Bonds or Stocks

There's no question stocks get a lot more press. The average investor may never have bought a bond, even after dabbling in Exchange Traded Funds, Futures or even more esoteric investments. Nevertheless bond prices are easier to predict, risk is often low yet with returns that are healthy.

Picking a stock and seeing its price rise by 10 percent overnight is a thrill. Seeing it double in six months makes the investor feel either very lucky or very smart. But with that comes considerable risk. Stock prices tend to be much more volatile - experiencing larger and more rapid swings.

Bonds come in much greater variety - from the unexciting but reliable U.S. or corporate AAA 10-year that pays a small yield to the heart-pounding junk bonds that can offer 15% or more. As with any investment, so it is with bonds: calculated risk vs intended reward is a standard trade-off. But risks tend to be both lower and more readily calculable in the bond market.

The capital needed for initial investment can be higher. A hundred shares of $10 stock generally buys only one bond. Still, there are mutual funds that invest primarily in bonds and other 'pay as you go' plans available. Your broker can provide information on specific programs.

Bonds are sometimes slightly harder to trade, requiring a phone call (with a correspondingly higher commission) rather than just a few mouse clicks on an Internet trading screen. Also, unlike stocks generally, not all bonds are traded by all brokers. Again, your broker - whether full-service or only Internet/Discount - will list the options. And there's no law that says you can't have more than one account.

Bonds are less volatile in the short-term, but they tend to be more sensitive to certain economic factors - particularly anything influencing interest rates. Stock dividends can be viewed as a kind of interest paid on share ownership, but they tend to be less popular these days and are subject to the whims of management. Bonds always carry a coupon rate.

Those coupon (interest) rates are fixed at time of issuance and are, naturally, going to be compared with other interest bearing investments by anyone interested in purchasing your bonds before maturity. (Maturity is the date on which the principal of a bond must be repaid in full.) And, bond prices are affected, not only by comparing their coupon rate against other investments, but by how close they are to maturity.

Governments influence bond prices much more directly than those of equities (stocks). Government creates effects through setting Prime Rate lending rates, through massive borrowing - either by issuing bonds themselves, or other means - and by enacting legislation that affects banks, insurance companies and other large institutions more directly than other businesses.

All this being so, it remains true that one fundamental rule of prudent investing is diversification. Either through direct purchase or via mutual funds, bonds offer relatively reliable and healthy returns on invested capital. They should be part of any portfolio.

Bond Rating

Research on bonds fills volumes. Or these days, the hard drives of web servers.

Nowhere else in the investing world can the interested investor get more helpful information than that available from the various bond rating agencies.

Standard & Poor's and Moody's are the most well known, but there are many others. (DBRS in Canada and Fitch are only two examples.) These agencies provide investors with thoroughly researched ratings on the risks associated with buying a particular company's (or government's) bond.

Stocks frequently get recommendations - (strong) buy, hold, sell - from analysts. Bond ratings get assigned over 20 different possible designations, from AAA (Highest Grade) to C (May Be In Default) or worse. And those designations are backed by some of the most thorough historical and technical research on the planet. The local geology of most cities is less well understood than the financial condition of many companies.

Because of select fixed characteristics - unlike stocks, for example, bonds always have an associated interest rate (which is sometimes zero) and a set maturity date - bonds are more predictable. Those two factors alone makes possible the use of an array of mathematical tools to provide predictions of future yields and price with a confidence unmatched by any other investment.

Standard and Poor's rates around 2,000 domestic and foreign companies, 8,000 government entities, and 1,300 commercial paper-issuing entities. Moody's rates over 19,000 long-term debt issues, 28,000 municipals, and 2,000 commercial paper issuers.

Some of the more common and useful ratings are explained below.

Moody's S&P's Aaa (AAA)

Bonds rated Aaa are judged to be of the best quality, carrying the smallest degree of investment risk. Interest payments are typically protected by a large or exceptionally stable margin and the principal is believed secure.

Baa (BBB)

Baa rated bonds are considered medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security are thought adequate at the time the rating is made, but might prove unreliable over time. Such bonds are less secure and have some speculative characteristics too.

B (B)

Bonds with B rating are generally considered speculative. Interest and principal payments are not assured.

A Moody rating may have digits following the letters, for example, A2 or Aa3, indicating finer grading. S&P attaches plus signs to some for the same purpose.

Agencies make clear that credit ratings don't represent recommendations one way or the other, but taking them into account is common practice. But remember, bond ratings for a particular issue can change over time, as the issuer's fortunes wax or wane.

In general, bonds with higher ratings tend to have lower yields. Higher risk bonds offer higher yields and/or lower prices in order to attract investors. These so-called high yield or 'junk bonds' (below Baa/BBB) aren't necessarily bad investments.

In 1991, those who gambled on lower rated bonds reaped the highest total returns: an average 34.5 percent. One year later, in a less outstanding year for bonds, junk debt took second place in the race for high returns, 18.2 percent compared to 22.4 percent return on convertible debt. The example remains relevant today.

