How Much Do Bond Holders Get Back in a Bankruptcy? (on average)

When a company goes bankrupt the bond holders stand a good chance of getting back some of their principal investment.   Bonds are a form of debt and when the company goes into bankruptcy they are supposed to repay their debts as much as possible.   Stock holders on the other hand are considered owners of the company and are generally last in line to get any money and therefore usually get nothing or next to nothing.

But how much do bond holders usually get back?


I found the answer in this Standard and Poors report : U.S. Recovery Study: Recent Post-Bankruptcy Recovery Levels Disappoint Senior Unsecured Bondholders

They say : "Recoveries averaged 33% in 2010 and 2012 (through May)--significantly lower than the long-term average of 43%" 

Of course those are just the broad averages so it varies considerably.  But this gives us a general idea of the typical loses for bond holders in the case of bankruptcy.

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What Are High Yield Junk Bonds?

This is a guest post written by Gary Dek, a personal finance blogger and freelance writer at Gajizmo.com. Gary graduated from a top-ranked university with a finance degree and worked in the industry for 3 years before venturing out to work online.

When it comes to bonds, one man's “junk” is another man's high yield investment. High yield bonds offer a better coupon rate than other types of investments because they carry a higher risk of loss. Sometimes the risk to return is better for junk bonds than it is for stocks, though the S&P just returned 16% in 2012. Despite the higher risks, junk bonds are not necessarily a bad investment, especially for smart investors who calculate risk-adjusted returns based on the sustainability of the underlying assets and their respective cash flows. Nonetheless, junk bonds are high yield securities that can be an important part of an investment portfolio, but investors should consider their needs and goals before jumping into this market. As with any investment, there are advantages and disadvantages that need to be considered.

What Are High Yield Bonds?
Companies issue bonds as a way to raise money, making them, in essence, a type of business loan. The company may need the money to expand operations through capital expenditures such as property, plant and equipment, pay off higher interest debt, or share buybacks. Most companies issue bonds at one time or another, but high yield bonds are issued by companies that have a less than stellar credit rating. The rate of return on these bonds is dependent on the credit worthiness of the issuing company. Because companies in a poor financial position have difficulty attracting investors, they offer higher returns to compensate investors for the higher risk of loss. Higher returns also attract investors who are in a position to take a loss if the company folds.

Advantages of “Junk” Bonds
Junk bonds offer a higher rate of income than their more secure counterparts, which is the clearest advantage for high yield investments. In a diversified, fixed income portfolio, junk bonds are a way to achieve higher returns when compared to other safe investment options available. The value of the bond may increase if the issuer's credit rating improves. Investors who believe a company has an unfair credit rating may have identified an excellent investment.

Bonds are more secure than common equity shareholders if a company goes bankrupt because they take precedence during a bank liquidation of assets. While bondholders may take a loss, they usually recover at least some of their initial investment even if company stock is rendered worthless. While you may not make any money, you will probably not lose all of your investment either. Another advantage of bonds over stocks is that they provide a consistent income as long as the company does not default and continues to pay the coupon rate. The returns on stocks tend to fluctuate with the market.

Some businesses, like discount retail chains, are less vulnerable to recession than other businesses. High yield bonds in a recession resistant company may actually be just as secure as a long term investment in a highly rated company in an industry that is vulnerable to recession. Sometimes, recessions are not the only catalysts for a strong company losing its leadership in an industry. For example, BlackBerry (formerly Research in Motion) was well-known as the leader in business smart phones in the early 2000s. However, their complacence and lack of innovation left an enormous niche in the consumer market unfulfilled, and Apple jumped at the opportunity with an amazing iPhone product. Now, Blackberry is trying to stay alive with a new mobile operating system, but who knows if it will be enough? If Blackberry were not a technology company with no debt, and instead was a highly-levered manufacturing company left behind, chances are, their debt would have been downgraded.

Disadvantages of High Yield Bonds
As with any high yield investment, the risk inherent in junk bonds is higher than the risk of other investments. Investors who are adverse to risk, or who cannot afford to take a loss should consider the pros and cons of more secure investments like mutual funds or annuities. Since these bonds can be more difficult to sell than other securities, liquidity can be a problem. Investors who want to recoup their investment quickly should probably find financial instruments that can be sold easily.

