Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 33)

Bonds (part C)

by

Charles Lamson

What's a Bond Worth?

One of the problems with bonds is the language and math used to describe how they work and are traded. So let us jump right in and get a handle on common bond terminology and math.

Bonds, like stocks, are sold on two venues. The first is at original issue and the second is in the secondary market.

Original Issue

When a bond is issued, it is at par value. Since most bonds are issued in $1,000 denominations, the par value is $1,000. The bond is also issued at a fixed interest rate, or coupon rate. The bond also has a maturity date, which is the day when the bond must be paid in full.

For example, XYZ Corp. might issue 10-year bond with an interest rate of 6 percent and a par value (the nominal value of a bond, share of stock, or a coupon as indicated in writing on the document or specified by the charter) of $1,000. The owner of this bond would receive $60 a year in interest, and at the end of 10 years would receive the full $1,000 back.

Under this scenario, the yield of the bond would be the same as the interest rate.

PROCEED WITH CAUTION Many issuers of new bonds will absorb the sales commission themselves, making new bonds more attractive. However, you must always look at the total return, which includes not only fees but also yield and any discount.

Secondary Market

The secondary market for bonds works much like the stock market in that buyers and sellers are matched for a fee. It is in the secondary market that a bond's yield may fluctuate.

Since bonds are issued for a specific interest rate, they react to changes in interest rates. If interest rates rise, the older bond will not be as valuable and must be sold at a discount. When the bond's price falls below par, the yield will drop also. Here's how it works:

XYZ bond is bought at issue for $1,000 with a fixed interest rate of 6 percent for a 10-year term, giving it a yield of 6 percent. After two years, the bondholder wants to sell, but interest rates have risen to 7.5 percent. No one will buy a 6-percent bond at par when they could buy a 7.5-percent bond at par. Translation: Why buy a bond that yields only $60 a year, when you could buy one that yields $75 a year? The answer is discount.

The bondholder will have to reduce, or discount, the face value to make the bond attractive in this market.

JUST A MINUTE The complicated nature of figuring a bond's worth often discourages investors from adding individual bonds to the portfolio.

The formula for calculating a bond's yield follows: annual interest divided by price equals yield.

For the bondholder to match the current yield of 7.5 percent, the par price is discounted on $800. To calculate the yield on the discounted bond, divide the annual interest ($60) by the price ($800) and you get the yield.

For the bondholder to match the current yield of 7.5 percent, the par price is discounted to $800. To calculate the yield on the discounted bond, divide the annual interest ($60) by the price ($800) and you get the yield.

Why would you want to buy an older bond with a lower interest rate? Take a look at this table from the buyers perspective:

	Original Bond Issued @ 6%	2 year-old 6% bond Bought on Secondary Market
Interest Rates	6%	7.5% (2 years later)
Par	$1,000	$1,000
Total Interest	$600	$480
	$1,600	$1,480
Less Original Cost	-$1,000	-$800
Return	$600	$680
Yield	6 percent	7.5 percent

Under the two-year old bond, we see that, if held to maturity, the bondholder would collect $480 in interest ($60 x 8). Added to the $1,000 face value the bondholder will receive at maturity, that gives a total gross return of $1,480. Subtracting the discounted cost of the bond ($800), That leaves the bondholder with a return of $680, or 7.5 percent.

See the advantage? Our bondholder invests $200 less than the original owner and makes more in yield and return.

Here is what the transaction looks like from the seller's perspective:

	Original Bond Issued @ 6%	2 year-old 6% bond Sold on Secondary Market
Interest Rates	6%	7.5% (2 years later)
Par	$1,000	$800
Total Interest	+$600	+$120
	$1,600	$920
Less Original Cost	-$1,000	-$1,000
Return	$600	-$80
Yield	6 percent

Rising interest rates have produced an $80 loss. This points out one of the risk factors in bonds: if you have to sell before maturity, you may suffer a loss if interest rates have climbed.

