds differ from one another only in when they’ll mature: One is a 2-year bond; the other is a 20-year bond. If interest rates were to rise just 1 percent (from 7 percent to 8 percent), the 2-year bond may decline about 2 percent in value, whereas the 20-year bond could fall approximately five times as much — 10 percent.

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, 7 percent, and interest rates on similar bonds rise to 8 percent, no one (unless they don’t know any better) wants to purchase your 7-percent bond. The value of your bond has to decrease enough so that it effectively yields 8 percent.

Bonds are generally classified by the length of time until maturity:

• 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, generally up to 30 years.

Although rare, a number of companies issue 100-year bonds! A number of railroads did, as did Coca-Cola, Disney, IBM, the New York Port Authority, and the government of China! Such bonds are quite dangerous to purchase, especially if they’re issued during a period of relatively low interest rates.

Most of the time, longer-term bonds pay higher yields than short-term bonds. You can look at a chart of the current yield of similar bonds plotted against when they mature — such a chart is known as a yield curve. Most of the time, this curve slopes upward. Investors generally demand a higher rate of interest for taking the risk of holding longer-term bonds. (To see the current yield curve, visit my website at www.erictyson.com.)

Weighing the likelihood of default

In addition to being issued for various lengths of time, bonds differ from one another in the creditworthiness of the issuer. To minimize investing in bonds that default, purchase highly rated bonds. 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 where, for example, AAA is the highest rating and ratings descend through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on. Here’s the lowdown on the ratings:

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

  Why would any sane investor buy a bond with a low credit rating? He or she may purchase one of these bonds because issuers pay 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, though, 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.

Examining the issuers (and tax implications)

Besides varying in credit ratings and maturity, bonds also differ from one another according to the type of organization that issues them — in other words, what kind of organization you lend your money to. The following sections go over the major options and tell you when each option may make sense for you.

Treasury bonds

Treasuries are IOUs from the U.S. government. The types of Treasury bonds include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years). These distinctions and delineations are arbitrary — you don’t need to know them for an exam.

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 high-tax-bracket investors may be better off in municipal bonds (explained in the next section), which are both federal- and state-income-tax-free (in their state of issuance).

The best use of Treasuries is in place of bank CDs. If you feel secure with the federal government insurance (which is limited to $250,000) that a bank CD provides, check out a Treasury bond (which has the unlimited backing of the U.S. government). Treasuries that mature in the same length of time as a CD may pay the same or a better interest rate. Remember that bank CD interest is fully taxable, whereas a Treasury’s interest is state-tax-free. Unless you really shop for a bank CD, you’ll likely earn a lower return on a CD than on a Treasury. I explain how to purchase Treasury bonds in the section “Purchasing Treasuries,” later in this chapter.

Municipal bonds

Municipal bonds are state and local government bonds that pay interest that’s federal-tax-free and state-tax-free to residents in the state of issue. For example, if you live in California and buy a bond issued by a California government agency, you probably won’t owe California 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’s normally required on other bonds — which means that 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, you may end up with a higher after-tax yield from a municipal bond (often called muni) than from a comparable bond that pays taxable interest. Compare the yield on a given municipal bond (or muni bond fund) to the after-tax yield on a comparable taxable bond (or bond fund).

Corporate bonds

Companies such as Boeing and Johnson & Johnson issue corporate bonds. Corporate bonds pay interest that’s fully taxable. Thus, they’re appropriate for investing inside retirement accounts. Lower-tax-bracket investors should consider buying such bonds outside a tax-sheltered retirement account. (Higher-bracket investors should instead consider municipal bonds, which I discuss in the preceding section.) In the section “Understanding bond prices,” later in this chapter, I show you how to read price listings for such bonds. If you buy corporate bonds through a mutual or exchange-traded fund, an approach I advocate, you don’t need to price such bonds.

