How To Invest In Bonds

in Bond

E*Trade claims finding and buying stocks is so easy, it can be done by a baby, so you already know how to do it, correct?

While stock brokers over the previous 10 years online have tried to make investing in stocks as easy as child's play, unfortunately, investing in bonds has been slower to evolve. On many broker sites online, bond platforms are not even in existence. Therefore, the world of investing in individual bonds remains murky.

While a certain percentage in your personal portfolio should be invested in bonds--a rule of thumb is 40% for someone in their 40s--you may have relied on mutual funds bonds for that portion. That in itself may not be bad since mutual bonds funds allow you to own bonds from several hundred companies while investing just a small amount. Also, professional managers do the bond investment research for you. Bond funds, however, also have a disadvantage to owning those individual bonds, which is significant.

When you purchase a bond, you know the following:   

* the exact amount of your interest payments
* when your payments will be received
* when your initial investment will be paid back--so long as there is no default of the company.

On the other hand, prices of the bond funds move up and down the same as other mutual funds. If your money is needed by you on any specific date, you do not know what value to expect of your mutual fund on that date. This makes individual bond investing, therefore, preferable for those who may need a certain amount of money at a particular time.

As an example, say you would need tutition in the amount of $40,000 for your 16-year-old to attend college at age 18. You would need to invest $40,000 in two-year individual bonds, and in investing that way, you would be assured of having that amount of money when you need it--so long as the company stays solvent and no bankruptcy occurs. If it is otherwise invested in bond mutual funds, no-one would know what it would be worth when it is time to withdraw the
funds. Typically, bonds do not go down by any large percentage, but in the year 2008 we learned that is not always true.

If you need a certain retirement income stream, or are saving for a timely goal, and you think you may profit by investing in individual bonds, here is a primer on the way bonds work:

How bonds work

Treasury bonds are issued by the United States Treasury Department to finance the Federal Government's operations. In a similar way, states, cities, corporations and companies issue bonds as a means of financing their operations. Considered a safe investment, Treasury bonds normally have no default risk. When a corporation or company issues bonds to raise money, however, investors demand interest rates that are higher than U.S. Treasury bonds offer, as compensation for the risk to investors in the event the corporation or company goes into bankruptcy.

For example, if a company--say General Electric--needed to raise an amount of one hundred million dollars for the building of a new factory to manufacture refrigerators, and planned to pay back the loan in 2020, they would look at the market in order to determine the interest rate the company would have to offer to interest investors in lending them that amount of money. If the investors' demand
was 6%, General Electric would then issue one hundred million in bonds with an interest rate--the coupon rate--of 6%, for immediate purchase, by pre-agreement with mutual funds, banks and possibly, individuals. Company bonds are mostly available in $1,000 denominations--called par value.
For each $1,000 bond the investor owned, therefore, he or she would receive $60 back--6% of $1,000--per year for each year until 2020, when he or she would get the entire $1,000 back.

Between the time that General Electric issued the bond and the time that the bond would mature--or come due--the investors are able to sell the bonds in the secondary market. Just like stock prices, however, bond prices will fluctuate.

If General Electric had issued the bond three years ago, the company's chances since then of surviving until 2020 may still be good, but may be definitely gloomier. If so, an investor selling his bond today will need to offer the buyer a higher interest rate than the 6% he orginally paid for it, due to the extra risk to the buyer. General Electric, however, will still pay $60 per year to the new investor. Therefore, the new investor will expect to buy the bond at less than the par value.

While the coupon rate of the bond will remain at 6%, if the new investor pays $900 for the bond, that makes the yield higher because he has only invested $900 for a $60 yearly return, and because he will still get back $1000. for the bond at maturity.

Of course, the reverse can happen, and at times investors buy bonds for more than par value, and that reduces the yield.

The trouble with buying bonds

Small investors, unfortunately, have more difficulty buying individual bonds than they would in buying individual stocks. One reason is, there are more single bonds than single stocks. Think of this: One single company may have several different times when it wanted to borrow capital, meaning it would have several different bonds offered on the market, as opposed to only one common stock.

More importantly, the process of actually buying a bond is not easy. Most often, the stock broker acts as an intermediary between the buyer and the seller. Bond brokers, however, often are the investors who actually buy or sell you the bond. As an individual bond investor, therefore, unless you have more than one broker, your bond purchases will be limited to whatever bonds your broker has in his inventory at any given time.  

Another area of confusion is bond commissions. Whereupon you may pay a flat commission in buying and selling stocks, with bonds the commission is built right into the price of the bond. For instance, if your broker originally paid $1000 for a bond that yielded 7%, he may offer it to you for $1100, and that means you would realize a yield of only 6.4%. That is, $70 divided by $1100. The difference between the price he paid and the price at which he sells it to you, becomes his commission. Larger investors who are able to invest millions of dollars into bonds at one time tend to get better price offers than small investors, who may be able to invest only $10,000 in bonds at a time.  

Until recently, smaller investors were unable to see how much other investors bought and sold bonds for, meaning that the broker had the potential to seriously scam the small investor. SIFMA, fortunately, has now built a website where individuals can research prices of recent bonds transactions.

Why the hassle is worth it

With all this information, one may wonder: Why bother?

For small start-up investors, or those who have only a small portion of their portfolios set aside for bonds--less than $100,000--the short answer is--Don't! Stick with a low expense no-load mutual fund--like this one or that one--until you have more funds accumulated to invest in bonds.

For investors who meet the criteria, though, using bonds will create the kind of predictable income stream that no bond fund is able to guarantee.

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James Fowlkes has 1 articles online

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This article was published on 2010/10/14