A municipal bond or municipal bond fund is suitable for an investor that wants income that is free from federal income tax. This is not an acceptable investment for a tax deferred account like a Traditional or Roth IRA. The information in presented in 4 sections: issuers, holders (investors), taxes, and risk.
Municipal bond issuers
Municipal bonds are issued by states, cities, and counties, or their agencies (the municipal issuer) to raise funds. The methods and traces of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the maximum legal limit. The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
Municipal bond holders
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself. Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
Taxability
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located. The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to federal income tax.
Risk
The risk ("security") of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder. Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents. The probability of repayment as promised is often determined by an independent reviewer, or "rating agency". The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.
The only risk is default risk with the issuer being unable to repay the full amount. Bonds issued by California with budget problems, and other states with high unemployment, should be avoided. You can reduce this risk by investing in a mutual fund rather than an individual bond.
Showing posts with label Bonds. Show all posts
Showing posts with label Bonds. Show all posts
Sunday, August 30, 2009
US Treasury Bonds
HISTORY LESSON:
The U.S. government knew that the costs of World War I would be great, and the question of how to pay for the war was matter of intense debate. The resulting decision was to pay for the war with a balance between higher taxes and government debt. Traditionally, the government borrowed from other countries, but there were no other countries from which to borrow in 1917: U.S. citizens would have to fully finance the war through both higher taxes and purchases of war bonds. The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty bonds.'
TYPES
A United States Treasury security is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS).
Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year).
Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5, 7 or 10 years, for denominations from $100 to $1,000,000.
Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. There are 2 types, a coupon bond with payment every six months like T-Notes, or a without a coupon called a zero coupon bond. They are commonly issued with maturity of thirty years. The secondary market is highly liquid.
Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-year maturities. This is not good for a long term growth investment.
TREASURY YIELD CURVE
The different time durations have different interest rates and when plotted on a graph form a curve. Some of the rates from yesterday are: 3 month = 0.15%, 6 month = 0.24%, 2 year = 1.06%, 5 year = 2.50%, 10 year = 3.57%, and 30 year = 4.43%. Note that the rate grows with time to compensate for the time risk of holding for a longer time period. This is normal and the shape is called a normal yield curve.
INTEREST RATE CHANGES AND LONG TERM BONDS
The price of the bond changes with the interest rate and the longer the time duration the bigger the change. To best illustrate this point, a 30 year zero coupon will be used. The value of the bond, the price to buy or sell, is shown below for different interest rates.
1% = $749, 2% = $563, 3% = $424, 4% = $320, 5% = $243
6% = $185, 7% = $140, 8% = $107, 9% = $82, 10% = $63
Notice how fast the value drops with rising interest rate. Imagine buying a $1,000 bond with interest rates are at 4%, about like now, and paying $320 and then selling it when the interest rate is at 5% and only having a value of $243 and losing 25% of your money, OUCH. Imagine buying a $1,000 bond with interest rates are at 7% and paying $140 and then selling it when the interest rate is at 5% and having a value of $243 and making 70% of your money, BEAUTIFUL. To get a capital gain you want to buy long bonds when interest rates are falling.
What is the bottom line: With the massive amount of US government spending and having a record deficit, $1.27 trillion so far this year, $180.7 billion in July alone, interest rates are going to go up. DO NOT OWN LONG TERM BONDS NOW, YOU ACCOUNT WILL GO OUCH!!!!!!!!
The U.S. government knew that the costs of World War I would be great, and the question of how to pay for the war was matter of intense debate. The resulting decision was to pay for the war with a balance between higher taxes and government debt. Traditionally, the government borrowed from other countries, but there were no other countries from which to borrow in 1917: U.S. citizens would have to fully finance the war through both higher taxes and purchases of war bonds. The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty bonds.'
TYPES
A United States Treasury security is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS).
Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year).
Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5, 7 or 10 years, for denominations from $100 to $1,000,000.
Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. There are 2 types, a coupon bond with payment every six months like T-Notes, or a without a coupon called a zero coupon bond. They are commonly issued with maturity of thirty years. The secondary market is highly liquid.
Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-year maturities. This is not good for a long term growth investment.
TREASURY YIELD CURVE
The different time durations have different interest rates and when plotted on a graph form a curve. Some of the rates from yesterday are: 3 month = 0.15%, 6 month = 0.24%, 2 year = 1.06%, 5 year = 2.50%, 10 year = 3.57%, and 30 year = 4.43%. Note that the rate grows with time to compensate for the time risk of holding for a longer time period. This is normal and the shape is called a normal yield curve.
INTEREST RATE CHANGES AND LONG TERM BONDS
The price of the bond changes with the interest rate and the longer the time duration the bigger the change. To best illustrate this point, a 30 year zero coupon will be used. The value of the bond, the price to buy or sell, is shown below for different interest rates.
1% = $749, 2% = $563, 3% = $424, 4% = $320, 5% = $243
6% = $185, 7% = $140, 8% = $107, 9% = $82, 10% = $63
Notice how fast the value drops with rising interest rate. Imagine buying a $1,000 bond with interest rates are at 4%, about like now, and paying $320 and then selling it when the interest rate is at 5% and only having a value of $243 and losing 25% of your money, OUCH. Imagine buying a $1,000 bond with interest rates are at 7% and paying $140 and then selling it when the interest rate is at 5% and having a value of $243 and making 70% of your money, BEAUTIFUL. To get a capital gain you want to buy long bonds when interest rates are falling.
What is the bottom line: With the massive amount of US government spending and having a record deficit, $1.27 trillion so far this year, $180.7 billion in July alone, interest rates are going to go up. DO NOT OWN LONG TERM BONDS NOW, YOU ACCOUNT WILL GO OUCH!!!!!!!!
Corporate Bonds
As of 2006, the size of the outstanding U.S. bond market debt was $25.2 trillion. Nearly all of the $923 billion average daily trading volume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. The New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds.
For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. When interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.
Key Point #1: Companies, such as Moody's and Standard and Poors, rate the risk of the bond. Companies with top ratings of A or better are called investment grade and those rated lower are called junk grade. Junk bonds have more risk and compensate the investor by paying a higher rate. The difference above the investment grade bond is called a spread. Conservative investors will choose to invest in primarily investment grade bonds or a mutual fund that invests primarily in investment grade bonds.
Key Point #2: You can make money by holding the bond to maturity and getting the interest that is paid every 6 months called the coupon payment. You can make money by buying and selling bonds and getting a capital gain on the face value of the bond.
Key Point #3: Normally, when interest rates go up the coupon payment stays constant, and the face value of the bond goes down and vice versa. Another factor, key point #4, is the risk of default can also drop the face value of the bond. Interest rate changes are more important for bonds that have a long time to maturity and less important for a shorter term duration. You can mitigate this risk by selecting short term bonds or mutual funds that invest in short term bonds.
Key Point #4: Bond holders have a risk of not getting paid full value. For example owners of GM bonds got paid about half of the face value. When the economy enters a recession and companies can go out of business the face value drops and the drop can be much larger than the gain from the dropping interest rate. This is what happened in 2008 and early 2009 and why virtually every corporate bond dropped in value.
Key Point #5: An investor needs to know where we are in the Business Cycle when investing.
Bottom Line: Given where we are in the Business Cycle, we have much less risk of a default. Face values that dropped last year should be recovered or recovering. Interest rates are rising so staying on the short time duration to maturity makes sense. A conservative investor should pursue a mutual fund with primarily investment grade bonds while a more aggressive investor should pursue a mutual fund with primarily junk bonds.
For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. When interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.
Key Point #1: Companies, such as Moody's and Standard and Poors, rate the risk of the bond. Companies with top ratings of A or better are called investment grade and those rated lower are called junk grade. Junk bonds have more risk and compensate the investor by paying a higher rate. The difference above the investment grade bond is called a spread. Conservative investors will choose to invest in primarily investment grade bonds or a mutual fund that invests primarily in investment grade bonds.
