A DEEPER UNDERSTANDING OF BOND INVESTING

For the past week or so, i have been concentrating mainly on bond and bond fund investing. While i have only skimmed the surface of this somewhat complicated bond market, it is better that you know some of these things because that is how education stars; first the introduction of concepts that are expounded later in an organized fashion.

I have been reading books and articles by professional investors for quite some time now and they all advice people to get into the investment world as soon as possible, so as so develop the right investor attitudes and get enough experience(a better name for mistakes).

In that same vein, i was reading an article on cnn.com that was basically addressing a question posed by a 26 year old asking for help in demystifying the complicated bond markets.

The answer explains in a very simple fashion, the inverse relationship between

-bond prices and their interest rates

-why they are called fixed income  investments and yet their interest rates fluctuate

-the risks involved in bond investing i.e. credit risk and interest rate risk. Credit risk is the risk of default and it is more common with corporate bonds than government bonds

-a little advice on the percentage to allocate to your porfolio.

I know what you guys may already be knowing these stuff but it never hurts to have a different perspective.

Here is the link

ADVANTAGES OF CONVERTIBLE BONDS TO AN INVESTOR

In a post that I did recently about convertible bonds (convertible bonds as the best of both worlds) a reader called Christian Pinnell Commented that I hadn’t really brought out the second part of the heading i.e. how they are the best of both worlds. So today’s post is dedicated to this.

To sufficiently cover this we have to look at which advantages of both stocks and bond ownership accrue to a convertible bond investor.

First of is the interest payments due to the convertible bond holder which can be seen in dividend paying stocks and all other bonds. These payments continue as long as this investment is still a bond and stops immediately after conversion into a stock at which point a different scheme is adopted.

As I said in the original post, these bonds are a very efficient way of protecting against market fluctuations while at the same time providing periodic returns. This addresses a down side of stocks which issuing companies can sometimes decide not to issue dividends for a myriad of reasons and the fact that they are less prone to the worst of market fluctuations means that the investor gets what he mostly wanted when he was investing in bonds; security from the volatility of the market, a fact that stocks have to deal with everyday.

Since companies sometimes go burst, a convertible bond holder will have a larger claim of the company’s assets than the stockholders making him at a better position when a company is undertaking bankruptcy proceedings(if he was still holding the bonds). This advantage would still be available to him but to a lesser extent if he had already converted to stocks at which point he would have enjoyed many of the advantages of common stock ownership.

Since conversion is not done haphazardly but conversion ratios are used at time frames set, this protects the convertible bond holder since he can only convert the bond into a stock when the market price of the stock goes above the calculated conversion price of the share. No convertible bond holder would convert to stocks if the market price is lower than the calculated price because this would mean a loss of cash. So as you can see there is almost no risk in conversion. It is a win-win case for all parties involved as bondholders will be happy common stock holders and the company still remains stable as their financial stability(or the lack of) is not speculated of as is normally done when a company decides to issue more shares.

As is with all bonds, when interest rates fall, their prices rise. This rise correlates to the increase in stock prices and at times this can lead to convertibles outperforming the market indices as happened in 2003 and 2004. If this doesn’t happen there is still the fact that these bonds mirror stock market indexes, kind of like index funds.

Another advantage that a convertible bond holder gains if he converts to common stock is more protection from inflation, This is because the market stock of the common stocks will rise with market prices unlike for the bonds where the interest rates are fixed. This means that bond holders bear the full blunt of inflation because his money looses value more.

Finally this website provides a more analytical basis in looking at convertible bonds and their benefits to investors.

CONVERTIBLE BONDS- THE BEST OF BOTH WORLDS??

As the name suggests, this is a corporate issued bond that can be converted into some other investment vehicle in this case, it can be converted into common stocks . This is done at only certain times and at a fixed conversion ratio.

But the conversion is not as straightforward as it may seem. Let me illustrate. At the time of issue (when the company is offering these bonds to the public for the first time), a few things are spelt out. They include;

-the conversion ratio i.e. the number of bonds that can be converted into stocks

-the time period through which conversion has to occur

-the common stock price at which conversion will occur

Let’s bring arbitrary figures into this to make it more understood.

