What time a government or corporation needs money to pay for a special project or expansion, it can fund operations with cash saved in the organization or with cash raised by selling securities. If the organization chooses to sell securities, it can sell bonds. Bonds represent a promise made by the issuer to repay principal and interest to the bondholder at prescribed intervals during a prescribed time period. When you think bond, think loan. And think of yourself as the lender because you supply the bond issuer with money that will usually be repaid to you as periodic interest payments. Bonds mature when the prescribed time period elapses.
Bonds are more defined and stable than stocks. Whereas the life of a bond is time-limited, your stocks can be passed on to your heirs and to your heirs' heirs for generations after you buy them. Bond payments are also more fixed than stock payments because the issuer promises a fixed interest payment at prescribed intervals. Dividends, which are the cash payments made to owners of stocks, can rise and fall unpredictably -- or even cease entirely -- for any given stock.
Unlike bond interest payments, the value of bonds can fluctuate just like stock values, but the changes are less volatile and the reasons for those changes are different. Stock values change as a result of market perceptions about the success of the stock issuer. Bond values fluctuate in response to changes in the issuer's ability to repay and to changes in the prevailing interest rates. For example, if a bond issuer suddenly encounters reduced sales that restrict its cash flow and ability to fulfill its promise to pay interest and principal to the bondholder, the market will treat the bond as a risky investment. And rising interest rates suppress bond values, while falling rates pump them up.
Governments back the payment of interest and principal with their taxing authority, but corporations back bonds with the corporation's ability to earn money. Corporate bonds are, therefore, generally riskier and pay higher interest than government issues. When the market questions a bond issuer's ability to repay interest or principal, the bond is called "junk." Junk bonds usually pay high interest to compensate buyers for the high risk they assume when buying them.
Bond issuers can choose, before they issue their bonds, how to time repaying their debt. Most bond repayment timing consists of bi-annual interest payments and principal repayment when the bond matures. Alternatively, bond issuers can postpone payments until maturity when they pay all interest and principal. Even if the bond issuer selects either of these, a brokerage firm can buy the bonds and resell the cash flows in different formats. For example, they can take the principal portion of a bond and sell it at a deep discount and not pay any interest on it. Then they can take the interest portion of the bond and sell that as a separate security that promises only interest payments without any principal payment.
Category of Bonds:
Commercial Bonds
• Mortgage bonds -- Issued for the purchase of certain assets that are pledged as collateral
• Equipment Trust Certificates -- Serial bonds secured by specific equipment
• Debentures -- Unsecured promissory notes
• Income bonds -- The indenture states that interest will be paid only if the issuer earns the money to make interest payments
• Convertible bonds -- Can be exchanged for prestated number of issuer's common stock
• Variable Interest bonds -- Pay interest rate tied to an indicator of prevailing rates such as Treasury bills
• Zero-Coupon bonds -- Pay all interest and principal upon maturity; also known as discount bond
• Euro-bonds -- Issued outside the United States and denominated in U.S. dollars
Government Bonds
• U.S. Treasury bills -- Zero-coupon issues with maturities less than one year
• U.S. Treasury notes -- Bonds with maturities from one to 10 years
• U.S. Treasury bonds -- Bonds with maturities greater than 10 years
• GNMA -- Mortgage pass-through bonds issued by the Government National Mortgage Association, a U.S. federal government agency
• FHLMC -- Mortgage pass-through bonds issued by the Federal Home Loan Mortgage Corporation, a U.S. federal government agency
• Collateralized Mortgage Obligations -- Fixed income securities created from mortgage-backed securities (like GNMAs) designed to control risks
• General Obligation Municipal bonds -- Local or state government issue backed by the taxing authority of the issuer, pay federally tax-free interest
• Revenue Municipal bonds -- Local, state or agency issues backed by the revenue earned on the funded project
• Series EE and HH bonds -- Issued by the U.S. Treasury in small denominations to appeal to individual investors
How to Value Bonds
Bond issues assure to repay the features value of their bond.Features value is the amount borrowed by the issuer, and is usually expressed in increments of $1,000, $5,000 or $10,000. Since the bond market assesses prevailing and expected interest rates, the interest paid on comparable issues and the issuer's ability to keep its promise, the market might not value the bond according to its features value. If it considers the bond to be a risky investment, it might only be willing to pay a percentage of face value, which is called a discount. If the market thinks this issue is a great deal, it might pay a premium for the bond.
