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Bond Basics – A Primer to the Bond Market


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Railroad BondToday we’re going to revisit the basics of the bond market. Bonds are issued by companies and government entities in order to finance their operations. They are a form of debt, contrasted with stocks which are a form of equity (though some bonds can be converted into equity in a company, these are called convertible bonds). Bonds are generally underwritten and issued on primary markets for companies. For governments they are usually issued at auction to both banks and individuals. Bonds have a par value at issuance and pay an interest rate called a coupon. They can be redeemed at maturity date.

Dynamics of Bonds

There are many factors that influence how much a bond will be worth.  Perhaps the most important factor is the market interest rates. Bonds are usually issued with fixed interest rates so when market interest rates increase, the price of bonds will decrease. The most basic way to measure bond performance is to calculate its yield: Yield = coupon amount / price. So for a $500 par value bond with a maturity date of 10 years and a coupon rate of 5%, its total coupon amount will be $25: 5% yield = $25 coupon value / $500 price. Decrease the price to $400 and the yield increases to 6.25%, increase the bond price to $600 and the yield drops to 4.17%.

Another dynamic to consider when buying bonds is their credit rating. US Government bonds usually carry a lower yield as they carry some of the lowest risk of default and investors are attracted by their security. Bonds with higher yields are often issued by companies and governments with troubled financials in order to attract investors; these bonds are called junk bonds. Credit rating agencies like Standard & Poors and Moody’s allow investors to check the health of bond issuers.

Types of Bonds

As we mentioned before, bonds can be issued by many different entities. US Treasury bonds are issued by the US federal government. This is generally the lowest category of risk and is classified by maturity time:

  • Treasury Bills (T-bill) – Matures in less than a year
  • Treasury Notes – Matures in 1-10 years.
  • Treasury Bonds – Matures in 10 years.

Municipality bonds, or muni bonds are bonds that carry a slightly higher risk but are still unlikely to default, as they are issued by cities and towns: Governments are able to adjust their taxes to pay back bonds. Many muni bonds are also completely tax-free which can be a great incentive for some investors.  Finally corporate bonds are the highest risk category and it’s important to check the credit rating and financials of the company issuing these before considering purchasing.

Zero-coupon bonds should also be of mention.  It’s possible for bonds to be issued without a coupon that is paid annually or semi-annually.  The most well-known kind of zero-coupon bond are Series EE Savings Bonds.  Instead of the Treasury paying coupon rate, these bonds are sold at a 50% discount and accrue interest that can be redeemed along with the par value on or after the maturity date.  There are even some rare bonds on the market which pay a coupon but do not mature.  Finally, it’s possible for the coupons and the par value of bonds to trade separately.

Why Bother With The Bond Market?

The first thing early investors often look to invest in is the stock market, but the bond market is just as important in a balanced portfolio. During a bull market, stocks generally outperform bonds and can deliver staggering returns. However, during a bear market, bonds are often seen as a safe haven to make a predictable return on investment.  Bonds usually perform well when looked at as a long term investment.

Since the fallout from the 2008 financial crisis, the bond markets have been highly active in part due to the fiscal policy adopted by the Federal Reserve.  We’ve reported before that the bond market can also be incredibly risky in this economy. Recent statements by the Federal Reserve chairman have caused the markets to turn and many investors are now exiting on concerns that the Fed will stop quantitative easing and/or raise interest rates.  It’s unlikely that the Fed will be able to keep up its bond purchase programs indefinitely and the bond market could be the next bubble to burst.  Indeed already the US Treasury yields have been on a steady climb.

Where to Purchase Bonds

Most bonds are purchased through a broker. Most brokers require investors to keep a deposit with them in order to purchase bonds on the market.  Be sure if using a broker to background check them at BrokerCheck to be sure of the legitimacy of the broker you’re working with.  The US Treasury also now sells bonds directly through their own Treasury Direct website.  Finally, it’s also possible to trade pools of bonds using various ETF’s to take advantage of leveraging and play on when the yields are going to move.

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Municipal Bonds Offer A Safe Way to Earn Tax Free Income


Municipal Bonds Have Fallen In Value Due to Default Concerns

Municipal BondsMunicipal Bonds have been out of favor during 2011 because the well regarded financial analyst Meredith Whitney warned in November 2010 about potential defaults in the Municipal Bonds sector, which caused many investors to sell their holdings in Municipal Bonds.  Many Municipal Bonds, and Municipal Bonds investment vehicles such as Municipal Bonds Exchange Traded Funds (ETFs), lost 10% to 20% of their value due to the analyst’s warning, and have yet to fully recover from the price drop.  This price drop has created an excellent buying for opportunity investors interested in investing money in Municipal Bonds.