Supposing a convertible bond (or CVs as they are more commonly referred to) has a conversion ratio of 100:1. This means that one bond can be converted into 100 common stocks per say every $1000 of bonds you own. This then means that every new common stock will be worth $10 [1000/100=10]. This $10 is called the conversion price and it is normally higher than the current stock price in the markets.

This means that if at the time of conversion the current stock price was lower than the conversion price, then the involved parties will have to wait until the stock price reaches the conversion price before the conversion can occur. If the current stock price was higher than the conversion price, then a different arrangement is brought up. Let’s say that the current common stock was worth $20 (against the calculated $10), then to keep the conversion ratio at 100:1, it means that the conversion would occur for every $2000 of bonds you own i.e. $2000/20=100

I know it seems a little difficult to get your head around these figures, but just study them a little more carefully and all will be revealed. [Hopefully my bounce rate will also reduce in the process ]. Teenanalyst.com has a similar example on this figures that you can read more of

The most significant advantages are:

-In the case of the issuer, the stock dilution brought about by so many common stocks for every bond means that they pay less dividends because the earnings per share is reduced.

-Also these convertible bonds generally have a lower coupon rate than normal bonds and this means less money that will have to be paid out be the company.

-they are also used by issuers to avoid misinterpretations by investors i.e. if a company chooses to issue more stock investors might think that the stock is overvalued and this might bring other problems like investors doubting the soundness of the stock. So to prevent this, the company issues these convertible bonds since there is a high likelihood that bondholders will convert them into common stock because these stock have many advantages over bonds.

-Since the yield of these convertibles is normally lower than those of other corporate bonds, means that they are more attractive. There is a rule that the lower the   interest the more valuable the bond since it means that there is a lower risk of default by the company.

-these convertible bonds also follow the market share price of the issuer’s stock. When the share price rises, the convertible bond price also rises and vice versa but not at the same levels. Convertible bond price goes up two thirds the rate at which the stock rises and less than ½ the decrease in stock prices.

-these bonds also earn interest when the stock is going up or down and it makes it attractive to investors since who wouldn’t want a check whether the markets are going up or down? This is because issuers are required to give fixed interest income to convertible bond investors before conversion.

-these convertibles are also good to protecting against market fluctuations while at the same time providing periodic gains.

These advantages are why I think that they offer the best of both worlds between stocks and bonds.

Finally, this is the second investment that can be converted to another that I have covered. The previous one was convertible stock

WHAT IS (OR WERE) BEARER BONDS??

These are just like normal bonds (corporate or government-) but the major difference is that they are unregistered i.e. when you invest in any other type of bonds, you go into the records as a registered owner and the paper you hold has proof of your ownership of the said bonds but with the bearer bonds, there is no such registration. The person who holds the certificate owns the bond. It’s just like having money in your hands. There is really no way of tracking a previous owner once it exchanges hands.

Bearer bonds also have a stated maturity date and a fixed interest rate but can be called in by the issuers for a myriad of reasons like if interest rates are too high, they might recall them to reduce the cost of paying interest to the holders.

Each bond certificate has a single coupon that the holder is supposed to submit to the issuer. The current holder of the bonds submits the coupon, which is by the way attached to the bond, to the paying agent either annually or semi-annually and they get paid. No identification of any kind is required.

It is worth mentioning that it is the holder’s responsibility to submit the coupons for interest payment- not like other types of bonds where the issuer has the obligation of paying the bond investors interest at given times.

Although they are distinctively different from other bonds, there are some things that the current bond holder is supposed to honor. But all these are set up at the time of purchase.

These include honoring the payment periods set at the purchase of the bonds, when to cash in the coupons and the number to cash in at a time (some allow that you cash in more than one coupon at a time).

BTW they are also called coupon bonds.