Mortgage bonds

Remember that mortgage you took out when you purchased your home? Well, you can actually purchase a bond, naturally called a mortgage bond, to invest in a portfolio of mortgages just like yours! Many banks actually sell their mortgages as bonds in the financial markets, which allows other investors to invest in them. The repayment of principal on such bonds is usually guaranteed at the bond’s maturity by a government agency, such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or the Federal National Mortgage Association (FNMA, also known as Fannie Mae).

The vast majority of mortgage bonds are quite safe to invest in. The risky ones that were in the news in the late 2000s for defaulting were so-called subprime mortgages, which lacked government agency backing.

Convertible bonds

Convertible bonds are hybrid securities — they’re bonds 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 nonconvertible bonds because convertibles offer you the potential to make more money if the underlying stock rises.

Inflation-protected Treasury bonds

The U.S. government offers bonds called Treasury inflation-protected securities (TIPS). Compared with traditional Treasury bonds (which I discuss earlier in this chapter), the inflation-indexed bonds carry a lower interest rate.

The reason for this lower rate is that the other portion of your return with these inflation-indexed bonds comes from the inflation adjustment to the principal you invest. The inflation portion of the return gets added back into principal. For example, if you invest $10,000 in an inflation-indexed bond and inflation increases 3 percent the first year you hold the bond, your principal would increase to $10,300 at the end of the first year.

What’s appealing about these bonds is that no matter what happens with the rate of inflation, investors who buy inflation-indexed bonds always earn some return (the yield or interest rate paid) above and beyond the rate of inflation. Thus, holders of inflation-indexed Treasuries can’t have the purchasing power of their principal or interest eroded by high inflation.

Because inflation-indexed Treasuries protect the investor from the ravages of inflation, they represent a less risky security. However, consider this little known fact: If the economy experiences deflation (falling prices), your principal isn’t adjusted down, so these bonds offer deflation protection as well. As I discuss in Chapter 2, lower risk usually translates into lower returns.

Buying Bonds

You can invest in bonds in one of two major ways: You can purchase individual bonds, or you can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund or exchange-traded fund (see Chapter 8.)

In this section, I help you decide how to invest in bonds. If you want to take the individual-bond route, I cover that path here, where I explain how to decipher bond listings you find in financial newspapers or online. I also explain the purchasing process for Treasuries (a different animal in that you can buy them directly from the government) and all other bonds. If you fall on the side of funds, head to Chapter 8 for more information.

Deciding between individual bonds and bond funds

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 exchange-traded fund. Here’s why:

• Diversification is more difficult with individual bonds. You shouldn’t put your money into 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 a substantial amount of money ($1 million) that you want to invest in bonds.
• Individual bonds cost you more money. 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 that you invest, the bigger the bite — on a $1,000 bond, the commission fee can equal several percent. Commissions take a smaller bite out of larger bonds — perhaps less than 0.5 percent if you use discount brokers.

  On the other hand, investing in bonds through a fund is cost-effective. Great bond funds are yours for less than 0.5 percent per year in operating expenses. Selecting good bond funds isn’t hard, as I explain in Chapter 8.

• You’ve got better things to do with your time. Do you really want to research bonds and go bond shopping? Bonds are boring to most people! And bonds and the companies that stand behind them aren’t that simple to understand. For example, did you know that some bonds can be called before their maturity dates? Companies often 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 mutual fund portfolio manager needs to do, such as track the issuer’s creditworthiness and monitor other important financial developments.