This is a simple example, although not necessarily representative of real market conditions, which shows the importance of understanding yield. Yield is the primary way you can compare bonds.

JUST A MINUTE Since bonds are tied so closely to interest rates, it is important for bond investors to know what is happening with interest rates and to be especially alert when the Fed board meets.

Professional bond traders use a more sophisticated version of the yield calculation called yield to maturity. Yield to maturity is a complicated calculation that takes into account relationships between price and interest rates. It assumes your coupon or interest payments are reinvested at the same interest rate and compounded. This gives you a way to look at return over time.

There are online tools that help you with this calculation, or your broker can figure it out for you. You can find calculators at About.com's bond site (www.bonds.about.com).

In summary, understanding bond pricing is not difficult, but it is somewhat counter-intuitive. Here are the key points:

• Bonds have fixed interest rates.
• Higher interest rates make lower-interest bonds less attractive, which lowers their price on the secondary market.
• Lower interest rates make higher-interest bonds more attractive, which raises their price on the secondary market.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 202-205*

END

PROCEED WITH CAUTION

Many issuers of new bonds will absorb the sales commission themselves, making new bonds more attractive. However, you must always look at the total return, which includes not only fees but also yield and any discount.

JUST A MINUTE

The complicated nature of figuring a bond's worth often discourages investors from adding individual bonds to the portfolio.

Original

Bond

Issued @

6%

2 year-old

6% bond

Bought on

Secondary

Market

Interest Rates

6%

7.5% (2 years later)

Par

$1,000

$1,000

Total

Interest

$600

$480

$1,600

$1,480

Less

Original

Cost

-$1,000

-$800

Return

$600

$680

Yield

6 percent

7.5 percent

Original

Bond

Issued @

6%

2 year-old

6% bond

Sold on

Secondary

Market

Interest

Rates

6%

7.5% (2 years later)

Par

$1,000

$800

Total

Interest

+$600

+$120

$1,600

$920

Less

Original

Cost

-$1,000

-$1,000

Return

$600

-$80

Yield

6 percent

JUST A MINUTE

Since bonds are tied so closely to interest rates, it is important for bond investors to know what is happening with interest rates and to be especially alert when the Fed board meets.

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 32)

Bonds (part B)

by

Charles Lamson

Municipal Bonds

Municipal bonds is a catchall phrase for bonds issued by state, county, city, or other local authorities. Most people are familiar with "munis," as they are called beecause local governments use them to pay for schools, roads, and other construction projects.

Municipal bonds are rated for the creditworthiness of the issuer. Usually, the issuer needs to show how the bonds will be repaid. The most common way is through existing or increased taxation. The tax money pays the periodic interest rate and builds a pool of money to retire the bonds at maturity.

Munis are exempt from federal income tax and, in some cases, when the purchaser lives in the jurisdiction of the issuer, may be exempt from state and local taxes; the so-called triple tax-free bond. High-income taxpayers are especially attracted to these bonds.

JUST A MINUTE Triple tax-free bonds or mutual bond funds sound great, but only make sense if you are in a fairly high tax bracket. Most middle-income investors will do better in regular funds.

Mutual bond funds that offer the triple tax-exempt status are sold in individual states because the buyer has to reside in that state to qualify for the triple exemption.You can identify these funds in the newspaper tables easily because they often are named for the targeted state.

For example, if you look under mutual funds listings in your Wall Street Journal, you will notice that the USAA Group offers funds titled "CA Bd, NY Bd, and VA Bd." These funds target  muni investments in California, New York, and Virginia, respectively, and are sold to the residents of these states.

Munis are usually issued at a lower coupon or interest rate than corporate bonds with the same rating because of the tax-exempt feature and are sold in denominations of $5,000 and up with maturities ranging from 1 month to 40 years.

Like most bonds, munis usually require a large minimum investment and are sold through brokers. Investment bankers often buy up blocks of the bonds and resell them to dealers and brokers who hold them in inventory to sell to their customers.

