A bond that sells for 100 and pay 5 percent looks like the clearest, easiest to understand investment possible. Yet it is actually a much more complex organism. Read these ten common bond misconceptions, and you will no doubt understand why.
A “sell for 100” bond costs $ 100
Welcome to the first bond complexity: jargon! When a bond broker says he has a “sell for 100” bond, it means that the bond is not for sale for $ 100, but for $ 1,000. If that same bond were “on sale for 95,” it would be on the market for $ 950. If it were “sold for 105,” you can buy it for $ 1050.
The face value or face value of a $ 1,000 security deposit is $ 1,000. But the market value depends on whether it is for sale for 95, 100, 105, or whatever. Also, that $ 1,000 face bond can be said to “pay 5 percent”, but that doesn’t mean you will get 5 percent for your money!
It means that it will get 5 percent of the face value: that is, 5 percent in 1000 dollars, or $ 50 per year, which can mean a return of about 5 percent for you.
If you paid 105 for the bond (which is called a prize), we will find ourselves making less than 5 percent for your money. If you paid 95 for the bond (which is called a discount), you will be making more than 5 percent for your money.
Buying a bond with a discount is better than paying a premium
Discounted bonds sell at a discount for a reason; Premium bonds sell at a premium for a reason. Here’s the reason: These premium bonds typically have high coupon rates than prevailing coupon rates. Discount bonds, by contrast, usually have promotional rates lower than the prevailing coupon.
Both in theory and in practice, two bonds with similar ratings and similar maturities, all other things are the same, will have similar yields to maturity (the yield that really matters) either sold at a premium or a discount.
Example: Bond A, published in 2005, has a coupon rate of 6 percent. Bond B, released in 2010, has a coupon rate of 4 percent. All the rest of the securities are the same: same issuer, same expiry date (say 2025), same due date.
Currently, similar bonds are paying 5 percent. One would fully expect Bond A to sell at a premium and Bond B to sell at a discounted price. In both cases, their returns to maturity would be expected to be around 5 percent.
A bond paying x% today will pocket you x% for the duration of the loan
A bond paying a 5 percent coupon can (if the bond is purchased at a discount) is something higher yielding, like 6 percent. But every six months, as you collect that 6 percent for your money, you can either spend or reinvest it.
If you reinvest at a higher interest rate – say 8 percent – then the total return on your money, over time, will be higher than both the coupon rate of 5 percent and the current yield of 6 percent.
Rising interest rates are good (or bad) for bondholders
In general, rising interest rates are good for future bondholders (who will see higher coupon payments); for those who currently own securities, the rise in interest rates may not be as good because the rise in interest rates will push bond prices down. (Who wants to buy your bond to pay 5 percent when the other bonds are suddenly paying 6 percent?)
On the other hand, rising interest rates allow present bondholders to reinvest their money (coupon payments that arrive twice a year) for a higher return.
In the end, however, what matters most to bondholders is the real interest rate , after taxes. The real interest rate is the nominal rate minus the inflation rate. You prefer to get 6 percent on a bond when inflation is running at 2 percent to 10 percent on a bond when inflation is running at 8 percent – especially after taxes, which the nominal rate and ignore inflation.
Some securities (such as treasuries) are completely secure
The United States government can print money and raise taxes. So there is not much chance of Uncle Sam having to default on his debt – This is true. Treasuries are not completely secure, however. There are still other risks faced by bonds: inflation risk and interest rate risk.
There is also the risk that a future crowd of heads of government may find the government so much in debt, and the thought of raising taxes or risking inflation intolerably, that they decide to pay bondholders 90 cents on the dollar. Other governments have done this.
Bonds are a retiree’s best friend
Rely on a fixed-income portfolio all to replace your salary, and it would be better to have a terribly large portfolio or you risk running out of funds. Bonds, unfortunately, have a long-run inflation track record surpassing only a modest margin.
If you’re planning on a long retreat, that little bit of gravy may not be enough to get you through the rest of your life without resorting to a terribly tight budget. The retiree’s best friend is a diversified portfolio that has stocks (for growth potential) and bonds (for stability) and money (for liquidity), with perhaps some real estate and a smattering of mixed goods in.
Individual bonds are usually a better deal than bond funds
Some of the more recent exchange-traded funds offer an instant diversified bond portfolio with a total expense ratio of peanuts – in the case of iShares, Schwab, SPDR ETF bonds, and Vanguard, you are looking at 0.10-0.15 percent l ‘year. (That’s 15 percent of 12 percent a year or less.)
These ETFs are excellent ways to invest in bonds. Many other bond funds offer professional management with reasonable expenses and impressive long-term performance records.
Buying single bonds may be the best route for some investors, but the decision is rarely a dunk, especially for those investors with bond portfolios of, say, $ 350,000 or less. Less than that, and it can be difficult to diversify a portfolio of individual stocks.
Municipal bonds are exempt from tax
Most municipal bond income is exempt from federal income tax, but can be taxed locally and state-wide. If you see a gain on the disposal of a muni or muni fund, that gain is taxed in the same way as any other gain would be.
And certain municipal-bond income is subject to the Alternative Minimum Tax (AMT), designed so that those who make six digits and more cannot deduct the way they pay no tax.
Do municipal bonds make sense to you? The tax issue is the primary one. Unfortunately, it is not as simple as it seems. Don’t invest in Munis, which typically pay lower interest rates than taxable bonds do, without the whole picture.
A discount broker sells cheaper securities
Often, a discount broker has the best offer in bonds, but sometimes not. This is especially true of new offers for municipal and corporate bonds, when a full-service broker can actually be packaging, binding for the public. It is always worth looking around. When buying Treasury securities, don’t go to any broker; purchase directly on the TreasuryDirect website.
The biggest risk in bonds is the risk of the defaulting issuer
Even in the world of corporate junk bonds, where the default risk is real, it is still not the greatest risk that bondholders have. A bond can also lose a lot of market value if the issuing company is simply downgraded by one of the major credit rating agencies.
Most commonly, however, major incidents of a bond if interest rates go up. No matter how creditable the issuer is, a rapid rise in interest rates will cause the value of your bond to dip. This is not a problem if you hold an individual bond until its expiration, but you may be less thrilled to be in possession of a bond that is paying 5 percent when all other stocks are paying 8 percent.