Key Point #2: You can make money by holding the bond to maturity and getting the interest that is paid every 6 months called the coupon payment. You can make money by buying and selling bonds and getting a capital gain on the face value of the bond.
Key Point #3: Normally, when interest rates go up the coupon payment stays constant, and the face value of the bond goes down and vice versa. Another factor, key point #4, is the risk of default can also drop the face value of the bond. Interest rate changes are more important for bonds that have a long time to maturity and less important for a shorter term duration. You can mitigate this risk by selecting short term bonds or mutual funds that invest in short term bonds.
Key Point #4: Bond holders have a risk of not getting paid full value. For example owners of GM bonds got paid about half of the face value. When the economy enters a recession and companies can go out of business the face value drops and the drop can be much larger than the gain from the dropping interest rate. This is what happened in 2008 and early 2009 and why virtually every corporate bond dropped in value.
Key Point #5: An investor needs to know where we are in the Business Cycle when investing.
Bottom Line: Given where we are in the Business Cycle, we have much less risk of a default. Face values that dropped last year should be recovered or recovering. Interest rates are rising so staying on the short time duration to maturity makes sense. A conservative investor should pursue a mutual fund with primarily investment grade bonds while a more aggressive investor should pursue a mutual fund with primarily junk bonds.
Mortgage Backed Bonds
Mortgage bonds are issued by 3 agencies: FNMA, FHLMC, and GNMA also known as Fannie, Freddie, and Ginnie. These are not the names of 3 donkeys.
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a stockholder-owned corporation chartered by Congress in 1968 as a government-sponsored enterprise (GSE), but founded in 1938 during the Great Depression. The corporation's purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers.
The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is a government sponsored enterprise (GSE) of the United States federal government. Freddie Mac has its headquarters in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia.
The Government National Mortgage Association (GNMA, also known as Ginnie Mae) is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).
In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity from the annual balance sheet of the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae). In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient secondary mortgage market.
Fannie Mae receives no direct government funding or backing; Fannie Mae securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae. Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrument other than Fannie Mae.
Ginnie Mae provides guarantees on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans, mainly loans issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBS that are guaranteed by the United States government. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.
On September 7, 2008, James Lockhart, director of the Federal Housing Finance Agency (FHFA), announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA. As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.
A key point to remember is that only GNMA bonds are guaranteed by the US government which makes them the choice for anyone wanting to invest in mortgage backed bonds. These are good investments for a conservative investor.
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a stockholder-owned corporation chartered by Congress in 1968 as a government-sponsored enterprise (GSE), but founded in 1938 during the Great Depression. The corporation's purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers.
The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is a government sponsored enterprise (GSE) of the United States federal government. Freddie Mac has its headquarters in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia.
The Government National Mortgage Association (GNMA, also known as Ginnie Mae) is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).
In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity from the annual balance sheet of the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae). In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient secondary mortgage market.
Fannie Mae receives no direct government funding or backing; Fannie Mae securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae. Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrument other than Fannie Mae.
Ginnie Mae provides guarantees on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans, mainly loans issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBS that are guaranteed by the United States government. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.
On September 7, 2008, James Lockhart, director of the Federal Housing Finance Agency (FHFA), announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA. As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.
A key point to remember is that only GNMA bonds are guaranteed by the US government which makes them the choice for anyone wanting to invest in mortgage backed bonds. These are good investments for a conservative investor.
Saturday, July 25, 2009
Earnings, Warren Buffet, Bonds
Last week's newsletter stated that earnings from companies should be positive, beating estimates, and that this should support the stock market. Last week, 78% of the Dow stocks reported better than the estimated earnings and stock markets around the world rose. The Dow rose to a high for the year breaking the 9000 mark, up about 4% for the week. This earnings trend should continue giving support to the stock market this summer.Numerous experts have been giving their opinion about the direction of the stock market based upon a number of reasons.