Even at the lower figure, they outpaced many stocks. Of course, that's an average and when considering a purchase investors have to look not only at potential returns but expected default rates.

Statistics making that estimate more rational are available from dozens of Internet sites that report on bonds. The prudent investor will take advantage of that information when making an investment decision.

Managing Risk in Bond Trading

Every bond carries some risk that the issuer will default on repayment of the principal or suspend interest payments. Once that risk is measured (see 'Measuring Risk' elsewhere in this series), then what?

First, a review.

Duration: Duration measures a bond's interest rate risk, expressed in years. The longer the duration, the more sensitive the bond's price is to changes in interest rates.

When interest rates change, a bond's price will change by an amount related to its duration. For example, if a bond's duration is 5 years and interest rates fall 1%, a bond's price will rise by approximately 5%. Therefore, if interest rates are expected to rise, invest in bonds with lower durations. Low duration means less volatility or price risk.

In general, the shorter a bond's maturity, the less its duration. Bonds with higher yields also have lower durations. ('Duration' is not the same as 'maturity', which is the date the principal repays. Duration is a technical approximation. See your favorite search engine for details and a 'Duration Calculator'.)

[Convexity also measures interest rate risk, but more accurately in an environment where yield change is greater or within shorter time frames. The concept is more technical and we'll save it for elsewhere.]

So, what to do with this information?

Managing risk is essentially an exercise in comparing how much capital you have against what you can afford to lose should an investment go sour, and what your goals are.

Investors with a low psychological or financial tolerance for risk would be well advised to accept the inevitability of lower yields. Tax-free muni's (municipalities) or AAA corporates are suitable for such investors. Investors with the time, temperament and funds to endure greater risk can lean toward lower ratings with higher yields.

Managing risk involves comparing instruments (prices and yields) available today with a prediction of what will be available tomorrow, then including inflation and tax considerations. Is a 5% bond selling at 102 better than a 4% tax-free selling at 100, when you add the effect of a 28% tax rate? Let's see:

Assume a $1000 bond. At 102 (2% above par, i.e. face value) that's $1020. 5% annual interest payment amount is $1000 x .05 = $50. At 28% tax, the after tax amount = $35.28 The after-tax yield = 35.28/1020 = 3.46%. For the 4% bond: $1000 x .04 = $40. Since the muni is tax-free, the yield is 40/1000 = 4.0%.

Part of the effect is due to taxable vs tax-free, another part from the discount or premium as a result of the coupon compared to prevailing rates. Include both factors when making calculations.

Other forms of risk than interest rate and credit risk exist. (Credit risk is the possibility of default on principal or suspension of interest payments. Interest rate risk is that incurred by the chance that rates will change over the lifetime of the bond.) Liquidity is also a factor.

Unlike most stocks, bonds - though the market as a whole is much larger - often do not attract buyers and sellers as readily. It may be - and happens often enough - that a buyer is harder to find unless the seller is willing to sell at a considerable discount.

Consider your goals. Are you seeking predictable cash flows and willing to retain the bond to maturity? Or, are you seeking the highest yields and willing to endure not only the credit risk, but the liquidity risk involved in selling a bond others may rate as 'junk'?

The choices can only be made wisely by the investor willing to do the extra research entailed in bond trading.

Bond Investment Basics for the Beginner

Unlike the stock market, there's no central exchange for trading bonds. Nevertheless, the process is almost as easy as trading equities also called stocks.

Acquire, if you haven't already, a brokerage account - such as the ones from a full-service broker or one of the many on-line only trading accounts. In some cases, it'll be necessary to phone rather than place an order over the Internet.

Ok, that's the easy part. Now, for the slightly more difficult aspects.

Bonds have a purchase and sale price, but also an interest rate. Purchasing one entitles the bearer (bondholder) to payment of the principal at maturity (when the principal must be repaid in full), and twice-annual interest payments.

Price Movements and Interest Rates
Just as with stocks, bond prices vary. The initial price (and the interest rate they pay) is set at the time they're issued. As soon as seconds later they may be worth more or less than that. One of the major factors influencing bond price movements is general market interest rates.

If interest rates on real estate loans, large corporate bank loans, savings instruments such as certificates of deposit (CD) fall after the bond is issued, the price of that bond will tend to rise.

Common sense reveals the reason. Purchase a 5 year bond at $1,000 that pays 7%, comparable (let's suppose) to that offered by a similar-risk 5-year CD. Six months later, interest rates fall to 6%. (A larger than normal drop for that period, but not unknown.) You now hold an instrument that pays more in interest than a competing investment. Yours will command a higher price, if you choose to sell. (Specifically how much they tend to rise or fall, based on the amount of rate change, over what expected period and other factors, is a complex topic we leave for elsewhere.)

Bonds trading 'over 100' are said to be trading at a premium and bonds 'under 100' at a discount. The terminology refers to: 100% over or under the initial price. For example, a $1,000 bond (face value, i.e. initial issue price) currently selling for $1,100 is trading at a premium. (By, 10% in this case, since $1,100-$1,000 = $100 and $100 is 10% of $1,000.)

