Never forget these two axioms:
Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.
Asset Class IIIB
Return of the Bonds: Revenge of the Market
Let’s get to it.
Three Types of Bonds:
1.) US Government Bonds
U.S. federal bonds are categorized according to its maturity.
Bills=bonds maturing in less than one year
Notes=bonds maturing between one and ten years
Bonds= er, bonds maturing in over a ten year period
(Sorry, Mrs. Cunningham. My high school English teacher insisted on never using the word in question to define that same word. But, I guess that’s the beauty [or curse] of having your own blog.)
The above bonds are known collectively as “Treasuries” —i.e., Treasury bills (often called T-bills since apparently saying “Treasury” is too tiresome), Treasury notes, and Treasury bonds. All the bonds (AKA debt) issued by the U.S. government is regarded as extremely safe, often referred to and/or considered as “risk-free” as are the bonds of many highly developed countries.
2.) Municipal Bonds
Municipal bonds AKA “munis” are bonds issued by state or local (city or county) governments or even government agencies. These bonds are often riskier than national government bonds. Cities don’t go bankrupt almost ever, but it can happen (Hi, Detroit!! I’m talking about you!).
The major advantage municipal bonds convey to investors is that any returns are exempt from federal taxes.
And, even better, state and local governments will often (but not universally) make the returns on their bonds non-taxable for residents of said state or locality thus making some (definitely not all) municipal bonds completely tax-free which is known as “triple-tax free” (ie, no federal, state, or local taxes).
Because of these tax exemptions, the yields on municipal bonds are usually lower than those of equivalent taxable bonds. When considering municipal bonds as an investment, it literally pays to check on their tax exemption status vs. their yield.
3.) Corporate Bonds
Short-term corporate bond < 5 years maturity
Intermediate corporate bond=5-12 years maturity
Long-term corporate bond> 12 years maturity
A few type of corporate bonds include the following:
Convertible bonds: corporate bonds that give the bondholder (you) the option to convert the bonds into shares of common stock at a later date.
The number of shares an investor gets for each convertible bond is determined by a conversion rate which may be variable or fixed depending on the terms at the time the bonds are offered.
For example, a conversion rate of 20 means that for every $1,000 of face/par value (remember that?) you hold and then convert, you receive 20 shares of stock.
It’s incumbent on you as the investor then to decide whether or not it makes sense to convert bonds into stock (i.e., equity).
The way to do that is by dividing the selling price of the bond by the conversion rate, known as the breakeven price, and seeing whether that price is lower or higher than the company’s stock price at that time.
Example:
Let’s use the above bond for our purposes.
A.)
$1,000 bond with a conversion rate of 20.
Breakeven price=50
Company’s current stock price=$53.25
Get your shares, people!!
B.)
$1,000 bond with a conversion rate of 20.
Breakeven price=50
Company’s current stock price=$33.85
Hold steady with your bond(s)!
C.)
$1,000 bond with a conversion rate of 20.
Breakeven price=50
Company’s current stock price=$50
Aah. Dilemma time.
Break out your calculators and, to a lesser extent, your crystal balls.
You (should) know how many years you have left until maturity, what the bond’s coupon (remember that?) is, and what your payout is finally.
Then, compare that final total amount to what you think the company itself will do over that same time period including any possible/potential dividends.
Realize that dividends are taxed differently (currently 23.8% for annual incomes over $250,000 for a couple) than any bond payments will (which will be taxed as ordinary income, not exempt from taxes—remember, these are corporate bonds, not municipal bonds).
Much more on taxes and their impact on your investing in a later post.
Callable bonds: ones that can be redeemed by the issuer at some point prior to its maturity.
For example, if interest rates drop since the company first put out the bond, then the company will want to refinance this debt (remember that’s all bonds are from the perspective of the company—debt) at a lower interest rate.
In this case, the company “calls its current bonds” AKA reissues bonds at a lower rate of interest. Not surprisingly, callable bonds usually have a higher interest rate to compensate for the potential risk of them being reissued at a lower interest rate.