These experts cause more confusion than providing real guidance. The best thing to do as an investor is to monitor the data and remember that stock prices increase as earnings grow and earnings grow as economic business conditions improve, which is the current situation. Earnings are growing now due mostly to cost cutting measures and improving business conditions. Since cost cutting only goes so far, revenue growth is key for stock prices next year.
I read in Barron's this week that Warren Buffet was asked this week about where to invest now given that the Dow had reached 9000. It was stated that Warren Buffet recommended continuing to own stocks and avoiding long term treasury bonds and cash for long term investments. Since I have been saying the same thing, I think he is rather smart. It was also reported in Barron's that Warren Buffet stated that the best types of bonds right now are mid term corporate bonds.
A bond is a debt obligation where an investor is paid interest and gets back their original investment. Lots of different types of bonds exist including municipal (state and local government), treasury (federal government) and corporate (companies). Municipal bond interest is tax-free which makes it a good choice for any account other than a tax deferred account like a traditional IRA. Corporate bond interest is taxed which makes it an especially good choice for a tax deferred account like a traditional IRA. Corporate bonds are rated by several agencies and can be lumped into investment grade and junk bond, a conservative investor will want mostly investment grade bonds. A junk bond rating for a company does not mean that the company that issue them is junk, they typically are an excellent company.
Bottom Line: The current investment direction of investing in stocks and stock market mutual funds should be maintained for a long term investor seeking growth who is willing to take some risk. Mid-term corporate bond funds that are mostly comprised of investment grade bonds are also an excellent choice for a conservative investor.
These experts cause more confusion than providing real guidance. The best thing to do as an investor is to monitor the data and remember that stock prices increase as earnings grow and earnings grow as economic business conditions improve, which is the current situation. Earnings are growing now due mostly to cost cutting measures and improving business conditions. Since cost cutting only goes so far, revenue growth is key for stock prices next year.
I read in Barron's this week that Warren Buffet was asked this week about where to invest now given that the Dow had reached 9000. It was stated that Warren Buffet recommended continuing to own stocks and avoiding long term treasury bonds and cash for long term investments. Since I have been saying the same thing, I think he is rather smart. It was also reported in Barron's that Warren Buffet stated that the best types of bonds right now are mid term corporate bonds.
A bond is a debt obligation where an investor is paid interest and gets back their original investment. Lots of different types of bonds exist including municipal (state and local government), treasury (federal government) and corporate (companies). Municipal bond interest is tax-free which makes it a good choice for any account other than a tax deferred account like a traditional IRA. Corporate bond interest is taxed which makes it an especially good choice for a tax deferred account like a traditional IRA. Corporate bonds are rated by several agencies and can be lumped into investment grade and junk bond, a conservative investor will want mostly investment grade bonds. A junk bond rating for a company does not mean that the company that issue them is junk, they typically are an excellent company.
Bottom Line: The current investment direction of investing in stocks and stock market mutual funds should be maintained for a long term investor seeking growth who is willing to take some risk. Mid-term corporate bond funds that are mostly comprised of investment grade bonds are also an excellent choice for a conservative investor.
Saturday, March 28, 2009
Federal Reserve, Bonds, and Mortgate Rates
This week the Federal Reserve started buying long term treasury bonds in an effort to lower mortgage rates and provide stimulus to the economy by having home owners refinance mortgages and have a lower monthly mortgage payment. The strategy is to create more demand for these bonds and increase the price of these bonds which would lower the interest rate. This strategy did not work and provides a good indicator for an investor. Let me explain this in more detail.
First, mortgage rates are linked to treasury bond rates in the following manner. For example, Wells Fargo offers a 15 year mortgage at a 4.625% interest rate to anyone who qualifies. They buy the amount of 15 year treasury bonds in proportion to the amount of the mortgage at a much lower rate, currently about 3%. Money is made by Wells Fargo on the interest rate spread of 1.625%.
Second, interest rates and bond prices on long term bonds go in the opposite direction. The reason is that a bond is purchased at a lower initial purchase price than the value of the bond and full value is achieved when the bond is held to maturity. For example, a 10 year bond with a value of $1,000 is purchased for about $500 and yields an interest rate of about 7%. If the price of the bond increases to $750 the resulting interest rate is about 3.5%. As the price of the bond goes up and down, and the investor gets the resulting lower or higher interest rate.