Risk
Bonds, like any other investment, entail risk. Though bondholders have priority over shareholders (owners of company stock) in case of bankruptcy, if there's no money to pay position in line is unimportant.

Most bonds are relatively low risk, at least in that they do repay bondholders the principal. Low risk tends to correlate with low return, however. Fortunately for the average investor several long-standing, well-respected bond rating agencies exist. The most well-known are Standard and Poor (S&P) and Moody.

These two companies rate bonds according to highly technical analyst-calculated formulas, but the result is relatively simple: a sliding scale of 'very low risk' AAA (or Aaa – Moody), to 'very high risk' CCC or lower (so-called junk bonds).

As with any investment, the investor should do considerable homework - investigating earnings projections, likely legal entanglements, outstanding amount of debt and other factors - before buying bonds. Remember, you're granting a loan. You'd like to earn interest on the loan and you want the principal to be repaid on time.

Understanding Bonds before Investing

There are certain things you must understand about bonds before you start investing in them. Not understanding these things may cause you to purchase the wrong bonds, at the wrong maturity date.

The three most important things that must be considered when purchasing a bond include the par value, the maturity date, and the coupon rate.

The par value of a bond refers to the amount of money you will receive when the bond reaches its maturity date. In other words, you will receive your initial investment back when the bond reaches maturity.

The maturity date is of course the date that the bond will reach its full value. On this date, you will receive your initial investment, plus the interest that your money has earned.

Corporate and State and Local Government bonds can be ‘called’ before they reach their maturity, at which time the corporation or issuing Government will return your initial investment, along with the interest that it has earned thus far. Federal bonds cannot be ‘called’.

The coupon rate is the interest that you will receive when the bond reaches maturity. This number is written as a percentage, and you must use other information to find out what the interest will be. A bond that has a par value of $2000, with a coupon rate of 5% would earn $100 per year until it reaches maturity.

Because bonds are not issued by banks, many people don’t understand how to go about buying one. There are two ways this can be done.

You can use a broker or brokerage firm to make the purchase for you or you can go directly to the Government. If you use a brokerage, you will more than likely be charged a commission fee. If you want to use a broker, shop around for the lowest commissions!

Purchasing directly through the Government isn’t nearly as hard as it once was. There is a program called Treasury Direct which will allow you to purchase bonds and all of your bonds will be held in one account, that you will have easy access to. This will allow you to avoid using a broker or brokerage firm.

What Is Bond Investing?

Have you ever found yourself in need of cash and wanted to buy something urgently? You tell yourself, if you just had a faster computer you could learn more and get things done much quicker, leaving more time for other productive activities. Ever borrowed the needed money then paid it back with interest, say by using a credit card?

So do most commercial enterprises. Like you, businesses have only so much cash - working capital - to buy equipment, pay for research and a thousand other items that could be used to improve productivity. Raising productivity lowers costs and increases their income (revenue).

When businesses need to borrow, though, they have more choices than the average person. Like you, they can get a straight bank loan - but they can also 'float stock' (i.e. issue shares of ownership in the business) or issue bonds.

Bonds are a form of loan, made by bondholders to a company. They're issued with a fixed face value (usually in increments of $1,000), interest rate (the 'coupon rate') and maturity date.

The face value is what an investor pays to acquire them, receiving interest payments at specified intervals - traditionally every six months. On a certain (maturity) date, five years from the date of issue, or two, ten, thirty - the number varies - the initial amount (the 'principal') is paid back in full.

For various reasons - most of them associated with the vagaries of human interest in news stories - bonds are much less well known or understood by the average investor. Even so, the bond market is much larger.

The world total amount of outstanding bond debt has been estimated at $33 trillion, with the U.S. portion about half that. Much of that is government borrowing, who are among the largest issuers. The total equities (stock) market is roughly $20 trillion, with the NYSE (about 1/2 the U.S. total) at $8.5 trillion.

Comparing by daily trading volumes, US Treasury Securities alone are around $360 billion per day. The U.S. equity markets trade only around $50 billion per day. Both of these pale in comparison to the Foreign Exchange market that averages $1.5 trillion in transactions every day.

Bonds may get less press, but they offer investors several attractive features. As a shareholder, the risk of loss of capital is much greater. In the event of bankruptcy, owners get paid after bondholders. Also, stock prices tend to be much more volatile - change more rapidly, more unexpectedly and with larger price swings.

Tax considerations play a larger role in bond investing. Many countries, states and municipalities issue bonds - often tax free. That means such interest payments received aren't taxed as, say, corporate stock dividends (or corporate bonds) are.

Bonds have the added advantage of having much more objective, calculable properties. Because of their inherent tie to general market interest rates and their set maturity dates, their future price and the worth of their present coupon rates in the future are safer to predict. For example, if interest rates are currently 4% and the investor owns an 8% bond, that instrument will sell today at a much higher price than the original face value. Sorry, it's not quite so simple as double the original price.

The ability to calculate, with higher probability, the likely future value of bonds makes investing in them much more science and much less gambling art.