Many investors rely too heavily of stocks for generating investment returns over long periods of time.  This is largely due to the allure that the stock market has for exceptional profit opportunities and the media coverage of the stock market versus other asset classes.  However, investment advisors almost universally recommend that maintaining a balanced investment portfolio is the best way to protect one’s investments from downturns in various asset classes, such as stocks and real estate.  Typically, a 20% to 30% investment in highly rated bonds is recommended, with even higher bond investment percentages for investors who are near or in
retirement.

Municipal Bonds Offer Tax Free Income

For those looking to shift some of their investment portfolio into bonds or increase their exposure to bonds, now could be the right time to buy Municipal Bonds, as they continue to trade at reduced levels after the late 2010 analyst downgrade.  This is due to ongoing concerns about Municipal Bonds defaults, as the United States economy continues to expand slowly, with indications that a new recession could be brewing due to the European debt crisis.  However, these concerns about Municipal Bonds defaults so far appear to be overblown, as the default rate for Municipal Bonds has not be unusually high in 2011.

What really makes investing in Municipal Bonds appealing is the tax free income that they provide.  Depending on the type of Municipal Bonds and where one lives, an investor may be able to earn tax free interest that is free of local, state, and federal income taxes.  With some Municipal Bonds offering 7% yields, their tax free income is especially appealing in the current low interest rate environment in which many savings accounts earn less than 1% in taxable interest.  Another reason that Municipal Bonds are an appealing investment at this time is that if the Municipal Bonds market recovers from its current slump, investors will not only earn tax free interest on their holdings in Municipal Bonds, but could also make money on the appreciation of the price of the bonds, as they increase in value.  The money made on the appreciation of the price of the bonds would be considered a taxable capital gain when the Municipal Bonds are sold.

Since it is not practical for most individual investors to research the risks associated with investing in specific Municipal Bonds and putting all one’s investment eggs into one bond is not a good investment strategy, it is recommended to invest in Municipal Bonds via an investment vehicle such as an ETF or mutual fund.  There are many ETFs and mutual funds that invest in Municipal Bonds in specific states, thus ensuring that the income earned by investing in Municipal Bonds is tax free in the state in which an investor lives.

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Investing In Government Bonds


The Basics of Investing In Government Bonds

Investing In Government BondsInvesting In Government Bonds, in particular United States Treasury Bonds, is a “safe haven” investment that investors have relied on for years to provide steady returns on investment in the form of periodic interest payments by the United States government.  Investing In Government Bonds in the form of United States Treasury Bonds is considered a “safe haven” investment because regardless of the state of the economy, the United States government is viewed as an entity that can be relied upon to make interest payments on their debts.  There are a number of different types of government bonds to consider, from United States Treasury Bonds issued by the federal government to Municipal Bonds, which include bonds issued by local, county, and state governments.

Interest earned from United States Treasury Bonds is not usually taxed on a local or state level, but is subject to federal taxation.  Interest earned from Municipal Bonds is not subject to local, state, or federal taxation, which make municipal bonds appealing to investors looking for a tax haven.

Investing In Government Bonds – The Benefits and Risks

The United States Treasury sells government bonds with a variety of maturity periods, ranging from three months to thirty years.  The interest rate paid to investors holding United States Treasury Bonds is determined during the initial auction of the bonds; the longer the maturity, the higher the interest rate.  For example, the popular 2-year, 10-year, and 30-year United States Treasury Bonds currently provide annual interest rates of 0.35%, 2,80%, and 4.12% respectively.  On a historical basis, the interest rates paid on United States Treasury Bonds are currently very low, and the bonds are selling at elevated levels.  This is due to the 2008 financial crisis and subsequent severe recession and slow economic recovery, which has resulted in an enormous demand for United States Treasury Bonds from investors seeking a safe place to invest their money.  Investors who are interested in Investing In Government Bonds should take this into consideration because when the United States economy returns to a healthy condition, the value of United States Treasury Bonds that are brought at currently elevated levels will likely fall, as demand subsides and investors sell government issued bonds to seek out higher investment returns elsewhere, such as via the stock market.  This would cause a loss of investment principal for investors who invest in government bonds at currently elevated levels.