The value of the bond will fluctuate with the company's credit rating. If the credit rating goes up, the value of the bond increases, but if it goes down, the bond may be worth less than the original purchase price. Like all other types of bonds, the prices are also affected by changes in interest rates. If interest rates go down, the value of bonds increase; but if interest rates go up, bonds decrease in value.

Additionally, junk bonds are subject to loss of value in a recession when investors run to conservative investments like gold and cash and investment-grade bonds. Since high yield bonds are viewed as risky even in a strong economy, investors believe they are even riskier during periods of recession.

Investing in Junk Bonds
The most common and probably the easiest way to buy high yield bonds is through a broker. Both online discount brokers and those with local offices can help you purchase bonds and some will even offer advice on the bonds that are best for your particular needs and goals. You should check to make sure the broker you use has a good reputation and charges a fair commission.

Another option is mutual funds that specialize in high yield bonds. Many mutual fund companies buy a variety of bonds (diversification) which offers more security than buying bonds from a single company. Check out the fund's performance and the types of investments they make before deciding where to put your money. Mutual funds may have a fee (load) at the time of purchase, and usually have annual fees for administering accounts.

The third way to invest in high yield bonds is to buy them directly from the company and not pay any sales commission. Commercial banks sometimes sell bonds with no commission, but this service is usually reserved for customers with large accounts.

Bond Prices Can Be Affected By Sales
Major purchases of bonds can affect their price and therefore their value, so small investors should know who invests in high yield bonds. Pension funds often invest in high yield bonds to increase their earnings, but they usually only invest a small amount of their total assets because government regulations prohibit high risk portfolios. Insurance companies are probably the largest investors in high yield bonds, which they use to fund annuities and other financial products they sell. While mutual funds invest in high yield bonds to an extent, they tend to be more conservative in their investments and limit their exposure.

For investors with a tolerance for risk, high yield bonds offer many advantages. It is important to do your homework and only place a portion of you total investments in these high-risk investments. While returns are high, high yield bonds will not necessarily behave like investment bonds and increase in value. The performance of these securities is affected by factors other than the company's rating, like interest rates and general economic environment. Unless you are 100% certain and comfortable with your investment choice, investors should always wait until allocating a portion of their portfolio to riskier alternatives. In the meantime, retail investors can always take advantage of short term investment options that offer greater returns than a checking or savings account. This way, your money is readily available for when you want to take the plunge, but is also yielding more than .01% interest.

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S&P Credit Ratings for each State

Yesterday we looked at credit ratings for nations.   Today we'll look at the ratings for individual U.S. states.  

Here is the list of the S&P ratings for state governments as of July 15 2011.

Delaware	AAA
Florida	AAA
Georgia	AAA
Indiana	AAA
Iowa	AAA
Maryland	AAA
Minnesota	AAA
Missouri	AAA
Nebraska	AAA
N. Carolina	AAA
Utah	AAA
Virginia	AAA
Wyoming	AAA
Alaska	AA+
Idaho	AA+
Kansas	AA+
New Mexico	AA+
N. Dakota	AA+
Ohio	AA+
Oklahoma	AA+
Oregon	AA+
S. Carolina	AA+
S. Dakota	AA+
Tennessee	AA+
Texas	AA+
Vermont	AA+
Washington	AA+
Alabama	AA
Arkansas	AA
Colorado	AA
Connecticut	AA
Hawaii	AA
Louisiana	AA
Maine	AA
Massachusetts	AA
miss	AA
Montana	AA
Nevada	AA
New Hampshire	AA
New York	AA
Pennsylvania	AA
Rhode Island	AA
West Virginia	AA
Wisconsin	AA
Arizona	AA-
Kentucky	AA-
Michigan	AA-
New Jersey	AA-
Illinois	A+
California	A-

The ratings do change gradually over time but only gradually.
 
The table I got the list above from was on the PewStates.org website.   They also have an info graphic that shows the history of upgrades and downgrades for each state from 2001 to 2011.


The TaxFoundation website put together a nice graphical map showing the ratings by state.

