We have been adding individual bonds and CDs across many accounts since December, as we looked to reduce our equity exposure and take advantage of higher yields now available in short-term, investment grade fixed income. When you are an owner of individual bonds, you are likely to encounter some terminology that may be new, even if you’ve been investing in bond funds for many years. Here are some important things to know:
Bonds are generally priced in $1,000 increments. One bond will mature at $1,000. However, instead of quoting bond prices in actual dollars, we basically use percentages. A bond priced at 100 (note, no dollar sign or percentage symbol is used) would cost $1,000. 100 is called its Par value. If you are buying newly issued bonds, they are generally issued at Par (100). This is called the Primary Market – where issuers directly sell their bonds to the public. We also buy bonds in the Secondary Market, which is where bond desks trade existing bonds between each other.
In the Secondary Market, bond prices are set by market participants. A bond priced at 98.50 would cost $985, and would be said to be at a discount to Par. A bond priced at 102 would cost $1,020, called a premium. As interest rates rise, the value of existing (lower yielding bonds) will fall. There is an inverse relationship between price and interest rates – when one rises, the other falls.
Bonds have a set Maturity date. That is when the issuer will return the $1,000 they borrowed from the bondholder and cancel the debt. Some bonds are also Callable, which means that the issuer has the right to buy the bond back before its maturity date. This benefits the company, but not the bondholder, because when interest rates are low, companies can refinance their debt to a lower rate.
Most bonds pay interest semi-annually (twice a year). We call this the Coupon. A bond with a 4% coupon would pay $20 in interest, twice a year. If the bond is priced exactly at Par, then the coupon is the same as the effective yield. However, if the bond is priced differently, we are more interested in its Yield to Maturity, commonly listed as YTM. This is very helpful for comparing bonds with different coupons.
Most bonds pay a fixed coupon, although some pay a step coupon, which rises over time, and others are floating, tied to an interest rate index, or inflation. When we purchase a bond between interest payments, the buyer will receive all of the next payment, so the buyer will also pay the seller Accrued Interest, which is the interest they have earned calculated to the day of sale.
For bonds which are callable, we also have the Yield to Call (YTC), which measures what your yield would be if the bond is called early. Generally, if we are buying a bond at a discount, Yield to Call is attractive. If we buy at 96 and they redeem at 100, that’s a good thing. But if we buy a bond at a premium, we need to carefully examine if or when it might be callable. Yield to Worst (YTW) will show the worst possible return, whether that is to maturity or to a specific call date.
Some bonds do not pay a coupon and are called Zero Coupon Bonds. Instead, they are issued at a discount and grow to 100 at maturity. Treasury Bills are the most common type of zero coupon bonds. US Government Bonds include Treasury Bills (under one year), Treasury Notes (1 to 10 years), and Treasury Bonds (10 to 30 years). There also are Treasury Inflation Protected Securities (TIPS), which are tied to the Consumer Price Index, and Agency Bonds, which are issued by government sponsored entities, such as Fannie Mae or Freddie Mac.
In addition to Government Bonds, we also buy Corporate Bonds – those issued by public and private companies, Municipal Bonds issued by state and local governments, including school districts, and Certificates of Deposit (CDs) from Banks.
Most Municipal Bonds are tax exempt, at the Federal and possibly at the state level. If you live in New York, any Municipal Bond would be tax-free at the Federal Level, but only NY bonds would be tax-free for NY state income tax. In states with no income tax, such as Texas, a tax-exempt bond from any state will be tax-free for Federal Income Tax purposes.
To make their bonds more attractive, some municipal bonds are Insured, which means that if they were to default, a private insurance company would make investors whole. Those municipal insurers got in trouble in the previous financial crisis, and some are still weak today. My preferred insurer is Assured Guaranty (AGMC).
Please note that some Municipal Bonds are taxable; we sometimes buy these for retirement accounts. In addition to the types of bonds we’ve discussed, there are thousands of bonds issued outside of the US, in other currencies, but we do not purchase those bonds directly.
There are several agencies that provide credit ratings to assess the financial strength of the issuer. Standard and Poor’s highest rating is AAA, followed by AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-. These are considered all Investment Grade. Below this level, from BB+ to C are below Investment Grade, often called High Yield or Junk Bonds. D means a bond has Defaulted. Moody’s ratings scale is slightly different: Aaa is the highest, followed by Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3 for Investment Grade. Junk Bonds include Ba(1,2,3), B(1,2,3), Caa(1,2,3), Ca, and C.
There are about 5,000 stocks issued in the US, but there are probably over a million individual bonds issued, each one identified by a unique CUSIP number. Every week, there are bonds which mature and new ones which are issued.
Our approach for individual bonds is to buy only investment grade bonds, and ladder them from one to five years with diversified issuers. We also sometimes invest in other types of bonds, such as floating rate bonds, mortgage backed securities, emerging markets debt, or high yield. For those categories, we will use a fund or ETF because it’s more important to diversify very broadly with lower credit quality.