When the Internet gold rush was at its peak in late 1999, few investors thought it worthwhile to seek the diversification and lower risk of bond investing. After all, why put money in a bond fund yielding 8% when the Nasdaq Composite was up 80% in one year? Well, in March 2000, technology stocks began spiraling downward. Investors not interested in stomaching that type of gut wrenching volatility might think about diversifying into bonds.
So - you may be interested in checking out this bond thing, but how? The world of bonds is somewhat murky in comparison to equities. Traditionally, it has been the role of institutions to navigate the credit markets. Hopefully, this tutorial will help clear things up for the individual investor.
Although the news media covers bonds far less than the stock market, the U.S. bond market is enormous. In fact, the Bond Market Association estimates that the total dollar value of public and private debt during mid-year 2000 was at $15.5 trillion AND GROWING. - Since 1990 - that's ten years - the total level of debt has grown more than 100% from just $7.4 trillion.
So why doesn't the media cover the bond market much? It's because, in comparison to the stock market, the bond market is illiquid. Many of the corporate and municipal issues are traded infrequently, although treasuries are traded actively. There are two reasons why bonds are rather staid. First - most individuals who buy bonds are interested in holding the bond to term for the income stream, as opposed to speculating on interest rates (we'll get to that in a bit). Secondly - bonds fluctuate based primarily on prevailing interest rates, whereas most stocks fluctuate based on a myriad of variables, interest rates being only one of them.
The federal government, corporations, municipalities and federal agencies issue bonds to investors as debt instruments. When you buy a bond, you are the lender and the issuer is the creditor. The issuer pays a specified rate of interest, usually two times each year, from the time of issuance until the maturity of the bond, at which time the principal amount of the loan (the bond par value) is repaid.
Does the type of bond that you buy matter? You bet. Purchasing the correct type of bond will depend upon each individual's risk tolerance, investing goals and tax situation. Included here are the main categories, not covered are miscellaneous federal agency bonds, money markets, and various asset-backed pools.
Treasury notes, bills and bonds -
these are debt instruments issued by the U.S. Federal Government. Now that's solid - no risk of default here, at least we hope, or we're all in trouble! Because default risk is zero, these instruments pay a lower rate of interest than corporate or federal agency bonds. Investors who receive interest payments from a treasury issue will pay federal taxes on the interest income, but are not subject to state or local taxes. Of course, if the bond is sold before maturity, any capital gains will be taxed just like a stock capital gain.
Treasury bills, notes and bonds are issued in denominations of $1000 each. Individuals are estimated to own only 5% of the total treasury market through directly buying treasuries, but mutual funds account for another 11% of the total. Want to know what the total is? About $3.2 trillion.
Federal Government debt is designated as a Bill if the maturity of the debt is less than 1 year. Notes range in term from 1 year to 10 years and Bonds are anything in excess of 10 years. The price of treasury issues is driven higher or lower by expected changes in interest rates.
Federal Agency Bonds -
Federal Agency Bonds are also called mortgage securities, because the underlying asset against which the debt is borrowed is real estate, primarily home loans.
Did you know that when you pay your home mortgage, your payment is ultimately passed on to bondholders? Federal agencies take on the very important role as issuers and guarantors of mortgage securities when they bundle thousands of real estate loans for resale in the credit markets. Why is this so critical? Banks, Savings and Loans and Credit Unions do not want to hold long-term mortgage loans on their books. By passing these real estate loans to federal agencies, lenders are free to issue more loans, thereby freeing up adding additional credit liquidity to our economy.
The market for agency backed securities is very large, about two-thirds the size of the federal debt. At mid-year 2000, Agency bonds were at approximately $2.3 trillion.
Three government agencies handle mortgage debt. The first, The Government National Mortgage Association (Ginnie Mae) is a federally owned corporation under the control of the Dept of Housing and Urban Development. The other two agencies are directed by Congress but owned privately. They are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
These loans are not free of default risk. Ginnie Mae, Fannie Mae and Freddie Mac act as guarantors for the securities they issue, but the federal government does not, in turn, back these agencies with "full faith and credit". Since there is a very slight risk, the yield of these bonds is slightly higher than a treasury bond of equivalent maturity.
Agency bonds have a special pricing structure based on "weighted average life", also called duration. The duration computation is necessary because agency bonds are a bundle of thousands of mortgages, each with a different maturity. Duration is used to arrive a definable maturity for the bond.
Agency bonds are susceptible to interest rate fluctuations in a peculiar way. Homeowners, who pay the interest payments on their mortgages, are more likely to prepay when prevailing interest rates decline. When prevailing interest rates increase in comparison to existing home loans, homeowners are likely to extend the life of their loans as long as allowed.
Municipal Bonds -
State and local government issue Municipal Bonds for anything from day to day running of the bureaucracy to building of roads, bridges, stadiums, etc. Rates on Municipal bonds are typically lower than any other type of bond, for one reason. Muni's are not taxed at the federal level.
Since interest payments from a Municipal bond are federal tax exempt, they are a popular investment for individuals in high tax margin brackets. Individuals who purchase Munis issued in their own state of residence are often exempt from state and local taxes as well. Keep in mind though, that if the bond is sold before maturity, capital gains taxes do apply. This is a consideration when purchasing a Muni, since the maturity of these bonds can range up to 50 years.
There are two primary types of Munis. The first, called a Revenue Bond, repays interest from the flow of revenues generated by a project, such as a highway toll. The other type is a General Obligation bond, which repays interest in the normal way - by collecting taxes.
Recent statistics show that individuals own approximately 35% of all outstanding municipal debt. During mid year 2000, the total municipal debt market stood at $1.5 trillion.
Municipal bonds do not enjoy the default free status of treasuries, as such, their credit risk is measured by one of the main rating services, which include Standard & Poors and Moody's Investor Services.
Corporate Bonds-
Corporates are the high yielders of the bond market. Many are traded on the New York Stock Exchange, but the majority are traded in the electronic OTC market. The most active issues are traded every day, but the majority of issues do not see trades on a daily basis, making the market illiquid overall.
Corporate debt outweighs all other categories in terms of size. At mid-year 2000, the total corporate market stood at $3.15 trillion, yielding an average of 8.1% on long-term maturities, according to estimates by Moody's Investor services.
Speaking of Moody's, corporate bonds are rated according to credit risk and ratings range from AAA to Baa/BBB (investment grade ranges) all the way to junk bonds (or high yield bonds for those wishing to roll the dice!) Other companies, including Standard and Poor's, also assign a rating system to corporate debt.
Corporate bonds are issued at $1000 par, but due to high transaction costs, purchases of $25,000 or more are usually necessary to make corporate bond investing worthwhile.