The actual data is from Standard & Poor and they have specifics for each state buried among all the municipalities of each state on their website. BUT.. you may need to register and log in to get to full reports.

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The Muni Bond Armageddon that Didn't Happen

Hey do you remember how all the municipal bonds were supposed to start defaulting in mass?    It was around 11 months ago that Meredith Whitney made a prediction that we'd see massive defaults on municipal bonds because governments simply couldn't afford their debt levels.   She was on the show 60 Minutes and declared that

"There's not a doubt in my mind that you will see a spate of municipal bond defaults,"  ... "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults." and later "' It'll be something to worry about within the next 12 months,"


The prediction seemed to make sense to many people at the time given how our economy and state of municipal finances have been.   But its been nearly a year and we've seen nowhere near the amounts of defaults she predicted.  

In fact in the first half of 2011 the amount of defaults dropped significantly from what was seen in 2010.   see : Meredith Whitney Loses Credibility as Muni Defaults Fall 60% from Bloomberg.

They say : "Standard & Poor’s counted 28 municipal-market defaults totaling $511 million in the first six months of 2011, compared with 53 totaling about $1.55 billion in the first half of last year, according to a report from the New York-based credit- rating company."  

The Bloomberg article also pointed out that the record for municipal bond defaults was $8.15 billion in 2008.  Note that Mrs Whitney was talking about sizable defaults in the order of 100's of billions of dollars.    

Not only did muni's not fail in mass in some sort of Armageddon, the article Time’s Up Meredith Whitney, Muni Prediction Was Wrong points out that muni. bonds performed well as an investment.   They say : "the ML Muni Master Index is up 9.5 percent this year"    You can verify that muni's are up yourself by seeing the performance of the ETF iShares S&P National Municipal (MUB).

Default rates on municipal bonds have been historically very low.    So far this year the default rate is only 0.03%.    Thats not much at all and its actually lower than the historical rates.

When you hear these kinds of dooms day predictions you need to be critical of them.   There are a lot of financial pundits and alleged gurus out there who make drastic predictions.   These predictions don't often pan out.  Next time you hear such a prediction from Meredith Whitney you should know better.


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Bonds are Safer than Stocks

Recently Jim at Bargaineering asked Are Bonds a Safe or Risky Investment?   He concluded "In the end, I don’t think bonds are any safer or less risky than investing in stocks."   Theres more to his discussion then that, so read his full article for all the details.    I thought this was a good topic to discuss so I'll give my take on it.


In general as classes of investment : Bonds are safer than stocks.   If you look at the two classes of investments there are several reasons why bonds are safer.

1. Protection of principal.    If you buy a bond then hold the bond to term you will get back your principal.   With a stock you have no expectation at all that your principal will be refunded.  


2. Defaults and bankruptcy are generally better for bonds than stocks.   Bond holders have a higher priority to recover funds if a company goes bankrupt.   Remember when GM went bankrupt?   The bond holders got 29% of their money back (if I recall right).   What do you think the stockholders got?  Nothing much.

3. Guaranteed returns rather than speculation on appreciation.    With bonds you have a fixed rate of return.   With stocks you hope your investment might do better and if theres dividends then you hope the company will continue to pay them.   With bonds you have a contract that says you'll get paid X interest for the term of the bond.  Theres no hoping, its an agreement.

4. Lower volatility.    Bonds can go down in value based on fluctuation in interest rates and the market forces.   So yes, bonds can lose their value.   However stocks are much more volatile.   Stocks can go down significantly in short periods of time.  In general the volatility of bonds is much lower than stocks.

Lets compare the Vanugard Total Stock Market ETF (VTI) versus their Total Bond Market ETF (BND).   For the past 5 years this is how their prices have looked, red is VTI and blue is BND (click on image for larger version):

Clearly the bond fund has been much less volatile.   Of course this is just a short few year period for two ETFs, but if you look back longer periods the markets are much more volatile for stocks.   Stocks have bigger ups and downs over time in general. 