Third, from a supply and demand perspective the price of anything goes up as demand goes up or supply goes down. Conversely, the price of anything goes down as demand goes down or supply goes up. As we know from the previous paragraph, as demand for bonds goes up the purchase price goes up resulting in a lower interest rate.
This week the Federal Reserve started buying $300 Billion worth of long term bonds in the open market. Since no additional bonds were issued, the price of the bonds should have gone up lowering the resulting interest rates. What actually happened was exactly the opposite, the price of the bonds dropped resulting in increasing interest rates.
What this means is that more investors are selling their bonds than being bought by the Federal Reserve. When investors start selling long term bonds it is an indicator of future inflation and higher interest rates. As an investor, you do not want to follow the direction of US government, you do not want to own long term bonds.
When interest rates are going up it is positive for investors who purchase short term bonds or stocks. A risk averse investor would purchase CDs or Money Market funds. A risk taking investor would purchase stock. An investor can do better by watching interest rates rather than financial experts on TV.
First, mortgage rates are linked to treasury bond rates in the following manner. For example, Wells Fargo offers a 15 year mortgage at a 4.625% interest rate to anyone who qualifies. They buy the amount of 15 year treasury bonds in proportion to the amount of the mortgage at a much lower rate, currently about 3%. Money is made by Wells Fargo on the interest rate spread of 1.625%.
Second, interest rates and bond prices on long term bonds go in the opposite direction. The reason is that a bond is purchased at a lower initial purchase price than the value of the bond and full value is achieved when the bond is held to maturity. For example, a 10 year bond with a value of $1,000 is purchased for about $500 and yields an interest rate of about 7%. If the price of the bond increases to $750 the resulting interest rate is about 3.5%. As the price of the bond goes up and down, and the investor gets the resulting lower or higher interest rate.
Third, from a supply and demand perspective the price of anything goes up as demand goes up or supply goes down. Conversely, the price of anything goes down as demand goes down or supply goes up. As we know from the previous paragraph, as demand for bonds goes up the purchase price goes up resulting in a lower interest rate.
This week the Federal Reserve started buying $300 Billion worth of long term bonds in the open market. Since no additional bonds were issued, the price of the bonds should have gone up lowering the resulting interest rates. What actually happened was exactly the opposite, the price of the bonds dropped resulting in increasing interest rates.
What this means is that more investors are selling their bonds than being bought by the Federal Reserve. When investors start selling long term bonds it is an indicator of future inflation and higher interest rates. As an investor, you do not want to follow the direction of US government, you do not want to own long term bonds.
When interest rates are going up it is positive for investors who purchase short term bonds or stocks. A risk averse investor would purchase CDs or Money Market funds. A risk taking investor would purchase stock. An investor can do better by watching interest rates rather than financial experts on TV.
Monday, November 17, 2008
Basics of Investing in Bonds
A balanced retirement portfolio usually contains some exposure to bonds in the form of a bond mutual fund. I found this article on bond mutual funds written by David Pitt, it gives good basic information for consideration.
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The type of bond fund you choose depends in large part on your financial goal. You need to first ask yourself whether you're seeking safety with little growth or more robust growth at higher risk. While they are safer investments, it's a mistake to think that bond funds are entirely without risk. Government bond funds, for example, have performed very well compared to other stocks and bonds this year and are considered relatively safe investments.
A Morningstar analysis shows that year to date, short-term government bond funds have earned an average of 2.6 percent and long-term government bond funds, averaged a 1.9 percent gain. In the same time frame the various categories of domestic stock funds have lost on average between 27 percent and 55 percent year-to-date. What's more, investors who earlier this year moved from equity funds into bond funds -- which have significant holdings in corporate bonds -- were able to stem some of their losses. Short-term bond funds are down 4.1 percent and long-term bond funds are down 11.5 percent so far this year.
