Bond Investing For Dummies
If you want to invest in bonds, you need to know how to read the bond ratings that the big three rating companies use and how to figure whether a taxable or tax-free municipal bond is the better investment. Knowing the right questions to ask about a bond can save you money, and you can find answers to many of those questions on the Internet.
How to Read Bond Ratings
Before you buy a bond, get an idea of how much financial muscle the issuer has. Bond ratings are available through any brokerage house. Three of the most popular rating services are Moody’s, Standard & Poor’s, and Fitch. The following table shows the system each uses to rate bonds:
|Credit risk ratings||Moody’s||Standard & Poor’s||Fitch|
|Not investment grade|
|Definitely don’t-take-home-to-Mom quality||Caa||CCC||CCC|
|You’ll be extremely lucky to get your money back||Ca||CC||CC|
|Interest payments have halted or bankruptcy is in process||C||D||C|
|Already in default||C||D||D|
Bond ratings are available through any brokerage house.
Questions to Ask a Bond Broker about a Bond
As you enter the world of bond investing, you may choose to work with a broker. But use some caution. Ask the questions in the following list — and get acceptable answers — before parting with your cash.
Who is the bond issuer?
Is it the U.S. Treasury? General Electric? Dade County, Florida? The Russian Federation? Moe’s Hardware Store? A bond is an IOU, and an IOU is only as good as the entity that owes U. In addition, different kinds of bonds have different characteristics, such as taxability, callability, and volatility.
How is the bond rated?
Especially among corporate bonds (more likely to default than municipal or agency bonds), you want to know whether the company issuing the bond is financially stable. Ratings are readily available through any brokerage house.
What is the maturity date?
Long-term bonds tend to pay higher rates of interest, but your money is tied for longer and the price of the bond, should you wish to sell it before maturity, tends to be more volatile.
What is the yield-to-maturity?
There are many ways of measuring a bond’s return. Yield-to-maturity is perhaps the most important measure. (Bond funds, which have no maturity, can be more difficult to compare.)
Is the bond callable?
Can the issuer of the bond hand you back your money at any time? All things being equal, a callable bond is not desirable, and you should get more interest in compensation for the call feature.
What’s the worst-case yield?
Suppose the bond does get called. What would be your yield on the bond at that point? When comparing callable bonds, this figure is very important.
May I please have the CUSIP?
The CUSIP (Committee on Uniform Security Identification Procedures) identification allows you to go to www.investinginbonds.com or www.finra.org to see what recent trades have been made on any particular bond. Doing so gives you a very good idea of what a fair price would be for the bond you’re being offered.
Important Websites for Bond Investors
Successful bond investing isn’t about luck, it’s about researching markets, comparing offers . . . and luck. These seven websites serve as your navigation guide through the vast universe of bonds and bond funds.
Run by the Securities Industry and Financial Markets Association, this is the place to go to find out overall bond market yields and, perhaps more importantly, what individual bonds (which you can look up by their CUSIP number or issuer) are selling for.
This independent securities regulator was formed in June 2007 when the National Association of Securities Dealers merged with the New York Stock Exchange Member Regulation. Find scores of information on bond yields, prices, and trends.
Find out what your savings bond are worth. Buy and sell U.S. Treasury bills and bonds at no cost.
Go to Market Data→Rates and Bonds for up-to-date information on multiple bond markets.
Find scads of information on individual bonds and bond funds. Go to Bond Screener for a complete bond shopping guide.
In this simple calculator, you put in the price of the bond, the coupon rate, and the maturity date, and out comes the all-important yield-to-maturity.
Click the Funds icon on the bar at the top of the screen to find lots of information on any bond fund you can imagine, including Morningstar’s exclusive rating system. (Avoid one-star funds; shoot for five stars.)
How to Choose between a Taxable and a Tax-Free Municipal Bond
As a bond investor, you’re probably most interested in the bonds that will leave you with more money at the end of the day. If it comes to a choice between taxable and tax-free municipal bonds, grab your calculator and apply the following rather simple formula to determine the potentially more profitable bond:
Start with 100.
Subtract your tax bracket to find your reciprocal.
If you are in the 28 percent bracket, for example, subtract 28 from 100. That number — 72 — is called the reciprocal of your tax bracket.
Divide the municipal yield by the reciprocal.
The result tells you what you would have to earn on the taxable bond to equal the amount you would get on the tax-exempt municipal bond.
Using these numbers, consider a muni (a short, and rather endearing, abbreviation of municipal bond) paying 5 percent:
5 / 72 = 6.94 percent
That number, 6.94, represents your tax-equivalent yield, or your break-even between taxable and tax-exempt bond investing. If you can get 5 percent on a muni versus 6.94 percent on a taxable bond, it won’t matter which you choose, as far as take-home pay. (Of course, other factors may matter, such as the quality or the maturity of the bond.) If the taxable bond is yielding greater than 6.94 percent, it will likely be your best bet. If the taxable bond is yielding less than 6.94 percent, you’re likely better off with the tax-free bond.