Different risk levels for individual bonds and stocks
Of course there are different kinds of bonds and stocks out there.   Now that I've said in general that bonds are safer than stocks, I should point out for completeness that not all bonds are created alike.  There are riskier bonds and safer stocks.  A junk bond is a riskier investment than buying GE stock but US Treasuries are much safer than Enron's of the world.   However, if you buy bonds or stocks of entities with similar credit ratings then your overall risks will be higher in general with the stocks.

Cumulative Bond Default Rates

Data from the Municipal Bond Fairness act has cumulative historic default rates for various ratings of municipal and corporate bonds.

Here is the table :

CUMULATIVE HISTORIC DEFAULT RATES [in percent]
	Moodys		S&P
Ratings Categories	Muni	Corp	Muni	Corp
Aaa/AAA	0	0.52	0	0.6
Aa/AA	0.06	0.52	0	1.5
A/A	0.03	1.29	0.23	2.91
Baa/BBB	0.13	4.64	0.32	10.29
Ba/BB	2.65	19.12	1.74	29.93
B/B	11.86	43.34	8.48	53.72
Caa-C/CCC-C	16.58	69.18	44.81	69.19
Investment Grade	0.07	2.09	0.2	4.14
Non-Invest Grade	4.29	31.37	7.37	42.35
All	0.1	9.7	0.29	12.98

Source. Moody's, S&P.

A few things strike me about this. First of all the cumulative default rate for junk bonds is awfully high. On the other hand the cumulative default rate for investment grade bonds is quite low. There is a significant difference in the risks of default between high rating and low rating bonds over their lifetime.

Specific Maturity Date Bond Funds

Earlier this year a new style of bond funds was introduced by some of the investment companies.   I read about these in a recent CNN Money article.  The funds are specific maturity date bond funds.   Each such fund holds only bonds that mature in a specific date.   For example a 2012 funds would consist entirely of funds that mature in 2012.  This kind of fund is compelling to me for a few reasons.  

First of all it beats buying individual bonds because with such a fund you will be diversified across multiple bonds rather than having all your eggs in one basket.   You could of course buy a bunch of individual bonds and diversify your holds that way, but this kind of fund does all that for you. 

The second big benefit of a specific maturity date funds is that it will retain the principal of the bonds.   THe way normal bond funds are setup the funds trade bonds in and out in a regular cycle.   One downside with that is that if you want to cash in the fund at a given time then the trading value of the fund as a whole may be negative due to market conditions.   With the specific maturity date fund on the other hand the funds don't trade the bonds in and out, they hold the set of bonds until the maturity date and then liquidate them all at maturity.   In the given year of maturity the funds will be returned to the investors in the form of cash.  However the specific maturity date funds aren't immune from fluctuations in value either.   If you buy a 2017 fund then it could go up or down from now till 2017.   If you do hold the fund till 2017 and then they liquidate you should get your principal value back however.  

There are at least a couple investment houses offering this kind of bond fund so far.

Guggenheim has a set of BulletShare corporate bond ETFs for 2011 to 2017 (BSCB through BSCH).   They also have a set of High Yield Corporate Bond ETFs for 2012 (BSJC) to 2015 (BSJF).    Summary of the Guggenheim BulletShares ETFs.

iShares has AMT-free Municipal series ETFs for 2012 (MUAA) to 2017 (MUAF).

One way to invest in these funds would be to ladder a sum across multiple years.   Say you had $10,000 to invest, instead of putting it all into one fund you could put $2,000 into each year from 2012 to 2016.

I like the idea of maturity specific bond funds.   They offer the safety of diversification and should retain the principal values.   However they are relatively new and not very tested yet.  Hopefully they will work out well.

Bond Credit Rating History Standard & Poor's NetAdvantage via Libaries

A while ago I talked about finding the credit rating history of  GM and at the time I didn't know a source for the rating history on bond issuing companies.  Now I've found one that might be available via your local library.

I have access to the Standard & Poor's NetAdvantage service via my local library.  Your local library may or may not offer access to the service. You'd have to check your library to find out.   I don't know how common it is for libraries to carry the service so sorry if this doesn't apply to you.   If your library does have S&P NetAdvantage then its a good source for corporate credit history ratings on bonds.