So, you need to decide how much risk you're willing to take to determine which type of bond fund you want to choose as part of your portfolio. Fidelity Investments offers tips on how to choose bond funds.
If you're planning on investing for a year or less, a short-term bond fund may give you a better return than a money-market fund but you must be willing to see your investment fluctuate daily with market conditions. If you have more time to invest and a desire to earn more, you may want to look at intermediate- or long-term bond funds. These funds invest more heavily in higher yielding, lower-quality corporate bonds, which are higher risk. All of these choices require you to know your risk level, which may have changed with double-digit losses in your retirement account. If you can't stand losing some of the money you put into your account, many financial advisers would say a money-market fund might be your best option.
If you can tolerate losing some of your initial money and are willing to trade a little risk for higher reward, then an investment grade bond fund might work for you. The key to investing for retirement even now is not to panic and have a plan, said Jack Thurman, president of BKD Wealth Advisors, a Springfield, Mo.-based wealth management company. Unless you're within a few years of retirement, he said you should have one year's worth of expenses in savings outside your retirement account and the rest should be invested to earn as much as possible.
Millions of workers, scared by the falling stock market have taken their money out of stocks and stock mutual funds. TrimTabs Investment Research, which tracks the flow of money in and out of various funds, said through early November stock mutual funds have seen an outflow of $145 billion and international funds have shed $73.5 billion while bond mutual funds have seen an inflow of $83.2 billion over the same period.
Though the talk is of a deep recession, market watchers are increasingly discussing whether now is a good time to buy stocks because prices are so depressed. Of course the potential length of the recession is unclear, but if you're in this age group, you don't want to be on the sidelines with cash when the market surges upward. Once stocks begin to regain their strength, recovery can happen fairly quickly and if you're retirement plan is properly allocated -- many advisers recommend 60 percent in diverse stock funds and 40 percent in bonds -- you should take advantage of the upside. If you're just a few years from retirement you should have a conservative asset allocation. That means heavier investment in bonds and fewer stocks. If possible, resist the temptation to take more money out of the stock market because you'll probably need to take advantage of the market improvements to recover some of your losses.
Keep in mind that bond prices typically react opposite interest rates. When interest rates go up, bond prices likely fall and falling interest rates send bond prices higher. The current environment has also shown that bond issuers can default and fail to make payments.
One of the drawbacks to bond funds is that they may fail to keep up with inflation and therefore are often used in combination with higher yielding funds to offer portfolio balance. Fidelity advisers say it's a good idea to look at the quality of the bonds in the fund, whether they are investment grade or junk status. Those rated below investment grade (S&P rating of BB or lower) could change more suddenly if the credit quality of the issuer changes.
One more thing to look at is the expense ratio.
Morningstar says its more important to look at the cost of a bond fund, because bonds earn less over time than stock funds they're costs are a heavier burden. Morningstar believes very good bond funds are available with expense ratios of 0.75 percent or less.
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The type of bond fund you choose depends in large part on your financial goal. You need to first ask yourself whether you're seeking safety with little growth or more robust growth at higher risk. While they are safer investments, it's a mistake to think that bond funds are entirely without risk. Government bond funds, for example, have performed very well compared to other stocks and bonds this year and are considered relatively safe investments.
A Morningstar analysis shows that year to date, short-term government bond funds have earned an average of 2.6 percent and long-term government bond funds, averaged a 1.9 percent gain. In the same time frame the various categories of domestic stock funds have lost on average between 27 percent and 55 percent year-to-date. What's more, investors who earlier this year moved from equity funds into bond funds -- which have significant holdings in corporate bonds -- were able to stem some of their losses. Short-term bond funds are down 4.1 percent and long-term bond funds are down 11.5 percent so far this year.
So, you need to decide how much risk you're willing to take to determine which type of bond fund you want to choose as part of your portfolio. Fidelity Investments offers tips on how to choose bond funds.