The value of a bond is the "present value" of future interest and principal payments. Present value is absolute cash payments adjusted for the timing of the payments. Since a future payment is worth less than a payment made today, timing is important. If you have to wait a year for a payment, you are losing the interest you could have earned by investing in a bond with quarterly payments and then using those payments to invest in something else. For example, say that you are considering buying a bond that pays both interest and principal upon maturity one year from now. The absolute cash payment will be $1,100 and today's market price, according to your broker, is $1,020. You do some research and find bonds with the same maturity and risk that yield 5 percent. This little formula calculates the present value of the bond:
Future payment / (1 + yield)
If payment will not come for two or more years, the denominator (1 + yield) is raised by an exponent equal to the number of years before payment. In the example above, the present value is ($1,100 / (1 + .05) =) $1,047.62. Since the present value is greater than today's market price, this bond is a bargain at the broker's quoted price of $1,020. This formula can be applied to the future interest and principal payments of all bonds.
Evaluating Bond Performance
As we've seen in previous lessons, sound investment practice includes the periodic evaluation of your investment performance. The two-step process below compares the performance of individual investments, grouped into categories, with available indices. An index is a group of bonds selected to represent a certain type of bond. Examples of indices include high-grade (safe) corporate bonds and Treasury bonds.
In the first step of the process, you compare the performance of all bonds you own with an appropriate index. If, for example, your high-grade corporate bonds earned 5 percent during the prescribed period, which is usually a year, and a good high-grade corporate bond index earned 2 percent, you can conclude that your corporate bonds are performing well.
The second step compares individual bonds with appropriate indices. This step identifies high- and low-performing investments and helps you to decide whether you should sell or stand pat.
The decision to sell is driven by the goals and preferences expressed in your investment plan. If you don't have the time and expertise to do this kind of evaluation yourself, mutual funds offer an outstanding and potentially lucrative alternative to investing in individual bonds and stocks.
Investing in Mutual Funds
What Is a Mutual Fund?
A mutual fund is an investment cooperative managed by an investment company. As in other cooperatives, (such as credit unions), mutual fund investors pool their assets together and employ an investment company with investment professionals and administrators who conduct the day-to-day business of managing the fund. Each mutual fund is distinguished by an investment objective. For example, the Vanguard 500 Index fund invests only in stocks comprising the Standard & Poor 500 index.
The popularity of mutual funds exploded in the 1980s and 1990s, mainly because they offer more benefits to individual investors than individual stocks do. They reduce investment costs and provide professional investment management while enabling individual investors to diversify portfolios very easily.
Reduced Costs & Diversification
Brokers charge commissions on individual security prices that can quickly add up in a well-diversified portfolio, eating into your returns. Most Internet discount brokers charge $20 to $50 commissions to buy and sell one round lot (100 shares). Full-service brokers, who also provide investment advice, charge much more. If you owned 20 stocks, their round-trip discount commission could total approximately $1,000. Since investors pool all their money into mutual funds, they enjoy economies of scale in management and transaction fees, which usually lowers the cost of broker fees.
Mutual funds also enable investors with small- and medium-sized portfolios to diversify in an efficient manner. You could create a minimally diversified portfolio on your own with $50,000, but some experts say that you'd need to invest $100,000 to do the job right. In contrast, a mutual fund will allow you to invest in all 500 stocks comprising the S&P 500 Index with only $1,000.
The Impact of Fees and Loads
Mutual fund investors still need to pay attention to fees and loads despite the economies of scale they enjoy. The cost of mutual funds assumes two forms: periodic fees and transaction fees.
Periodic fees, which are also known as management fees, are assessed at least annually as a percentage of the value of your investment. The percentage varies significantly from one investment company to another, depending on whether the fund invests in stocks or bonds and whether it tracks an index or is actively managed to beat an index.
Fixed-income funds and index funds charge the lowest fees. Fees exceeding 1 percent are common, though you can find funds charging less than 0.25 percent. Actively managed stock funds charge the highest periodic fees, often exceeding 2.75 percent per year.
Transaction fees, known as loads, are also expressed as a percent of investment value. The charge applies when you buy and/or sell the investment. Most loads are less than 5 percent. No-load mutual funds charge periodic fees and, as the name implies, don't charge any transaction fees. These periodic fees, however, are often higher than load fund fees, so you need to be careful.
Culling Useful Information From the Prospectus
Investment companies are required to offer a prospectus when offering mutual fund shares for sale. The prospectus details everything about the fund. Though the prospectus is filled with legalese and technical terms, a novice can cull the vast majority of essential information by following these five simple steps:
1. Select a prospectus from one of the widely known investment companies.
2. Read the investment objective on the first page. The objective states whether the mutual fund invests in fixed income, equity or both, giving clues about how risky the fund is. Be on the lookout for an elaboration of the objective deeper in the prospectus.