Understanding bond prices

Business-focused publications and websites provide daily bond pricing. You may also call a broker or browse websites to obtain bond prices. The following steps walk you through the bond listing for PhilEl (Philadelphia Electric) in Figure 7-1:

• Bond name: This column tells you who issued the bond. In this case, the issuer is a large utility company, Philadelphia Electric.
• Funny numbers after the company name: The first part of the numerical sequence here — 71/8 — refers to the original interest rate (7.125 percent) that this bond paid when it was issued. This interest rate is known as the coupon rate, which is a percent of the maturity value of the bond. The second part of the numbers — 23 — refers to the year that the bond matures (2023, in this case).
• Current yield: Divide the interest paid, 7.125, by the current price per bond, $93, to arrive at the current yield. In this case, it equals (rounded off) 7.7 percent.
• Volume: Volume indicates the number of bonds that traded on this day. In the case of PhilEl, 15 bonds were traded.
• Close: This shows the last price at which the bond traded. The last PhilEl bond price is $93.
• Change: The change indicates how this day’s close compares with the previous day’s close. In the example figure, the bond rose 21/8 points. Some bonds don’t trade all that often. Notice that some bonds were up and others were down on this particular day. The demand of new buyers and the supply of interested sellers influence the price movement of a given bond.

  

In addition to the direction of overall interest rates, changes in the financial health of the issuing entity that stands behind the bond strongly affect the price of an individual bond.

Purchasing Treasuries

If you want to purchase Treasury bonds, buying them through the Treasury Direct program is the lowest-cost option. Call 800-722-2678 or visit the U.S. Department of Treasury’s website (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 Treasury Direct requires you to transfer the bonds to a broker.

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 mutual funds easily and without fees. Funds, however, do charge an ongoing management fee. (See Chapter 8 for my recommendations of Treasury funds with good track records and low management fees.)

Shopping for other 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:

• Don’t buy through salespeople. Brokerage firms that employ representatives on commission are in the sales business. 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 (see Chapter 9).
• Don’t be suckered into high yields — buy quality. Yes, junk bonds pay higher yields, but they also have a much higher chance of default. Nothing personal, but you’re not going to do as good a job as a professional money manager at spotting problems and red flags. Stick with highly rated bonds so you don’t have to worry about and suffer through these consequences.

  Did you know what a subprime mortgage was before 2007, when stories of rising defaults were all over the news? Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default.

• 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 reissue 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.
• Diversify. To buffer changes in the economy that adversely affect one industry or a few industries more than others, invest in and hold bonds from a variety of companies in different industries.

  Of the money that you want to invest in bonds, don’t put more than 5 percent into any one bond; that means you need to hold at least 20 bonds. Diversification requires a good amount to invest, given the size of most bonds and because trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond mutual fund or exchange-traded fund.

• Shop around. Just like when you buy a car, shop around for good prices on the bonds that you have in mind. The hard part is doing an apples-to-apples comparison, because different brokers may not offer the same exact bonds. Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating, both of which I discuss earlier in this chapter.

Unless you invest in boring, simple-to-understand bonds such as Treasuries, you’re better off investing in bonds via the best bond mutual funds. One exception is if you absolutely, positively must receive your principal back on a certain date. Because bond funds don’t mature, individual bonds with the correct maturity for you may best suit your needs. Consider Treasuries because they carry such a low default risk. Otherwise, you need a lot of time, money, and patience to invest well in individual bonds.

Considering Other Lending Investments

Bonds, money market funds, and bank savings vehicles are hardly the only lending investments. A variety of 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 in the following sections.

Too many investors get sucked into lending investments that offer higher yields. Always remember: Risk and return go hand in hand. Higher yields mean greater risk, and vice versa.

Guaranteed-investment contracts

Insurance companies sell and back guaranteed-investment contracts (GICs). The allure of GICs is that your account value doesn’t appear to fluctuate. Like a one-year bank certificate of deposit, GICs generally quote you an interest rate for the next year. Some GICs lock in the rate for longer periods of time, whereas others may change the interest rate several times per year.

But remember that the insurance company that issues the GIC does invest your money, mostly in bonds and maybe a bit in stocks. Like other bonds and stocks, these investments fluctuate in value — you just don’t see it.

Typically once a year, you receive a new statement showing that your GIC is worth more, thanks to the newly added interest. This statement makes otherwise-nervous investors who can’t stand volatile investments feel all warm and fuzzy.