The 2008 financial crisis had a much different effect on Municipal Bonds than United States Treasury Bonds, which needs to be understood by those considering Investing In Government Bonds.  With local, county, and state governments reeling from the financial crisis, housing market meltdown, and the severe recession that followed, concerns have been raised about the ability of local, county, and state governments to make interest payments on the Municipal Bonds that they have issued, raising the possibility of large scale defaults in Municipal Bonds.  This has caused investors to sell their holdings in Municipal Bonds, which has caused Municipal Bonds to lose 10% to 20% of their value.  Unlike United States Treasury Bonds that are currently overvalued on a historical basis, Municipal Bonds are currently undervalued on a historical basis, which makes them attractive to investors looking to protect their principal investment.  Municipal Bonds are still at risk of widespread defaults, should the United States economy fall back into a recession in the near future.  But if the United States economy recovers, Municipal Bonds could appreciate nicely in price as they pay out tax free interest payments to the holders of the bonds.  For more information about Municipal Bonds, see:  Municipal Bonds Offer a Safe Way to Earn Tax Free Income.

Since 2011 is a year in which a slow economic recovery is occurring after a severe recession, Investing In Government Bonds has a number of risks and opportunities that are not normally present in the government bond market.  However Investing In Government Bonds is still be viewed as one of the safest ways to invest money.

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Information about Bond Futures Trading


How Bond Futures Trading Works

bond futures trading

As all futures trading, bond futures trading involves the sale and purchase of legally binding contracts that obligate one to buy or sell specific bonds at predetermined prices on a given date. While the details are all spelled out in the contracts, there is always one variable that enables investors to make incredible profits in these ventures. The price of a bond at the time of a futures contract purchase is not necessarily the price of the bond during the interval between buying the future and actually buying the bond. If the bond’s value increases before the date of the contract arrives, the investor can try to sell the bond future and keep the difference in prices as profit.

The Advantages of Bond Futures Trading

There is risk involved in bond futures trading. The investor cannot be certain of an increase in bond prices and must rely on his or her own knowledge of the market to predict how bonds will perform in the future. It is possible that the bonds will lose value and the investor will have a hard time exchanging the bond futures without taking a loss. However, the possibility for a quick return in the short term keeps the bond futures trading market quite active.

The first advantage of bond futures trading is the way that a large amount of bonds can be leveraged for just a fraction of their total price. This makes it possible for even small investors to participate in this risky but lucrative form of trading. In addition, investors can choose from the available types of bonds for their futures contracts. The 30-year Treasury bond and both the ten-year and five-year treasury notes are subject to investment as bond futures. These options in bond futures trading allay concerns about the risks involved.

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Investing In Bonds In 2011


Investing In Bonds In 2011 – What You Need to Know

Investing In Bonds In 2011Investing In Bonds In 2011 is more complicated than usual because investors who were spooked by the sharp drop in the stock market in 2008 and 2009 have invested their money heavily into bonds in recent years, which has caused highly rated bonds and bond funds to trade at elevated values during 2011.  Making the situation even more complicated is the fact that municipal bonds and municipal bond funds are currently trading at depressed levels due to concerns about municipal bond defaults.

What this all means is that Investing In Bonds In 2011 is not the same as investing in bonds during a typical economic period with moderate to robust economic growth.  In 2011, an investor’s bond trading strategy will be influenced by the type of bond one is contemplating investing in and their investment strategy and goals.

Investing In Bonds In 2011 – Investing Strategy Depends On The Type of Bond

Investors often seek out highly rated bonds for the safe and secure returns on principal that highly rated bonds pay out as interest payments.  Bonds are rated by major rating agencies such as Standard and Poors and Moody’s.  Bonds that are rated BBB- and above are considered investment grade bonds.  Investors who put their money into highly rated bonds face little risk of losing the principal invested due to a default on interest payments by the bond issuer.  The risk of bond default decreases with higher rated investment grade bonds, with AAA being highest rated and least risky bonds.  The trade off for investors is that the less risky the bond, the lower the interest payment, due to the higher demand for less risky bonds and the lack of a risk premium.

In normal times, the principal invested in highly rated bonds and bond funds is not considered to be at risk, and the risk of principal loss is not factor into an investors decision to buy highly rated bonds and bond funds.  However, Investing In Bonds In 2011 is different than bond investing is in normal times because highly rated bonds and bond funds are trading at elevated prices in 2011 due to all the buying interest from investors during the preceding three years.  Once the bond market returns to a more normal trading level, sometime after 2011 when the economy makes a sustained economic recovery, the highly rated bonds and bond funds will lose some of their principal as investors sell, perhaps as much as 20%.

Due to the low interest rates and the potential for loss of principal in investment grade bond investments, Investing In Bonds In 2011 means investors need to look at junk bonds to earn substantial interest payments and municipal bonds to earn modest interest payments.