3. Identify the cost of the mutual fund. Loads are usually stated on the inside cover. Periodic fees are reported in a table, which is usually found in the first few pages. Look for a tabled column or row entitled "Ratio of expenses to average net assets." Data are grouped to report annual results. While you're here, also find the turnover rate, the percent of the portfolio replaced each year. A 100 percent turnover rate means everything in the portfolio at the beginning of the year was sold and replaced once during the year. Higher turnover increases costs and may indicate excessive turnover due to bad investment decisions. You should favor income stock funds and fixed income funds with turnover rates less than about 100 percent. As you approach more risky investments such as small growth stock funds, 150 percent is not uncommon.
4. Examine historic investment returns. Usually you can find a table or chart illustrating returns. If you can't find this, go to the table you examined in step 3 and find either the two columns or rows (depending on the table's format) with these headings: net asset value at end of year and total from investment operations. To calculate annual return, divide one year's total from investment operations by the immediately previous year's net asset value at the end of the year. Compare annual returns with an appropriate mutual fund index to evaluate how well the fund has performed in relation to its peers.
5. Find a section with the word "risk" in the title. Risk discussions are usually straightforward, and lay out worst-case scenarios.
There's more in the prospectus, but these steps will be more than enough to get you started. The investment policy section is usually technical, but with time, practice and more experience you'll catch on. Be sure to keep the prospectus whenever you decide to buy a fund.
Taxes and Mutual Funds
Mutual funds have one major drawback: unlike taxes on individual investments, the federal income tax applies to all mutual fund earnings, even if you don't sell your shares.
And it doesn't take a CPA to imagine how painful this can be to an investor. Let's say you buy a growth fund and hold it for at least two years. In the first year, it earns 10 percent, and in the second year it earns 15 percent. You dutifully pay tax on your earnings without a second thought. But, since you could have reinvested this money, you should consider the taxes you pay for mutual funds as lost income.
If your mutual funds are invested in tax-favored accounts, you'll only have to pay taxes when you start drawing on your account.
Adopt a Consistent Mutual Fund Selection Process
With 10,000 mutual funds available, how are you going to find the best funds to achieve your goals? By the time you're finished researching all of them, you'll already be retired!
The best advice is to find a good book and use it until the pages get worn. The NEW Commonsense Guide to Mutual Funds by Mary Rowland delivers sound guidance and practical advice on selecting and managing mutual funds. Her list of 75 "Dos and Don'ts" lays the groundwork for a sensible approach to mutual funds.
Chaos characterizes the retail financial products industry. Every firm has a story to tell. While some tell it with colorful charts, others pummel us with performance data and index comparisons. Investors familiar with mutual fund advertisements would probably agree that it seems like most mutual funds are well aware of these two strategies and readily bombard us with them.
The investor's only defense is a written plan. A plan that identifies specifics and a firm strategy cuts through the blitz of advertisements and all the smooth sales pitches. A written plan leads to consistently applied mutual fund selection criteria. Get a book and write your plan.
Investment Considerations
The Effects of Taxes
Taxes reduce investment returns in two ways. First, federal and state taxes take a significant percentage out of each dollar an investor earns. Second, when the government takes its cut, you are unable to earn any returns on the money you paid in taxes.
When it comes to municipal bonds and treasuries, the issue of taxes present a small problem -- their interest payments are generally less than those of taxable bonds. A high-grade corporate bond might pay 6 percent, while a muni or Treasury with the same maturity might pay only 5 percent. You have to ask yourself one question: "Which investment yields a higher after-tax return?"
You'll only need to know two things and have access to a calculator in order to answer this question. The first piece of information is your marginal tax rate. The second is a little formula enabling conversion of taxable interest to non-taxable interest, and vice versa.
Calculating Your Marginal Tax Rate
The marginal tax rate is the rate you pay for each additional dollar of taxable income. To figure this out, you'll have to go digging through your files and find last year's federal and state tax tables. Find the row with the taxable income you expect this year. Subtract the lower "At least" value from the higher "But less than" amount. You'll need to use this number in the next step, so jot it down and hold onto it for a while.
Next, locate the associated income tax amount and then subtract from that value the tax owed for the range of incomes immediately below yours. Add the federal and state marginal tax rates, and you will arrive at your state and federal marginal tax rate.