The yield on a GIC is usually comparable to those available on shorter-term, high-quality bonds. Yet the insurer invests in longer-term bonds and some stocks. The difference between what these investments generate for the insurer and what the GIC pays you in interest goes to the insurer.

The insurer’s take can be significant and is generally hidden. Unlike a mutual fund, which is required to report the management fee that it collects and subtracts before paying your return, GIC insurers have no such obligations. By having a return guaranteed in advance, you pay heavily — an effective fee of 2-plus percent per year — for the peace of mind in the form of lower long-term returns.

The high effective fees that you pay to have an insurer manage your money in a GIC aren’t the only drawbacks. When you invest in a GIC, your assets are part of the insurer’s general assets. Insurance companies sometimes fail, and although they often merge with a healthy insurer, you can still lose money. The rate of return on GICs from a failed insurance company is often slashed to help restore financial soundness to the company. So the only “guarantee” that comes with a GIC is that the insurer agrees to pay you the promised rate of interest (as long as it is able)!

Private mortgages

In the section “Mortgage bonds,” earlier in this chapter, I discuss investing in mortgages that resemble the ones you take out to purchase a home. To directly invest in mortgages, you can loan your money to people who need money to buy or refinance real estate. Such loans are known as private mortgages or second mortgages, in the case where your loan is second in line behind someone’s primary mortgage.

Private mortgage investments appeal to investors who don’t like the volatility of the stock and bond markets and aren’t satisfied with the seemingly low returns on bonds or other common lending investments. Private mortgages seem to offer the best of both worlds — stock-market-like, 10-plus percent returns without volatility.

Mortgage and real estate brokers often arrange mortgage investments, so you must tread carefully because these people have a vested interest in seeing the deal done. Otherwise, the mortgage broker doesn’t get paid for closing the loan, and the real estate broker doesn’t get a commission for selling a property.

One broker who also happens to write about real estate wrote a newspaper column describing mortgages as the “perfect real estate investment” and added that mortgages are a “high-yield, low-risk investment.” If that wasn’t enough to get you to whip out your checkbook, the writer/broker further gushed that mortgages are great investments because you have “little or no management, no physical labor.”

You know by now that a low-risk, high-yield investment doesn’t exist. Earning a relatively high interest rate goes hand in hand with accepting relatively high risk. The risk is that the borrower can default — which leaves you holding the bag. (In the mid- to late 2000s, mortgage defaults escalated significantly.) More specifically, you can get stuck with a property that you need to foreclose on, and if you don’t hold the first mortgage, you’re not first in line with a claim on the property.

The fact that private mortgages are high risk should be obvious when you consider why the borrower elects to obtain needed funds privately rather than through a bank. Put yourself in the borrower’s shoes. As a property buyer or owner, if you can obtain a mortgage through a conventional lender, such as a bank, wouldn’t you do so? After all, banks generally give better interest rates. If a mortgage broker offers you a deal where you can, for example, borrow money at 10 percent when the going bank rate is, say, 6 percent, the deal must carry a fair amount of risk.

I would avoid private mortgages. If you really want to invest in such mortgages, you must do some time-consuming homework on the borrower’s financial situation. A banker doesn’t lend someone money without examining a borrower’s assets, liabilities, and monthly expenses, and you shouldn’t either. Be careful to check the borrower’s credit, and get a large down payment (at least 20 percent). The best circumstance in which to be a lender is if you sell some of your own real estate and you’re willing to act as the bank and provide the financing to the buyer in the form of a first mortgage.

Also recognize that your mortgage investment carries interest rate risk: If you need to “sell” it early, you’ll have to discount it, perhaps substantially if interest rates have increased since you purchased it. Try not to lend so much money on one mortgage that it represents more than 5 percent of your total investments.

If you’re willing to lend your money to borrowers who carry a relatively high risk of defaulting, consider investing in high-yield (junk) bond mutual funds instead. With these funds, you can at least diversify your money across many borrowers, and you benefit from the professional review and due diligence of the fund management team. You can also consider lending money to family members.