Ten Most Common Misconceptions about Bonds - dummies

Ten Most Common Misconceptions about Bonds

By Russell Wild

A bond selling for 100 and paying 5 percent looks like the clearest, most easy-to-understand investment possible. Yet it is, in reality, a much more complex organism. Read these ten common bond misconceptions, and you’ll no doubt see why.

A bond “selling for 100” costs $100

Welcome to the first complexity in bonds: jargon! When a bond broker says that he has a bond “selling for 100,” it means that the bond is selling not for $100, but for $1,000. If that same bond were “selling for 95,” it would be on the market for $950. If it were “selling for 105,” you could buy it for $1,050.

The par value or face value of a $1,000 bond is $1,000. But the market value depends on whether it’s selling for 95, 100, 105, or whatever. In addition, that $1,000 face bond may be said to “pay 5 percent,” but that doesn’t mean you’ll get 5 percent on your money!

It means you’ll get 5 percent on the par value: that is, 5 percent on $1,000, or $50 a year, which may mean a yield of greater or less than 5 percent to you.

If you paid 105 for the bond (that’s called a premium), you’ll actually be making less than 5 percent on your money. If you paid 95 for the bond (that’s called a discount), you’ll be making more than 5 percent on your money.

Buying a bond at a discount is better than paying a premium

Discounted bonds sell at a discount for a reason; premium bonds sell at a premium for a reason. Here’s the reason: Those premium bonds typically have higher coupon rates than prevailing coupon rates. Discount bonds, in contrast, typically have lower coupon rates than prevailing coupon rates.

Both in theory and in practice, two bonds with similar ratings and similar maturities, all other things being equal, will have similar yields-to-maturity (the yield that really matters) whether sold at a premium or a discount.

Example: Bond A, issued in 2005, has a coupon rate of 6 percent. Bond B, issued in 2010, has a coupon rate of 4 percent. Everything else about the bonds is the same: same issuer, same maturity date (let’s say 2025), same callability.

Currently, similar bonds are paying 5 percent. You would fully expect Bond A to sell at a premium and Bond B to sell at a discount. In both cases you would expect their yields-to-maturity to be roughly 5 percent.

A bond paying x% today will pocket you x% over the life of the bond

A bond paying a coupon rate of 5 percent may (if the bond is purchased at a discount) be yielding something higher, like 6 percent. But each six months, as you collect that 6 percent on your money, you’ll either spend it or reinvest it.

If you reinvest it at an higher rate of interest — say 8 percent — then your total return on your money, over time, will be higher than both the coupon rate of 5 percent and the current yield of 6 percent.

Rising interest rates are good (or bad) for bondholders

In general, rising interest rates are good for future bondholders (who will see higher coupon payments); for those who presently own bonds, rising interest rates may not be so good because rising interest rates push bond prices down. (Who wants to buy your bond paying 5 percent when other bonds are suddenly paying 6 percent?)

On the other hand, rising interest rates allow present bondholders to reinvest their money (the coupon payments that arrive twice a year) for a higher return.

In the end, however, what matters most for bondholders is the real rate of interest, after tax. The real rate of interest is the nominal rate minus the rate of inflation. You’d rather get 6 percent on a bond when inflation is running at 2 percent than 10 percent on a bond when inflation is running at 8 percent — especially after taxes, which tax the nominal rate and ignore inflation.

Certain bonds (such as treasuries) are completely safe

The U.S. government can print money and raise taxes. So there isn’t much chance of Uncle Sam having to default on his debt — that’s true. Treasuries are not completely safe, however. They are still subject to the other risks that bonds face: inflation risk and interest-rate risk.

There’s also the risk that some future bevy of government leaders may find the government so much in debt, and the thought of raising taxes or risking inflation so intolerable, that they decide to pay 90 cents on the dollar to bondholders. Other governments have done this.

Bonds are a retiree’s best friend

Rely on an all fixed-income portfolio to replace your paycheck, and you’d better have an awfully big portfolio or you risk running out of funds. Bonds, unfortunately, have a long-term track record of outpacing inflation by only a modest margin.

If you plan on a long retirement, that wee bit of extra gravy may not be enough to get you through the rest of your life without resorting to an awfully tight budget. The retiree’s best friend is a diversified portfolio that has stocks (for growth potential) and bonds (for stability) and cash (for liquidity), with maybe some real estate and a smattering of commodities mixed in.

Individual bonds are usually a better deal than bond funds

Some of the newer exchange-traded funds offer an instant diversified bond portfolio with a total expense ratio of peanuts — in the case of iShares, Schwab, SPDR, and Vanguard bond ETFs, you’re looking at 0.10 to 0.15 percent per year. (That’s 15 percent of 12 percent a year or less.)

These ETFs are excellent ways to invest in bonds. Many other bond funds offer professional management with reasonable expenses and impressive long-term performance records.

Buying individual bonds may be the better route for some investors, but the decision is rarely a slam-dunk, especially for those investors with bond portfolios of, say, $350,000 or less. Less than that, and it may be hard to diversify a portfolio of individual bonds.

Municipal bonds are free of taxation

Most income from municipal bonds is free from federal income tax, but may be taxed at the local and state level. If you see a capital gain on the sale of a muni or muni fund, that gain is taxed the same way any other capital gain would be.

And some municipal-bond income is subject to the Alternative Minimum Tax (AMT), designed so that those who make six figures and more can’t deduct their way out of paying any tax.

Do municipal bonds make sense for you? The tax question is the primary one. Unfortunately, it isn’t as straightforward as it looks. Don’t invest in munis, which generally pay lower rates of interest than do taxable bonds, without having the entire picture.

A discount broker sells bonds cheaper

Often, a discount broker has the best deals on bonds, but sometimes not. That’s especially true for new offers on municipal bonds and corporate bonds when a full-service broker may actually be packaging the bond for the public. It always pays to shop around. When buying Treasuries, don’t go to any broker; shop directly on the TreasuryDirect website.

The biggest risk in bonds is the risk of the issuer defaulting

Even in the world of corporate junk bonds, where the risk of default is real, it’s still not the biggest risk that bondholders take. A bond can also lose plenty of market value if the issuing company is simply downgraded by one of the major credit ratings agencies.

Most commonly, however, a bond’s principal crashes if interest rates soar. No matter how creditworthy the issuer, a swift rise in interest rates will cause your bond’s value to dip. That’s not an issue if you hold an individual bond till maturity, but you may be less than thrilled to be holding a bond that is paying 5 percent when all other bonds are paying 8 percent.