They have a large number of advantages like convenience in that a large amount of cash can be carried around in a few of these bonds, anonymity in that current bond holders are not asked awkward questions when they go to cash in these bonds, tax avoidance in the case that tax collectors couldn’t trace a paper trail for them as they exchanged hands etc.

Their major disadvantages which in most cases cloud out all their merits is the fact that in the case of accidental damage, destruction they become totally useless. Also they are totally impossible to trace when stolen. Also in they are easily used in bank fraud which to some extent discredits the issuers.

But their features are the main reason why many investors are veering away from these unregistered bearer bonds to the more secure registered counterparts. There have been many cases of criminal use of bearer bonds but the most infamous was the case of the $134 billion in bearer bonds found by Japanese travelers crossing into Switzerland from Italy.

I also read that they were made illegal in the US in the 1980s but the ones issued before that are still in circulation. There are also fewer institutions that will cash in these bonds.

Finally some legit bond holders may or have lost their invested capital since issuers may have recalled them without the holder knowing. In a case like this, it becomes really hard to get invested cash back.

That is just about all I could get about the bearer bonds (which I am sure that most of you have heard of on tv).

Any additions are very much welcome.

WHY THEY CALL THEM JUNK BONDS

This is a type of corporate bond that is has a high risk of default and thus offers high yields.

A salient feature of bonds is that their risk of default depends on among other things, the credit worthiness of the issuing company. If the company has low credit worthiness, there is a higher risk that the bonds they have offered have a higher risk of default. This risk is normally felt in economic slowdowns when most of these junk bonds default at around the same time, which has happened quite a few times in the past and will happen in the future taking some junk bond investors with them to their graves.  To counteract this, these bonds give unusually high yields that more often than not cannot be sustained in the long haul.

To copy-paste Wikipedia, since the term junk bond is synonymous with risk, the types of risks involved are interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody’s, or Standard & Poors.

The yields are like 3 to 9 percentage points higher than government bond issues

As there is a high risk of an investor losing his invested capital, there is also a chance of him getting spectacular returns if he managed the risk involved well and he did his research well on the bond and the issuer. But in this, there is a lot of speculation. But still many investors take on the risk with the hope of higher returns but try to lessen this risk by a somewhat broad diversification in these corporate junk bonds and limit these high risk investments to a small part of their portfolio.

In light of the above, the other two names of junk bonds are high yield bonds and speculative bonds or non investment grade bonds.

These bonds have a low credit rating mainly because the issuing company is not financially stable e.g. like a young company with no other ways of getting much required funding or any other financially troubled institution that has very little in the way of raising funds for operations [bond offering is one of the last money raising options that most corporations have because the banks may not be willing to loan them the large amounts needed]-

Here is a long linked article about the history of junk bonds and the strange case of billionaire Michael Milken, the Junk Bond King.

That is basically the Junk bonds for you, any questions and/or comments are welcome

WHAT YOU NEED TO KNOW ABOUT GOVERNMENT BONDS

Just like corporate bonds are IOUs by the companies issuing the bonds, government bonds are IOUs to the general public to borrow money that will be returned at a predetermined time at face value with interest payment periodically up to maturity.

Governments issue these bonds when they have more money needs than can be satisfied by tax revenue. Another reason is to regulate the amount of money circulating in the economy. If there is too much money (which can cause inflation), the government issues bonds that it will buy back (redeem) at a given future date and this reduces the money supply. It does the exact opposite when there is too little cash in the economy i.e. redeems the already issued bonds.

They also have other names in other parts of the world. In the UK they are called gilts or gilt edged securities and in the US they are called treasuries. Also bonds issued by governments in foreign countries are referred to as sovereign bonds.

To some extent these government bonds reflect what will happen to interest rates in the future. If interest rates are expected to rise, investors will sell to keep any capital gains and prices will fall. This is because as interest rates rise their prices fall. On the other hand, if the interest rates are expected to fall investors buy for the higher yields that the bonds have as at that time and for the future capital gains, means that their prices rise. It goes without saying that anything that affects interest rates, inflation, economic growth and expectations about both also affects these bonds.