If you're planning on investing for a year or less, a short-term bond fund may give you a better return than a money-market fund but you must be willing to see your investment fluctuate daily with market conditions. If you have more time to invest and a desire to earn more, you may want to look at intermediate- or long-term bond funds. These funds invest more heavily in higher yielding, lower-quality corporate bonds, which are higher risk. All of these choices require you to know your risk level, which may have changed with double-digit losses in your retirement account. If you can't stand losing some of the money you put into your account, many financial advisers would say a money-market fund might be your best option.
If you can tolerate losing some of your initial money and are willing to trade a little risk for higher reward, then an investment grade bond fund might work for you. The key to investing for retirement even now is not to panic and have a plan, said Jack Thurman, president of BKD Wealth Advisors, a Springfield, Mo.-based wealth management company. Unless you're within a few years of retirement, he said you should have one year's worth of expenses in savings outside your retirement account and the rest should be invested to earn as much as possible.
Millions of workers, scared by the falling stock market have taken their money out of stocks and stock mutual funds. TrimTabs Investment Research, which tracks the flow of money in and out of various funds, said through early November stock mutual funds have seen an outflow of $145 billion and international funds have shed $73.5 billion while bond mutual funds have seen an inflow of $83.2 billion over the same period.
Though the talk is of a deep recession, market watchers are increasingly discussing whether now is a good time to buy stocks because prices are so depressed. Of course the potential length of the recession is unclear, but if you're in this age group, you don't want to be on the sidelines with cash when the market surges upward. Once stocks begin to regain their strength, recovery can happen fairly quickly and if you're retirement plan is properly allocated -- many advisers recommend 60 percent in diverse stock funds and 40 percent in bonds -- you should take advantage of the upside. If you're just a few years from retirement you should have a conservative asset allocation. That means heavier investment in bonds and fewer stocks. If possible, resist the temptation to take more money out of the stock market because you'll probably need to take advantage of the market improvements to recover some of your losses.
Keep in mind that bond prices typically react opposite interest rates. When interest rates go up, bond prices likely fall and falling interest rates send bond prices higher. The current environment has also shown that bond issuers can default and fail to make payments.
One of the drawbacks to bond funds is that they may fail to keep up with inflation and therefore are often used in combination with higher yielding funds to offer portfolio balance. Fidelity advisers say it's a good idea to look at the quality of the bonds in the fund, whether they are investment grade or junk status. Those rated below investment grade (S&P rating of BB or lower) could change more suddenly if the credit quality of the issuer changes.
One more thing to look at is the expense ratio.
Morningstar says its more important to look at the cost of a bond fund, because bonds earn less over time than stock funds they're costs are a heavier burden. Morningstar believes very good bond funds are available with expense ratios of 0.75 percent or less.
Sunday, January 20, 2008
Bond Gains and Losses
The previous blog gave some information about how an investor can make or lose money on a bond when it is not held to maturity. When a bond is held to maturity the investor gets the face value. A $1,000 zero coupon bond regardless of the interest rate when purchased will pay the holder $1,000 at maturity and the transaction is between the issuing entity and the investor. If not held to maturity, the price is set in the secondary market and the transaction is between investors.
Let's go into more detail on this topic by looking at long term bonds at 10, 20, & 30 years in duration. If the normal interest rate on a long term bond is 5%, let's look at a higher rate of 7% and a lower rate of 3%.
Our example will be a $1,000 bond that has no coupon. The value of a 10, 20, and 30 year duration at 3 & 7% is shown below:
10 Year Values: 3% = $766, 7% = $544
20 Year Values: 3% = $570, 7% = $277
30 Year Values: 3% = $424, 7% = $141
If an investor buys a 30 year zero coupon bond at 7% the cost is about $141. If it is held for 10 years and the interest rate is still 7% the price is about $277, a $136 gain. If it is held for 10 years and the interest is 3% the price is about $570, a $429 gain. Having the interest rate drop resulted in an additional increase in value of about $293. This is a beautiful thing as the investor got about 4 times the initial investment over a 10 year period.
What happens if we do this in reverse. If an investor buys a 30 year zero coupon bond at 3% the cost is about $424. If it is held for 10 years and the interest rate is 7% the price is $277, a $147 loss. This is a terrible thing as the investor lost about one-third of their money.