PROCEED WITH CAUTION Municipalities guard their bond ratings carefully. A lower rating can mean millions of dollars in extra interest.

While not as safe as U.S. Treasury issues, top-rated munis are considered a minimal risk. Of course, this relative safety and tax-exempt status significantly reduce the interest rate.

Municipal bonds that do not earn a good rating often pay a much higher interest rate to compensate for the higher risk of default. There are a number of mutual funds that specialize in high income from these higher-risk bonds.

Munis, especially those issued with high interest rates, may have a call provision. This provision, which is covered in  the "Prepayment" section later in a later post, allows the issuer to redeem or buy back the bond at certain points in the bond's maturity.

Corporate Bonds

Corporations issue bonds to finance a wide variety of business related needs, from expansion of physical plants to finance acquisitions. Bonds are often preferred over bank loans, because the company may be able to structure the bonds to fit its need at a lower interest rate.

Corporate bonds are rated by the top services based on much the same criteria as munis: creditworthiness, ability to repay, and so on. The bonds are issued at $1,000 par value (that is, full price), but are usually sold in large bundles.

Corporate bonds come in three maturity lengths:

• Short term for 1 to 5 years
• Mid term for 5 to 15 years
• Long term for 15 years+

PROCEED WITH CAUTION Corporations find bonds an attractive way to finance growth and acquisitions. Commercial loans are usually more expensive, and issuing stock may dilute shareholder positions.

Corporate bonds are at the top of the risk scale when compared to U.S. Treasury Bonds, agency bonds, and municipal bonds of the same rating. The reason is that corporations are more vulnerable to the ebbs and flows of the economy, market conditions, and competitions.

Highly rated corporate bonds offer very little risk and are often used in income mutual funds for their stability of income streams. Some corporate bonds have a call feature, so be sure you understand this status before you invest (see the section "Prepayment" in a later post for more information on calling).

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 199-201*

END

JUST A MINUTE

Triple tax-free bonds or mutual bond funds sound great, but only make sense if you are in a fairly high tax bracket. Most middle-income investors will do better in regular funds.

PROCEED WITH CAUTION

Municipalities guard their bond ratings carefully. A lower rating can mean millions of dollars in extra interest.

PROCEED WITH CAUTION

Corporations find bonds an attractive way to finance growth and acquisitions. Commercial loans are usually more expensive, and issuing stock may dilute shareholder positions.

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 31)

Bonds (part A)

by

Charles Lamson

In this post we are going to look at bonds in greater detail than in previous posts, when I introduced you to some of the basics of "fixed income securities," as bonds are known.

The total worth of bonds owned by Americans is more than stocks and mutual funds. Bonds occupy a huge role in our economy and continue to be an attractive source for corporate financing, as well as for governments.

Types of Bonds 

In previous posts, we have touched briefly on different types of bonds. Now it is time to dig deeper for a better understanding of their strengths and weaknesses. The types of bonds we will be discussing are as follows:

• U.S. Treasury
• U.S. government agency
• Municipal
• Corporate

However, today's post will only cover U.S. Treasury and U.S. government agency bonds. In the next post, I will focus on municipal and corporate bonds.

PROCEED WITH CAUTION Bonds have some unique characteristics that make them well suited for many investors. However, they are not necessarily for everyone. A fixed yield and known maturity can be a positive tool in your investment arsenal.

U.S. Treasury Bonds

The U.S. government through the Department of Treasury issues debt instruments of various maturities to finance the day-to-day and long-term needs of the government. They come in three basic flavors:

• T-bonds have the longest maturities ranging from 10 to 30 years
• T-notes have mid-range maturities ranging from 2 to 10 years
• T-bills are short-term issues ranging from 90 days to 1 year

All of the Treasury issues come with the full backing of the U.S. government, meaning they are the benchmark for safety. The absolute assurance that they will be paid back comes with a price in the form of relatively lower interest rates.

The bond market watches these issues very closely because they represent the absolute in safety if held to maturity. When interest rates change on new Treasury issues, it usually signals a movement in interest rates on other issues.