As am sure you have come to learn that more often than not returns in investments like bonds and mutual funds are directly related to risk i.e.  the lower the risk the lower the returns and vice versa, this means that governments bonds are good for the conservative risk averse investor that does not want to risk hard earned money and doesn’t necessarily require high yields. An investor like this would be interested in risk government bonds because of the higher safety in that at maturity, the government can raise taxes to get enough cash to redeem them and thus a lower risk of default.

Other than a steady fixed income in the form of interest paid either annually or semi annually, the low risk of invested capital invested if bonds are held to maturity, a fixed date of maturity, they have a provide a more diversification to a portfolio mostly dedicated to more risky investments(everyone needs safety once in a while)

The best time to but the government bonds is when they are first issued because buying them from the secondary market since expecting to profit from them here has a number of variables like the time to maturity, market interest rates, credit worthiness of the issue (the risk of default) and the liquidity of the bond(some bonds are virtually impossible to sell at certain times). Also if an investor pays less than the face value of the bond(at a discount), he stands to profit when the bond matures to its face value. If he buys at face value or at a premium(above), there is a higher likelihood for a loss when the bond matures.

Another good thing is that you do not have to wait until maturity to sell the bonds. You can sell them in the secondary market and profit if the interest rates have gone down since you bought the bonds and lose if the rates have gone up. There is a lot more on this in a small fascinating government bond post that I have just found. Please read through it because their explanations contain figures and ease understanding.

That is an overview of the government bonds. I will take you deeper into them in future so sit tight.

SENIOR & SUBORDINATED CORPORATE DEBT EXPLAINED

Yesterday’s post was about corporate debt of which there are two types secured & unsecured debt and senior & subordinated debt. We will look at the latter in this post

Senior debt is a secured debt in that it is the primary debt that is paid off in the unfortunate event of an issuer’s bankruptcy. Most high grade debt securities are senior debt and also loans from financial institutions. Since they are secured, this means that secured investors receive lower yield that their unsecured counterparts.

In the words of Wikipedia, senior debt is a class of corporate debt that has priority with respect to interest and principal over all the other classes and equity that an issuer has.

In most cases the law states that taxes and certain payments to employees be paid before creditors have their share of a dying company.

The opposite of senior debt is junior debt also called subordinated debt.   It is a corporate debt that is serviced after senior debt(secured debt) in the event of liquidation. It goes without saying that a subordinated debt holder is exposed to more risk that in the senior debt holder because he will be paid by the portions left over in the loan repayments. This could be a portion of his initial capital.

A little about subordinated debt is that a company issues it as a last resort in that it has already used its assets to back up senior debt but the money obtained is not enough and so they issue this corporate debt. It is more expensive to them in that they have to pay higher interest rates to the investor because he bears most of the risk in case the company goes bankrupt.

Also not all companies can issue subordinated debt. Only those with good reputations and high credit worthiness find this debt somewhat success as no investor want to loan out cash to a company with a reputation of defaulting.

But for the risk tolerant investor, even though there is a large possibility in losing invested capital in the case of bankruptcy, there is also the chance of a higher pay off if all goes well. But this is pure speculation as there is no way of knowing a company’s future. But still an investor will insist on details of a company’s financial records and past performance.

Finally this linked Wikipedia article has quite a lot to say about subordinated debt

That is senior and subordinated debt for you. If you have any questions or additions, the comment box is all yours.

AN OVERVIEW OF SECURED & UNSECURED CORPORATE BONDS

Yesterday, I did a post on corporate bonds and Wikipedia stated that there were two types of these bonds;

-secured and unsecured bonds

-senior and subordinated bonds

I will run through secured and unsecured bonds and the next post will deal with senior and subordinated bonds

Secured corporate debts are bonds that are backed up by the issuer’s (company giving out the bonds) physical assets. This means that if the company is not able to pay back the debts to investors, these assets are liquidated to pay them.

These assets are stocks and bond holdings, furnishings and/or real estate. Because of this backing, they are normally better investments that their unsecured counterparts.

