Before you invest in bonds, you should learn some fundamentals related to bonds:
- Yield & its relation to Price:This is one of the most fundamental thing that novice investors can get confused. When the (effective) yield of a bond or bond mutual fund goes higher, the actual price goes lower; when the yield goes lower, the price goes higher. Because the paid out yields are already determined at the time of the issue of the bonds, the interest pay-outs are fixed by the term of the issue, while the actual price of the bonds can fluctuate. So when the price of these original bonds go down, its effective yields actually go up (because you pay less money for that fixed interest payout). And vice versa, when the price of bonds go up, the interest rates go down.Once you understand this concept (you may need to repeat it in your head a couple of times higher yields = lower prices and lower yields = higher prices, or at least that’s what I did), you need to understand the next step about bond investing: you want to buy low and sell high (yeah, of course) by investing your money into bonds when the interest yields will be going DOWN so that by the time when the interest yields stop going down, you can sell your bonds AT a HIGH point. Got that? Let me give you a real example:
Let’s say you bought your bond (or bond mutual fund) when it is yielding at 5%. So if you put $100, you should get $5 back as interest every year.
Now, because of Federal Reserve’s interest rate policy, the newly issued bonds that are coming out are yielding at 2.5% instead. Now, if a new guy who invest $100, they will only get $2.5 as interest. Let’s assume that your bond has exactly the same quality/maturity as before (actually the time to maturity will change), it should be yielding at 2.5% also. What does that mean? Now because you are still getting $5 interest on your original investment of $100, at the prevailing interest rate of 2.5%, your bond will actually be valued at $200 because 2.5% of $200 is $5 interest.
Wow!! You just doubled your money. Isn’t that great? Better than stocks, huh? Now imagine that if interest rate goes from 2.5% to 5%, you would have lost 50% of your money in case you decide to sell. Despite the fact that interest rates change very slowly, bond investing is NOT without risk. This risk of losing money in your principal can be totally eliminated when you invest in actual bonds, instead of bond mutual funds (see the how-to post in this series) but it will take TIME.
- Time to Maturity:This determines when the principal of bonds will be repaid. The longer to the maturity it is, the higher interest yield you should be compensated (with the assumption that the yield curve is not inverted, see below).
- Yield Curve:When you plot the yields of short term bonds to the long term bonds against their time to maturity, it’s called the yield curve (click to see Wikipedia’s explanation). The yield curve is one of the most important tools for macro-economic analysis. When the yield curve is inverted (the long term bonds have less yield than short term bonds), it almost always indicates an economic recession in the near horizon. I don’t have the exact numbers, but I think it’s prediction power is higher than 90%, extremely high for any economic theories. Here is an article from FinancialSense that studies the yield curve and recession. Just pause and think that why in the world will someone invest in 30-year bonds for less yields than 10-year or even 1-year bond for that matter? The only plausible reason is that the shorter term bonds are too good to be true and can only last for 1 year or 10 year, or whatever terms for that particular bond. Well, of course, all the yields are true yields (instead of too good to be true), except that they only last as long as their term. In such cases, often it is caused by central banks to control the economic growth to a more sustainable rate.
- Credit rating:The best ratings of AAA are for US treasury bonds, or GSE (including Fannie Mae and Freddie Mac) bonds. The biggest corporate companies such as GE have pretty good credit ratings too. Then there is municipal bonds that may or may not have good credit ratings. Here is the credit ratings from Moody’s site. S&P also has its set of credit ratings (which you need to register & login to see).
- Is the interest taxable, and how is it taxed?Municipal bonds are usually both state tax-free, and federal tax-free. US treasury bonds are only state tax-free. If you don’t have any state taxes to pay, this tax benefit does not matter to you. Since you still need to pay federal taxes on bonds, the exists a bond called series EE saving bond which allows you to pay taxes on all the interests only at the end of redeeming the bond. Some people like to use this to their tax advantage when buying EE saving bonds for their child who has a lower tax bracket, and won’t need to pay kiddie tax after age of 14.
- Is it callable?Callable bonds allow the issuer of the bonds to repay the debt before maturity. This kind of bond, the issuers may give you a better up-front interest rate, but once the issuers find a cheaper way to refinance their debt, they will do so, and immediately pay you off on the bonds that you bought. Therefore, the expected length to maturity can be much shorter in reality. Do NOT price such bonds at their time to maturity with the assumption that the bonds will not be repaid earlier.
Here are all the posts in the same bond investing series: