Bond Investing Basics

[Igor 10]

What is a bond?

 

A bond is a loan. There are three kinds: short, medium, and long term.

 

A short-term loan of less than two years is called a "bill." A loan for two to five years is called a "note." All loans for a longer term are called bonds. Despite these technical distinctions, people often use these terms interchangeably. We will not be investing in bills. So for convenience, I will use the term bond for both notes and bonds.

 

In addition, three different types of borrowers use bonds: governments, municipalities, and corporations. We will be making loans to corporations.

 

A key difference between stocks and bonds is that stocks make no promises about dividends or returns. The company is under no obligation to pay you.

 

However, when a company issues a bond, it guarantees it will pay back your principal (the face value) plus interest. If you buy the bond and hold it to maturity (when the loan expires), you know exactly how much you're going to get back. Bonds are traded in $1,000 increments. So for each bond you buy, you'll receive $1,000 at maturity.

 

When we make a loan we want to know four things:

 

1) What is the amount of the loan?

2) Who is the borrower?

3) How much interest do we earn?

4) When do we get paid?

 

Let's use the Goodyear Tire and Rubber 7.86% bond due 8/15/2011 to illustrate how this works.

 

You decide the answer to the first question. You decide how much money you want to loan.

 

The "face value" of each bond is $1,000. But that's generally not what you pay for our bonds. For example, if the Goodyear bond was selling for $740, and you wanted to invest $10,000, you would buy 13 bonds ($10,000/$740).

 

The next three are answered in the description of the bond.

 

Goodyear (borrower) 7.86% (coupon) Note due 8/15/2011 (repayment date):

 

Goodyear Tire and Rubber Company is the borrower. That's easy. The next question – how much interest do we earn – is a little tougher.

 

The "coupon" is 7.86%. This is the interest the borrower pays on the loan... But it's not necessarily the interest you earn.

 

The borrower calculates the interest payment by multiplying the coupon (7.86%) times the par value ($1,000)... So 7.86% times $1,000 equals $78.60. This is the annual interest amount paid in two equal installments of $39.20 on February 15 and August 15.

 

The coupon will not change. Bondholders are guaranteed payments equaling $78.60 a year per bond. But the price of the bond can change. Here's what it looks like for the Goodyear bond:

 

 

Current price of the bond $740.00

Annual interest payments $78.60

Yield (7.86%/$740) 10.6%

 

So if you held $740 for this bond, you would receive an 10.6% yield – much higher than the original coupon.

 

The last part of the bond description is the maturity date. This is the date the loan will be repaid. The borrower borrowed $1,000 and will repay $1,000. So you will receive a $1,000 for each bond you hold.

 

What is my return?

 

When you buy a bond, you will get the interest payments, plus you'll be repaid the full amount of the bond at the end of the loan. Your return is the combination of the interest payments plus the capital gain amount.

 

Ideally, you want to be buying bonds at a discount to par value. So when the bond matures, you will have a capital gain equal to the amount of the discount. In the case of the Goodyear bond, the purchase price was $740 and the amount repaid is $1,000. Your capital gain would be $260, or 35.1%. And your interest would be $78.60, or 10.6%, a year until the bond matures.

 

When will I get paid?

 

Most corporate bonds pay interest twice a year.

 

The borrower pays interest to the bond trustee, who sends the interest payments to you. The bond trustee will be an independent company – selected by the borrower – that takes care of bookkeeping.

 

Do I have to pay taxes on the interest?

 

Yes. Unlike municipal bonds, which are exempt from federal (and sometimes state) taxes, corporate bonds pay taxable interest to bondholders. You can get around this by holding the bonds in a tax-exempt retirement account (like an IRA).

 

What are the risks?

 

A bond manager faces many risks: Interest-rate risk, event risk, default risk, credit risk, downgrade risk, prepayment risk, duration risk, and more.

 

We don't have to worry about most of these if we buy debt that's already been downgraded. And if we hold these bonds until they mature, we eliminate interest-rate risk, duration risk, and prepayment risk.

 

In fact, we face only two risks (and they are related)... credit risk and default risk. If the borrower's credit deteriorates, we face the prospect of a default. If the borrower defaults, we may lose all or part of our capital.

 

How do I buy a bond?

 

There is no central place or exchange for bond trading, as there is for publicly traded stocks.

 

Bonds are traded through bond dealers, more specifically, the bond trading desks of major investment dealers, like Goldman Sachs. These dealers buy and sell huge volumes of bonds. They know all about a particular bond and are prepared to quote a price to buy or to sell.

 

When you want to buy a bond, you call your broker, and he calls one of the dealers to arrange the trade. You need to give your broker this information about the bond you want to buy:

 

• How many bonds

• The name of the borrower, the coupon, and the maturity date

• The CUSIP number

 

A CUSIP is a unique nine-digit code assigned by Standard and Poor's to every traded security.

 

Your broker will arrange the trade, and credit the bonds to your account. Bonds are "book traded," which means your ownership is accounted for and maintained by the bond trustee, an independent company – selected by the borrower – that takes care of bookkeeping. A certificate is not issued.

[bobcollett 10]

Hi neg

Nicely explained

Mayby you could help Rande Howell with his syntax

Regards

bobc

[bobcollett 10]

OK neg

Your description was the easy part.

Now , how do you trade them?

regards

bobc