 Its fairly easy to find the bond rating history for a company.   In the top right side of the screen is a search box for 'Database Search'.   For that select 'Corporate Bond Reports' under resources then for search by select 'Company Name' then type in the name of a company in the 'Enter' field and hit the arrow button.

I searched for a few companies and it was hit or miss.  I'm assuming some companies simply don't have bond reports since they don't have a report specific to that company or they may just not issue bonds.   I searched for Microsoft, Toyota and Walmart and came up empty. But I found several other well known names.   The bond rating history for a sample of companies I found is given below:



Ford Motor

Rated	Last Change Date
CCC	11/3/2009
CCC-	4/13/2009
CCC+	11/27/2006
B	9/19/2006
B+	6/28/2006

Merck
Rated	Last Change Date
AA-	11/16/2004
AAA	Initial

The Boeing Co.
Rated	Last Change Date
A	7/29/2009
A+	11/3/2006
A	5/15/2003
A+	2/5/2002
AA-	12/4/1998

If your library has access to it then Standard & Poor's NetAdvantage service has a lot of information including the credit rating for bond issuing companies.

Illustration of Relationship Between Bond Rates and Bond Fund Values

A while back I talked about a Potential Trap in Bond Funds which is that if prevailing interest rates go up then the market value of a bond fund will go down.   This isn't exactly a secret but I don't know if its widely understood.   In the past couple of years a lot of money has flowed into bond funds as people fled the scary stock market into security of fixed investments.  Many of the people putting their investments into bond funds may assume their principal is safe, but they may be in for a shock.

To illustrate this phenomenon I figured I'd look at the history of the price of a bond fund and compare it to the history of bond yields.  I got historical data for The Bond Fund of America (ABNDX) from the American Funds website.    They have the NAV price there dating back to the 1970's.   Now keep in mind that this is not looking at the dividend payments from the fund, but just the market price of the fund shares.   I had researched historical yield rates for AAA bonds previously so I used that data.

Here is the chart showing how the change in AAA bond yields and the market value of the Bond Fund NAV change from year to year.  

As you can see the two generally move in opposite directions, when the blue line goes up the the pink lines goes down and vice versa.   As bond yields go up the market value of the bond fund goes down. 

Looking at a specific year, in 1999 AAA bonds yielded 6.2% average.   Then in 2000 the rates went up to 7.8%.   The Bond fund was selling for 13.65 in 1999 and then went down to 12.90 in 2000.

You might notice that the market value of the bond fund goes up or down a bit more even when bond interest rates don't change drastically.    I'm not certain of the cause for that but I might guess that it is due to other market conditions causing bond fund values to change.

History of US 10 year Treasury Yield

Treasuries are not paying very well right now. Interest rates are low in general. But in the past treasuries and interest in general have been higher. The Federal Reserve has data on the history of various interest yields including corporate bonds, treasuries, CDs and mortgages. I pulled the 10 year treasury bond rates off that page.

Here is a graphical look at the history of 10 year treasury yields since 1962:

The chart goes from 1962 to 2008 and in 2008 it was 3.7%. That 3.7% was the lowest they've been for over 40 years. The average yield from 1962 to 2008 was 7.0%. The high was in 1981 when it hit 13.9%.

Downside of individual bonds: simple interest

Here is a point I found in the Wall Street Jones blog article Should You Buy Municipal Bonds Individually or in a Fund?

They point out "If you own small lots of individual munis, you earn simple interest – not interest-on-interest. Say you hold a muni with a 5% yield to maturity. If you put your semi-annual coupon payments into a bank account yielding 0.5%, then your true yield over time will fall well short of the stated yield to maturity. A mutual fund, on the other hand, invests in bulk so it can plow the interest earned by its bonds directly into more bonds at market yields."

Individual bonds pay simple interest whereas bond funds can get you compound interest.

So why is simple interest so bad? Lets look at an example.

Consider if you've got $10,000 to invest. You could buy a single bond or a bond fund.

Option 1: Single Bond
Lets say you buy Municipal a bond with a coupon of 5% and face value of $10,000. The maturity date is 10 years from now. It pays you $500 every year. But you don't make that 5% interest rate on your interest payments. You get a $500 payment every year and then you'll have to find somewhere else to put that $500. If you put your bond interest into a high yield savings account making 2% then at the end of 10 years you would have a total of $15,474 and change including the principal.