According to wisegeek, secured bonds are not 100% safe investments but the risk is substantially reduced with the asset backing. For instance, let’s say that a secured bond is backed by a mortgage. This means that in the event of liquidation, the mortgage will be transferred to the new owner (the investor). But there is no guarantee that the mortgage itself will not default (there has been a lot of this in recent times) or if the underlying real estate will still be worth the value of the mortgage. But this is better than no backing at all. Wouldn’t you agree??

Needless to say, unsecured bonds are not at all backed by any physical assets but by the credit worthiness of the company issuing these bonds.

They are also called debentures so let this not confuse you

The fact that this debt carries more risk to the investor means that it becomes more expensive for the issuer which is in terms of higher interest rates to the investor. But this is not to say that if the issuer goes bankrupt the unsecured creditor will not be paid. Far from it. He will be paid but after the secured creditors which means that they may get a smaller portion that the secured investors.

To understand this pay back scheme in the event of a bankruptcy, secured creditors are paid first and then the next group is the unsecured creditors, banks and financial institutions, insurance companies etc(the general creditors companies have). Finally preferred and common shareholders are paid last.

As the unsecured bonds have higher yield, they are more attractive to risk tolerant investors.

That is basically an overview of the secured and unsecured corporate bonds. There are other things that I have left out like the types of unsecured bonds and what not which I will cover later. This was just to familiarize green readers

CORPORATE BONDS & CORPORATE BOND FUNDS EXPLAINED

First we will look at corporate bonds and then their corresponding mutual funds.

I recently covered the bond funds and mentioned the types of bonds.

Basically corporate bonds are debt instruments by which both private and public corporations (referred to as the issuer) use to raise money to expand their businesses by borrowing money from the general public. They have a relatively long maturity period(at least a year). Their corresponding shorter term securities are called commercial paper. The insurance of the corporate bond is the credit worthiness of the company and sometimes the company’s physical assets.

BTW corporate bonds are riskier investments that government bonds since with the latter, the government will just increase taxes and print more money so pay bond holders- something that unfortunately corporations cannot do. Therefore to counteract this higher risk, investors are offered higher interest rates.

In the agreement the principal is to be returned at a predetermined date until which you will be getting interest payments from the issuer. This is one of the major differences between corporate bonds and stocks because even though and investor gets interest payments from the company, he does not have any ownership interest as in the case of a stockholder.

Another interesting feature of corporate bonds is that they have call provisions/call options that allow the investor to redeem get his money back before the maturity date.

In investing in these bonds, the major thing that you should look for is that if the company has enough money to repay and the fixed interest so in a sense you could say that you have become a bank to the corporation

Wikipedia says that there are other types of bonds called convertible bonds that allow investors to convert the bonds into equity

Finally, as they are traded in the markets, their prices fluctuate a lot more or less like stocks.

Of late, corporate bond yields have been very good unlike in the recent years and this is because of this recession, Banks were wary about lending money in volatile times and since the companies needed money the encouraged bond holders with attractive interest rates.

According to thisismoney.com (and coincidentally Benjamin graham- the intelligent investor) the main risk for bond investors is inflation. If central banks see as if the economy is slowing down faster than the rising prices, they tighten monetary policy and this leads to the interest rates of bonds rising and their price falling, making investors wish that they has kept away from them.

In light of the above, the corporate bond fund is a mutual fund that invests in these corporate bonds. They make it easier for a small investor to invest in the somewhat complex bond market. Since the fund manager wants to maximize returns he selects corporate bonds (investors have no control over selection) and sometimes the bonds are not held up to maturity. This therefore means that interest payments fluctuate. Also these funds have low volatility and this yet another reason that they are good for risk aversive individual investors.

The corporate bond funds were hit hard by the recession just like the lower rated bonds.

Finally this linked article that I have found shows that one must never get into an investing craze because of the masses by showing the major losses that investors suffered because of this misjudgment.

That is basically the corporate bond and their corresponding mutual funds. Any additions or corrections or whatever are welcome.