JUST A MINUTE Brokers may charge relatively high commissions on bond sales. For the best rates, shop for brokers who specialize in bond sales.

The Federal Reserve Bank sells new issues at auction, but sales in the secondary market must be done through a broker.

New T-bonds and T-notes are issued in denominations starting at $1,000 and ranging up to $1 million. T-bills are issued in denominations of $10,000 and may be bundled for much larger investments.

T-bonds and T-notes pay periodic interest just like other bonds and are redeemable for face value at maturity. T-bills, on the other hand, are sold at a discount off the face value. The difference between the face value and the discount price is the interest. No interest payments are made; rather, the bills are redeemed at face value.

For example, a $10,000 T-Bill pays 5 percent interest. You would buy the bill for $9,523.81 and redeem it for the full $10,000 face value. The difference of $476.19 is your interest.

All three of the U.S. Treasury issues are exempt from state and local taxes, but not federal tax.

U.S. Government Agency

U.S. Government agency bonds are often used to finance mortgages provided under various government programs. The best known are Ginnie Mae (GNMAs), Fannie Mae (FNMAs), and Freddie Mac (FHLs) bonds. These bonds are taxable.

There are also bond programs that support student loans, loans to farmers, and other agencies. These bonds are reported in The Wall Street Journal under "Government Agency & Similar Issues." These bonds are exempt from state and local taxes.

Some of these issues may be rated by the standard rating services. They usually pay higher rates than Treasury issue, with just slightly more risk. Their maturities raise from 1 month to 20 years in some cases. Most are sold in very large denominations of $100,000 or more.

JUST A MINUTE U.S. government bonds feature lower yields than other bonds because of the absolute safety they provide. Agency bonds that are backed by mortgages may suffer during economic downturns when foreclosures rise.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 197-199*

END

PROCEED WITH CAUTION

Bonds have some unique characteristics that make them well suited for many investors. However, they are not necessarily for everyone. A fixed yield and known maturity can be a positive tool in your investment arsenal.

JUST A MINUTE

Brokers may charge relatively high commissions on bond sales. For the best rates, shop for brokers who specialize in bond sales.

JUST A MINUTE

U.S. government bonds feature lower yields than other bonds because of the absolute safety they provide. Agency bonds that are backed by mortgages may suffer during economic downturns when foreclosures rise.

Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 30)

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 Stocks (part F)

by

Charles Lamson

Special Situations 

Penny stocks and IPOs are two special situations that deserve attention in this analysis because they are topics of great interest.

Penny Stocks

Penny stocks, as the name implies, are a group of unlisted securities traded in the over-the-counter market. There are thousands of these companies, many very respectable.

Subsets of these stocks normally trade for less than a dollar and are often issued by highly speculative companies. When you can find pricing, it is often arbitrary and misleading.

PROCEED WITH CAUTION The Internet has given con artists a new venue to run their schemes. Many of these scams target honest but naive people who think it is possible to get in on hot deals.

Many of these stocks are legitimate; if highly speculative, companies. Unfortunately, they are also the weapon of choice for a particularly unscrupulous breed of stock manipulators.

Here is how this scam works:

You get a call or e-mail from a person who identifies himself as a broker with a hot deal. He may reference someone you know or use some other trick to gain your confidence. He encourages you to invest in this great, new, "undiscovered" company or some other come-on.

The great thing about this deal is that you can lock up 10,000 shares for just $5,000, again because the big boys" have not discovered this gem. If you cannot afford $5,000, he will try to get you in at a smaller amount.

You send him some money and, for the most part, that is the last you will see of it. You may get an update a few weeks after your check clears telling you things are going right on schedule, and wouldn't you like some more stock before it really starts to soar?

JUST A MINUTE People incorrectly assume that because the stock market is highly regulated, they are safe from illegal stock scams. Most of these scams operate without regulatory knowledge until someone complains.