Option 2: Bond fund.
If on the other hand you put your $10,000 into a bond fund then you can easily pump your $500 dividend yields back into the bond fund. Lets say every year you take your yield and buy more of the fund in question. If you have a $20 annual fee to buy the fund but it yields a consistent 5% then at the end of 10 years you'd have $16,819 total.

With simple interest the individual bond would net you $5,474 in interest and the compounding interest of the bond fund would net $6,819 interest. That's a $1,345 difference simply due to compounding.

Note that the bond fund is not going to yield a steady 5% every year for 10 years and I'm just using that assumption to make the example easy. One big negative for bond funds is that the rate will fluctuate which can be good or bad.

Potential Trap in Bond Funds

Right now with the state of the stock market investing in bonds is looking more and more attractive. If you can get a more dependable get 4-8% return off bonds then that is more attractive to many people than investing in stocks and hoping for a 10% long term annual gain but risking a -20 or -40% short term loss.

An ETF that invests in high yield corporate bonds like the iShares iBoxx $ High Yield Corporate Bd (HYG) can yield about 10% right now. While these are low credit quality rating bonds so the default rate is higher the wide diversification of an ETF and the high yield should make up for the higher defaults. Or you could go with a lower risk and lower yield ETF like the Vanguard Long-Term Bond ETF (BLV) which invests in high quality bonds and yields about 5%.

Say you own 100 shares of BLV today and it trades at $77.79. The yield is 5%. Lets say just for example sake that 12 months from now the average interest rates go up. Lets say at that point that a typical AAA bond will sell with a yield of 6%. If someone can easily buy a bond for 6% then thats what bonds are going to sell at. This means the price of the existing bonds being traded will be less. If you could take $100 and buy a new bond at 6% or you could buy an existing bond at 5% then you wouldn't want to pay the full $100 face value for the 5% bond. That older 5% bond would only be worth about $83 since the return of $5/$83 would equate to a yield of 6%. So if interest rates go up from 5% to 6% then your current bond investment would drop to 83% of what you paid for it. That would mean your BLV could easily drop down to a price of 83% of $77.79 or $64.56.

If the interest rates go up then the price of bond funds will go down.

Given the current situation the interest rates are near or at historic lows. Its very likely that interest rates will go up in the upcoming years. For this reason investment in a bond fund right now could have a built in loss looming in the future.

This is one of the major down sides of investing in bond funds. The price of the bond will go up and down based on changes in prevailing interest rates.

AAA Bonds trading for 6-7%

Corporate bonds with AAA ratings are trading in the 6-7% yield range. You can even find a number of AAA municipal (tax free) bonds trading for over 6%. I did a search in my Scottrade brokerage account and found a lot of GE bonds for 6-7% range and several municipal bonds in various states for over 6%.

These are good rates for bonds. Individual Bonds have fixed returns and AAA rated bonds have very low default rates. But if you're considering in investing in individual bonds make sure you have your investment diversified over several bond issuers so just in case a company or municipality defaults it won't take your entire investment down.

For more on bonds see my previous series:
Bonds 101, part 1 - Overview of Bonds
Bonds 101, part 2 - Glossary of Bond Terms
Bonds 101, part 3 - Treasury, Municipal, Corporate and Junk
Bonds 101, part 4 - Default Rates on Bonds
Bonds 101, part 5 - Bonds Versus Bond Funds
Bonds 101, part 6 - How To Buy Bonds

Municipal bond rates are looking good

The yields on municipal bonds have been edging up lately. The Composite Bond rates at Yahoo shows a rate of 5.57 for a 20 year AAA rated municipal. If your marginal tax rate is 30% then that equates to a 8% taxable rate.

Historical rates for corporate AAA bonds.

The federal reserve Economic Data - FRED site has information on various economic indicators including return rates for AAA rated bonds

From 1919 to 2008 the average rate for a AAA rated bond was 6%.