It’s no different than when you refinance your home mortgage. The only difference is that the advantage is for you in that case and to the issuing company in this case, BUT you do get an even higher interest rate than other bonds as compensation for an event that may actually never happen.
And just so you know and don’t accuse Physician, Wealth Thyself of shortchanging you (and I’m not sure how you can given how this is entirely free for you):
Asset-backed securities (ABS): a bond issued by banks or other large financial institutions
These bonds come from bundling the cash flows generated by other assets and offering them to investors thus why they are called “asset backed”.
If a bond like this is backed by a number of mortgages rather than other assets, they are known as mortgage-backed securities or MBS. These were a lot of the so-called “toxic assets” that propelled the entire planet into financial crisis once the US real estate market imploded.
Why?
Because these types of bonds, ABS or especially MBS, are usually only reserved for institutional investors (i.e., banks, hedge funds, etc.) or extremely sophisticated, high net worth individuals, not just the average Joe and Jill investor like you and me.
Lastly, a few other bond types that you may hear about or be offered (just so you’ve heard of them—don’t ever blame Physician, Wealth Thyself for being neglectful):
A put bond (I know, I know. It’s spelled differently.) or putable bond is a bond that allows the holder (you) to force the issuer to repurchase the security at specified date(s) before maturity. The repurchase price is set at the time of the bond being issued and is typically par value AKA face value AKA what you paid for this bond originally. So, usually, this works to your advantage as an investor.
A discount bond is a bond that is issued for less than its face (or par) value, or a bond currently trading for less than its face value in that pesky secondary market. Discount bonds sound just like zero coupon bonds (remember them?) because they are except for one simple thing: zero coupon bonds do not pay interest.
A retractable bond is one where the holder (again, you) to force the issuer to redeem the bond before maturity at par/face value. You may choose to shorten the maturity on a bond because of market conditions or because you need the principal sooner than expected (hopefully for a hot new investment and not because you’re massively in debt). By doing so, you’re giving up on the interest payments of all those years you could have held the bond, but decided not to…but, at least, you have cash on hand.
An extendable bond is somewhat the reverse of the above retractable bond where an option to lengthen its maturity period exists. Depending on the specific terms of the extendable bond, the bond holder and/or bond issuer may have one (or even more) chances to delay the repayment of the bond’s principal during which time further interest payments continue to be paid out to you. Nice!
Also, the bond holder or issuer may—emphasis on “may”— have the option to exchange the bond for one with a longer maturity at an equal or even higher interest rate (Yay!). Because these type of bonds contain an option to push back the date of maturity, which makes them more valuable than other bonds, extendable bonds sell at a higher price than non-extendable bonds.
A few more concepts surrounding bonds:
To boil down complex stuff into a simple, neat axiom: the price of bonds are inversely related with interest rates. The hows, whys, etc. will be discussed in a later post. (Boy, I hope we have time for all these later posts.)
Yield-to-maturity (YTM) of a bond is an extremely helpful metric to evaluate a bond’s true price. YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Makes sense given its name.
Though it’s considered a long-term bond yield, YTM is expressed as an annual rate. That number represents your return in any specific bond as long as you hold the bond until maturity and IF all payments are made as scheduled.
YTM is helpful as a measuring tool weighing the attractiveness of one bond to another. It cuts across the differences between bonds with different coupons and different maturity dates, so you can compare them in a true apples to apples fashion.
For those of you desperate to know how YTM is calculated…
Dr. Unwise: Who are these freaks!?!?!
PWT: … you should know it’s fairly complex:
There is a formula and a calculator for YTM in the midst of a great website.
There’s quite a bit left to know before actually investing in bonds.
Duration, modified duration, and convexity are all characteristics of bonds which we will leave for a later post before we get too far into the weeds.
Doesn’t it feel like a long lecture day in med school just let out and even the professors took pity on you…and themselves?
Whew.
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Talk to you soon.