Behind the scenes, this broker and maybe 50 others are all calling prospects that are known or suspected of being gullible. The company they are touting may in fact be a legitimate company with no knowledge of this activity, or it can be a sham designed just for the purpose of parting you from your money.

The brokers own a big chunk of the stock and use the money you send to generate a lot of activity in the stock, which causes the price to rise. When the price gets where they want it, they dump their stock and walk away from the deal.

The stock crashes when the brokers' shares are dumped on the market and all the investors who thought they were getting in on a hot deal get burned instead.

These schemes have many variations, but result in the same conclusion: You lose your money.

Part of the problem is the market in penny stocks is virtually unregulated. If a broker from a licensed and registered dealer misleads you or does something fraudulent, you have regulatory bodies that can step in and set things right.

 However, most of the penny stocks trade in an unregulated market, and many of the brokers who sell them are known securities law violators.

The bottom line is: Do not buy penny stocks.

IPOs

Initial public offerings (IPOs) occur when a company first issues stock to the public. They are the subjects of intense interest because their prices can jump so radically if the market takes a liking to the company.

JUST A MINUTE IPOs are the legal equivalent of stock manipulation. The only people that consistently make money in IPOs are investment bankers.

When a company wants to move into the publicly traded sector, it plans to issue (sell) stock to the public through an offering. This offering is highly regulated and must meet a number of requirements before the stock can be sold to the public

The company picks an investment banking firm or firms to handle the offering. Once the offering is priced and packaged, a target date is set for the public sale.

However, before the public gets a shot at the stock, it is often sold to the investment banker's real customers, the retail stock brokerage firms. They in turn will offer it to their best customers before the public has a shot.

PROCEED WITH CAUTION People make money in IPOs by getting in and getting out at the right time. Most people cannot figure this out and buy too high and sell too low.

As you can see, there are several steps along the way; at every step the stock price goes up so that by the time it hits the streets for public sale, it may already be way above the initial price listed in the IPO documents.

All of this is perfectly legal and an accepted way of doing business, although there are a couple of Internet-based organizations that are trying some different methods. One company, Wit Capital (www.witcapitalmanagement.com), allocates IPO shares on a first come, first served basis and also does the underwriting itself.

Generally, IPOs are not good investments. Most of them are trading at or near their offering price within a year of going public, no matter how intense the interest for the first offering.

The people who make money on IPOs generally are big customers of retail brokers and get the good offering price. They usually will sell all or part of their original purchase for a hefty profit and, if they think the company is going to be a significant player, hold some for future appreciation.

JUST A MINUTE Even the folks who get in early face some obstacles. If they sell immediately after the stock is made available, their broker may cut them off from future offerings. Selling so quickly is called "flipping," and the brokerage houses do not like to see it because it can erode confidence in the offering if holders sell so quickly.

Most of us will not get an IPO at or near the original offering price. We have to buy when the stock actually hits the market. If the company is hot, the price can skyrocket. If you can get in early and then get out, you may make a profit.

The bottom line on IPOs is that they are not good investments for the most part. If you want to chase them, do so with the understanding that it is a highly speculative activity and is not consistent with a sound investment strategy.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 191-194*

END

PROCEED WITH CAUTION

The Internet has given con artists a new venue to run their schemes. Many of these scams target honest but naive people who think it is possible to get in on hot deals.

JUST A MINUTE

People incorrectly assume that because the stock market is highly regulated, they are safe from illegal stock scams. Most of these scams operate without regulatory knowledge until someone complains.

JUST A MINUTE

IPOs are the legal equivalent of stock manipulation. The only people that consistently make money in IPOs are investment bankers.

PROCEED WITH CAUTION

People make money in IPOs by getting in and getting out at the right time. Most people cannot figure this out and buy too high and sell too low.

JUST A MINUTE

Even the folks who get in early face some obstacles. If they sell immediately after the stock is made available, their broker may cut them off from future offerings. Selling so quickly is called "flipping," and the brokerage houses do not like to see it because it can erode confidence in the offering if holders sell so quickly.