Here is a graph showing the history of AAA corporate bonds :

You'll notice that theres a peak there where bond rates were well over 10% for years and a short period when they went over 14%. From 1973 to 1992 the AAA rated corporate bonds averaged 10% return. By comparison in that same period the NASDAQ went from a value of about 115 to about 600 which is about 9% annual return. So for that 20 year period corporate bonds outperformed stocks (at least the NASDAQ).

By comparison from 1938 to 1968 bond yields were fairly low. In that period AAA rated corporate bonds only returned 3.5% per year on average. The NASDAQ on the other hand had a 9% annual average growth rate. So for 30 years from 1938 to 1968 stocks had 2.5 times the growth rate of corporate bonds.

Bonds 101, part 6 - How to buy bonds

Bonds can be a little less straight forward to buy and sell than stocks. When shopping for bonds you can buy new issues or resold buy bonds on the market. Discount brokers deal in bonds and you can buy treasuries direct from the U.S. government.

New bond issues have a price set at the face value and interest rate at the coupon rate. The bonds will have a specified time frame given as a maturity date. So for example you might see a new issue of bonds from ABC corp. with a coupon of 6.2 and maturity of 8/1/2018. That means the bonds will pay 6.2% interest for 10 years. ABC corp. will have a credit rating from the rating companies such as Moodies. Look for the letters such as AAA, A3, BB or similar.

For resold bonds bought on the open market you are buying a bond from someone else who currently owns it but is now selling it. Bonds bought on the market have a price which is basically a % of the face value. So if the price listed is 95.45 then you are paying 95.45% of the face value. Because interest rates go up and down people are willing to pay a premium for some bonds or less than face value for other bonds. If ABC corp issued a bond this month at 6.2 and then interest rates go up significantly in the future then people won't be as willing to pay as much for the existing 6.2 rate bonds if they could instead buy other new bonds for more than 6.2 rate. Or on the other hand if interest rates go down in the future then new bonds sell with coupon of less than 6.2 then people will pay more for a bond with a higher existing coupon. Since the price varies the actual yield you get when buying a bond may differ from the coupon rate. For example if a bond is originally sold at face value with a coupon of 6 and then 3 years later interest rates have gone down then the bond might sell at a premium price of 114. Your immediate yield for that bond is 6 / 114 or 5.2. Since you are paying more than face value for the bond your actual interest return is less than the coupon rate.

Where to buy?
Corporate and municipal bonds can be bought via a broker. Charles Schwab, Fidelity, E*trade, ScottTrade all deal in bonds. The minimum purchase for bonds can be pretty high and the commission fees for the broker are not always obvious. You will pay a commission or fee for the bonds you buy. The fees are in the $30-50 range per bond purchase. Zions Direct charges $10.95 per bond purchase so they might be worth looking into (I haven't used them myself).

Treasuries are a little simpler to buy. The treasury bonds are available to purchase direct from the US government. You can open an individual account at Treasury Direct and buy the bonds there online.

Bonds 101, part 5 - Bonds versus Bond funds

I've been discussing bonds as individual investments. Buying individual bonds is much like buying individual stocks. With individual bonds or stocks your money is dependent on specific companies or institutions. If all your money is in a single bond or stock at that bond or stock fails then your money is in jeopardy. For this reason it is always good to spread your money around and diversify your investment.

Bond funds offer a simple and easy way to invest in bonds and diversify your investment. Bond funds are managed mutual fund that invests in bonds. A bond fund will be a managed fund that is invested in a variety of bonds in a certain class.

Here are some pros and cons for bond funds:

Pros
Easy : buy a single fund easily
Diversified : you don't carry the risk of your individual bonds defaulting
Liquidity : funds can be sold fast and easily
Lower minimums : you can start investing in bond funds with a lower minimum cost

Cons
Variable returns : the yield for a bond fund will go up and down as the fund changes its bond investments
Variable price : the price you can sell the fund for will change over time as the fund does better or poorer and as the economy as a whole reflects on bond values
Management expenses : bond funds carry expenses usually around 0.75%, which is substantial expense relative to bond yields
Capital gains : a bond fund could be liable for capital gains taxes


In general the key benefit of a bond fund is the diversification and ease of investing. If you have a smaller amount to invest and don't have the time or knowledge to delve into individual bonds then a bond fund might be an OK choice. On the other hand individual bonds will give you better return and have lower expenses. So if you have enough funds to diversify your bonds and can take the time and effort to fully understand what you're investing in then individual bonds are going to be the better option.