Bottom Line: If your buying long term bonds and you think interest rates will be falling then you have an opportunity to get a capital gain. Currently, with long term interest rates are at or below historical levels I am not sure that now is a great time to become aggressive in long term bonds for the average investor. An investor that is buying long term bonds in this environmen t should review their investment savvy and ability to be nimble.
Let's go into more detail on this topic by looking at long term bonds at 10, 20, & 30 years in duration. If the normal interest rate on a long term bond is 5%, let's look at a higher rate of 7% and a lower rate of 3%.
Our example will be a $1,000 bond that has no coupon. The value of a 10, 20, and 30 year duration at 3 & 7% is shown below:
10 Year Values: 3% = $766, 7% = $544
20 Year Values: 3% = $570, 7% = $277
30 Year Values: 3% = $424, 7% = $141
If an investor buys a 30 year zero coupon bond at 7% the cost is about $141. If it is held for 10 years and the interest rate is still 7% the price is about $277, a $136 gain. If it is held for 10 years and the interest is 3% the price is about $570, a $429 gain. Having the interest rate drop resulted in an additional increase in value of about $293. This is a beautiful thing as the investor got about 4 times the initial investment over a 10 year period.
What happens if we do this in reverse. If an investor buys a 30 year zero coupon bond at 3% the cost is about $424. If it is held for 10 years and the interest rate is 7% the price is $277, a $147 loss. This is a terrible thing as the investor lost about one-third of their money.
Bottom Line: If your buying long term bonds and you think interest rates will be falling then you have an opportunity to get a capital gain. Currently, with long term interest rates are at or below historical levels I am not sure that now is a great time to become aggressive in long term bonds for the average investor. An investor that is buying long term bonds in this environmen t should review their investment savvy and ability to be nimble.
Understanding Bonds
The blog has been talking about making and losing money on bonds. Perhaps some questions need to be answered. How is it possible to lose money on bonds? Which bonds should a person buy? Should a person buy junk bonds?
How is it possible to lose money on bonds?
This is the main subject of the next blog. A few points of interest:
How is it possible to lose money on bonds?
This is the main subject of the next blog. A few points of interest:
- Bond prices move inverse to interest rates. What this means is if the interest rate drops it will cost more money to sell and buy a bond. To illustrate this point the value to sell and buy a $1,000 30 year bond that has no coupon, makes no semi-annual payments, is $141 at a 7$ interest rate and $424 at a 5% interest rate.
- If a bond is sold early, not held to maturity, price come into play and if sold for less than purchases is a capital loss and if sold for more is a capital gain.
Which bond should a person buy?
A bond is an obligation for an entity to pay you back on the money you are allowing them to use. A key is when do you want your money back? Realizing that the longer the time that this entity has your money the higher the return to compensate you for the additional risk. This is not always 100% true as yield curves on occasion do inverse with longer term bonds having a lower interest rates than shorter term bonds.
My guidance is to buy a series of bonds to ladder your maturity dates, have bonds mature at different times, instead of a single bond. Another alternative that is much easier is to buy a bond mutual fund. This gives a greater amount of flexibility for an average investor.
Should a person buy a junk bond?
The first thing to do is define a junk bond. The simplest definition is a bond that is assigned a speculative rating by a rating agency. To put it simpler, they have a higher chance of not paying you your money meaning a higher degree of risk. Why would anyone buy junk bonds because with greater risk should come the potential for a greater return.
Do I recommend an average investor buy a junk bond. No!!!
Do I recommend an average investor buy a mutual fund that includes a grouping of junk bonds. Yes!!! Why? In the book a Random Walk Down Wall Street, on average a mutual fund of junk bonds yields about 7.5% while a mutual fund with in investment grade bonds yields about 5.5%. This means to me that you can achieve about a 30% higher return at a low amount of risk of default. Things would have to be really bad if one of these funds had a 30% default rate.
Bottom Line: You need to understand your time horizon, needs, and risk level before buying bonds or bond mutual funds.
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