Junk bonds provide significantly higher yields than more highly rated investment grade bonds, due to the higher risk of default associated with issuers of junk bonds.  Investors demand higher yields from junk bonds in exchange for assuming a higher risk of default.  However, this trade off may be worth it to bond investors Investing In Bonds In 2011, since junk bonds offer attractive interest rates that are not available elsewhere.  Junk bonds also have little risk of principal loss, if they are brought via a junk bond mutual fund or Exchange Traded Fund (ETF).  These funds spread the risk out and avoid junk bond defaults.  Unlike investment grade bonds, junk bonds and junk bond funds are not trading at a premium in 2011, so as long as an investor avoids the principal risk associated with owning individual junk bonds by buying junk bonds via a mutual fund or Exchange ETF, their principal invested will be relatively safe.  For more information about junk bonds, see:  The Junk Bond Market Offers High Yield Returns.

With the potential for appreciation of the principal invested, Investing In Bonds In 2011 is different than normal times in the municipal bond market.  Because concerns have been raised regarding potential defaults in municipal bonds, as local, county, state governments struggle with fiscal challenges due to the 2008/2009 recession, bond funds that invest in municipal bonds are trading at depressed levels in 2011.  A sustained economic recovery after 2011 should cause municipal bonds and municipal bond funds to increase in price, thus providing an increase in the principal invested in municipal bonds and municipal bond funds.  It should be noted that if the economy goes into another severe recession, funds invested in municipal bonds could fall substantially if defaults in municipal bonds occur on a widespread scale due to cash flow problems at local, county, and state governments.  For more information about municipal bonds, see:  Municipal Bonds Offer a Safe Way to Earn Tax Free Income.

Investing In Bonds In 2011 is very different than a typical year, and therefore, investors need to look closely at what kind of bond or bond fund they are thinking of investing in during 2011, and what market forces are impacting the bonds and bond funds they are considering investing in.

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Is It Too Late to Buy Bond Funds?


How Bond Funds Reached Current Elevated Levels

Bond FundsBond Funds, including mutual funds and Exchange Traded Funds (ETFs), that invest in a wide variety of bonds (both government and corporate) have done well since the financial crisis of 2008 and 2009.  The reason why Bond Funds have done well in recent years is because investors who were spooked by the sharp drop in the stock market in 2008 and 2009 sought out safer places to invest their money.  Not wanting to put their cash in low yielding bank savings accounts, investors piled into Bond Funds, which pushed the price of Bond Funds higher.

Many investors have done well over the past two to three years with the strategy of investing their money in Bond Funds, as their money has been earning a decent steady rate of return.  The weak economic recovery and reluctance of the Federal Reserve to raise interest rates has caused demand for bonds and Bond Funds to continue to be strong, which has supported the price of Bond Funds, as strong money flows have keep buy side pressure on Bond Funds.

While investors jumped into Bond Funds because they were looking for a safe haven during the 2008 and 2009 financial crisis, investment advisors recommend maintaining a 20% to 30% investment in highly rated bonds during all times to diversify one’s investments across multiple asset classes.

The Current Risk Associated With Buying Bond Funds

With bonds and Bond Funds currently at elevated levels due to the buying pressure over the past three years, the question must be asked whether buying Bond Funds is currently risky since in a normalized economy the bonds and Bond Funds should revert to their mean and fall in price.  Those who brought Bond Funds before or early on in the 2008 and 2009 financial crisis are sitting on good positions that have earned interest over time, and have little risk of losing money on the principal that they invested in Bond Funds.  However, those who are contemplating purchasing Bond Funds now, at their current elevated price levels, need to realize that there is a real risk that once the economy returns to normal, and growth rates and interest rates start to rise, the Bond Funds will fall in price, as buying pressure eases and holders of bonds and Bond Funds sell.  This will put their investment capital at a risk of a slight loss as the value of the Bond Funds they hold decrease.

The potential for a slight loss from buying Bond Funds now may seem acceptable to some investors since the economy currently appears to be slowing, and another recession may be on our doorstep.  Another recession would ensure that Bond Funds will maintain their elevated levels for a prolonged period of time, allowing the buyer of Bond Funds to recoup some of their initial investment via interest payments on the bonds held by the Bond Funds.

It should be noted that due to concerns about defaults in municipal bonds, Bond Funds that invest in municipal bonds are actually at depressed levels, so the risk of buying these funds at elevated levels is not a factor.  However, funds invested in municipal bonds could fall substantially if defaults in municipal bonds occur on a widespread scale due to another recession causing cash flow problems for state and local governments.  For more information about municipal bonds, see:  Municipal Bonds Offer a Safe Way to Earn Tax Free Income.

There are many different Bond Funds that invest in a wide variety of bonds with various bond ratings and maturity dates.  Although, the risk associated with buying Bond Funds now and incurring a loss of principal when the economy recovers is something to consider, Bond Funds are worth considering for the relative safe and secure returns that they provide.

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