Treasuries are a separate case. Treasuries carry virtually no risk of default and are relatively easy to understand and invest in. Therefore a treasury bond fund makes little sense compared to investing directly in individual treasuries.


Additional articles on the topic:

• Bonds vs. Bond funds at SmartMoney.
• Bonds vs. Bond Funds at Forbes.
• Bonds vs. Bond Funds at Motley Fool
• Bonds vs. Bond Funds at Yahoo finance.

Bonds 101, part 4 - Default rates on bonds

Last time I discussed the different types of bonds. I mentioned that treasuries have virtually no risk and junk bonds have high risks. But what are the risks specifically? Here are the default rates for different bond types:

Default rate on junk bonds = 4.9%
Default rate on municipal bonds = 0.02%
Default rate on Treasury bills = 0%

Corporate and municipal bonds have credit ratings and there are general default levels for bonds of that rating class. Bonds with the highest AAA rating are very unlikely to fail and B rated bonds (Junk) are much more likely to fail.

As shown in the chart, 1 year default rates for bonds at various levels for 1970 to 1995 are:
Aaa = 0.00%, Aa = 0.03%, A = 0.01%, Baa = 0.13%, Ba = 1.42%, B = 7.62%



References:

• Junk bond default rate: USAtoday article Slowing economy scuppers junk bond funds
• Municipal bond default rate: Businessweek article The case for Municipal bond funds
• One year default rates Chart 5 source: Moodys
  

Bonds 101, part 3 - Treasury, Municipal, Corporate and Junk

In the first two articles I discussed the a basic overview of bonds and an explanation of bond terms. Now I'll take a closer look at the different types of bonds. The main categories of bonds are Treasury, municipal, corporate and junk.

Treasury:
Treasury bonds or 'treasuries' are issued by the U.S. federal government. As you may know the US government carries substantial debt and treasuries are one way they borrow money. Individuals can buy treasuries direct from the Treasury department. Treasuries are about the safest investment vehicle around and are backed by the full credit of the U.S. government. Due to the almost non existent level of risk in the investment treasuries have a relatively low interest rate.

Municipal bonds:
Municipal bonds or 'munis' are bonds issued by state or local governments. Local and state governments borrow money for a variety of projects: to build highways, fund schools, cover debts, etc. Munis are generally not taxable by federal or the state they are issued in. Municipal bonds have a very low default rate and so similar to treasuries they carry a relatively low interest rate.

Corporate bonds:
Bonds issued by corporations have a range of risk. Because the bonds are only backed by the credit worthiness of an individual corporation their risk is a bit higher and the interest rates are higher as well.


Junk bonds:
Corporate bonds with very high risk are known as 'junk' bonds. These are corporate bonds with the worst credit ratings and the highest risk levels for corporate issuers. Due to the high risk of default you can get pretty high returns on junk bonds.


What kind of bond should you consider investing in? It depends on your investment goals of course:

Very low risk - Treasury bonds are good for very safe investment.
Low risk and tax shelter - Muni's are good for a low risk investment with added tax benefits. If you have a high tax rate then munis can be especially attractive. If your tax rate is lower than munis are not as appealing.
Low risk and moderate return - Corporate bonds with high credit ratings can be a good moderate return investment with a low risk level.

Bonds 101, part 2 - Glossary of Bond Terms

In part #1 I discussed an overview of bonds. Now I'll explain many of the key terms used to discuss bonds.

Maturity - The date when the bond is finished.

Callable - A bond is callable if the issuer can repay it early.

Coupon - This is the interest rate that is paid on the face value of the bond.

Face value - The principal in the bond. The value that the bond is bought at originally.

Zero coupon - A bond without periodic interest payments or a 0% coupon. For this kind of bond the interest is paid at maturity. For example you might buy a bond for $50 and then get $100 in return years later at maturity.

Price - The price is the amount that the bond is currently traded for. Price is expressed as a fraction of 100 to represent a percent of the face value. So if the price is 99.1 then the bond is trading at 99.1% of the face value.