Translating Taxable and Non-Taxable Rates
The non-taxable equivalent of a taxable interest payment is the stated payment rate multiplied by one minus the marginal rate. Let's say your marginal rate is 30 percent and a taxable bond pays 6 percent. The non-taxable equivalent is .06 times (1 - 0.3) = .042. The result of this calculation tells you that a muni issued in your state paying more than 4.2 percent will earn more after taxes than a taxable bond paying 6 percent. Looking at this from the other direction, the taxable equivalent of a non-taxable interest payment is the stated non-taxable payment rate divided by one minus the marginal rate. Continuing with the scenario we used in the example above, a muni from the state where you reside paying 4.2 percent is .42 divided by (1 - .3) = .06. The result of this calculation tells you that a taxable bond paying more than 6 percent will earn more after taxes than a non-taxable bond paying 4.2 percent.
Use only your state marginal tax rate for Treasuries, and only use the federal marginal rate for munis issued outside your home state.
Dollar Cost Averaging
Dollar cost averaging is one of the most powerful and simple wealth-enhancing techniques ever devised. Put the same amount of money into your investments at preset intervals. Consistently apply the practice indefinitely, and do so without respect to whether the market rises or falls.
Dollar cost averaging draws its power through consistent application and by forcing you to buy more shares when prices are low and fewer shares when prices are high. Here's an example of how dollar cost averaging works: Each month you write a check for $100 and deposit it into your stock fund. Let's say that in the first month you begin the plan, shares of a stock cost $10 dollars, so you buy 10 shares.
The second month, the stock market has skyrocketed. You buy 6.67 stock fund shares at $15 with your $100. So now, after the second month, you own a total of 16.67 stock fund shares. At this point, even though stock fund shares sell for $15, your average cost is only $12.
The markets will rise and fall from month to month. But over the long run, markets will rise in value. By practicing dollar cost averaging over a long period of time, you will always buy more shares when prices are low and fewer shares when prices are high. As a result, your cost per share will be less than their current market value. Besides instilling discipline in the investing process, dollar cost averaging results in more shares purchased at lower prices than prevailing prices. That translates to a sound long-term strategy for wealth enhancement.
Records: Keeping It Simple and Organized
It is a taxable event whenever you sell an investment or your investments pay a dividend or interest. Keeping good records helps you avoid paying more tax than you have to. Brokers and investment companies do most of the record keeping for you. They send you statements itemizing all of your transactions on, at the very least, a quarterly basis. Put all of these statements in chronological order, keeping a separate file for each individual investment. But even a good filing system serves only half of the record-keeping task.
Since files can get thick and unwieldy after a few years, you should also maintain a chronological journal by investment that records each transaction. If you make it a regular practice to record the transaction each time you receive a statement, you can save yourself a lot of trouble later on when you need to call on your records in an emergency situation.
It pays to keep things simple whenever possible. Avoid buying two mutual funds with the same objective unless you have a good reason to duplicate your investment. To keep from becoming overwhelmed, minimize the number of brokerage firms you employ so that the information comes from as few sources as possible. Using brokers that supply reports via the Internet can also lessen the burden if you can download the reports and file them electronically. Just be sure they are safe in case harm comes to your computer.
Evaluating Portfolio Performance
The investor's ability to apply his or her investment plan is an essential element of evaluating a portfolio. A good investment plan starts with an introspective assessment of your risk tolerance and financial goals. These can be at odds with each other, so it's important to reduce them to objective terms.
Let's say your goal is to become rich -- really rich. How will you know when you've become really rich? Define "rich" in terms of the value of your assets or income and a time horizon for achieving it. For example: My goal is to own investments worth $1,000,000, fixed assets worth $500,000 and liabilities not exceeding $250,000 by June 30, 2020.
You'll use investments as one of the means for achieving your goal. But before you begin investing, you need to nail down your risk tolerance and reconcile it with your goals. Risk tolerance places an upper limit on the rate of return you can expect to earn. So if your goal requires above-average returns, your risk tolerance must also be above average. Reconciling risk tolerance and goals requires adjusting your risk tolerance upward or adjusting your goal downward, depending on the situation you find yourself in. Your tool for this reconciliation is the investment plan, where you write down your risk tolerance and goals.
The investment plan states, with as much objectivity as possible:
• Investment categories and their allocations
• Rejected investment categories
• Target rates of return
• Intermediate goals
• General policies, such as broker selection and tax strategies
• Investment strategies including decision rules that govern buying and selling
• Procedures for evaluating your plan and goals
A well-conceived plan establishes your blueprint. The implementation of the plan consists of periodic performance reviews, usually on a semi-annual basis, and your ability to follow through with your plan. During the review, examine your plan. Does it still reflect your risk tolerance and goals? Compare each element of the plan with the status of your portfolio. Does the portfolio allocation match the plan? Have portfolio elements matched your targets? Are returns likely to achieve intermediate goals? Have you worked within your policies? Your answers to these questions will govern the implementation of your decision rules for buying and selling.
