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Course 103
Buying Bonds

Introduction

Although, at first, buying bonds may seem simpler than buying stocks, there are still many factors investors need to consider. The constant changes in the bond market can make it difficult to know where and when to buy. As an educated investor, you need to understand what buying bonds is all about.

Things to Consider When Buying Bonds

Bonds are more stable than stocks but riskier than certificates of deposit or money market accounts. They are not great for making your money grow rapidly, but they can help to diversify your portfolio. Most traditional bonds provide a relatively stable source of interest payments and a return of your principal.

The purchase of a bond is basically a loan to the issuer: a loan that must be repaid to you at maturity. Bonds differ in their maturity.

Maturity is the time at which a bond issuer pays you back the money you loaned. If you hold your bond until it matures, you get back all of the money you paid for it, unless the issuer has defaulted. Shorter-term bonds have maturities of only several years. Long-term bonds take from 10 to 30 years to mature. In general, the longer the maturity, the greater the total of interest payments you will receive from the bond.

If you would like to conservatively invest money for a major purchase to be made within the next few years, consider a short-term bond. These types of bonds will generally maintain your principal without much risk. If the timeline of your investment is longer, you may want to consider a longer-term bond.

Long-term bonds will typically offer a higher yield in exchange for the use of your money for a longer period.

The bond issuer may decide to pay off a bond before its maturity date. This is known as "calling" a bond. Bonds are called because an issuer no longer needs to borrow the money, or because interest rates have fallen and the issuer wants to issue new bonds at a lower interest rate.

A bond's market value is directly related to interest rates. As interest rates go up, the market prices of bonds go down and vice versa. Until a bond matures, its price on the secondary market constantly changes in response to changes in interest rates. If you sell your bond before it matures, the price may be more or less than you originally paid for it, depending on current interest rates.

The other factor affecting the prices of bonds is the credit quality of a bond. If a bond issuer is at risk for default, it will be assigned a low credit rating. Credit ratings are based on a grading system, with AAA being the highest possible mark, all the way down to a grade of C. Rating agencies include Moody's Investors Service and Standard & Poor's.

How to Buy Bonds

Ready to start investing in the bond market? First, you will need to know how to go about trading bonds.

You can purchase U.S. Treasury bonds on the secondary market or directly from the Federal Reserve. When you purchase bonds directly from the Federal Reserve, you must buy new issues, but there are no broker commissions. The Treasury holds regularly scheduled government auctions four times a year: the first weeks of February, May, August, and November. You can enter competitive bids for Treasury securities.

You can also buy new-issue corporate bonds through bond dealers. Corporate bonds are IOUs issued by private and public corporations both in and outside the United States. They are issued by public utilities, as well as private sector firms such as transportation companies, financial services companies, and industrial corporations. The corporate bond market is quite large, with a lot of active trading.

When bonds are first issued, their prices, or face values, are fixed. Once issued, these prices can fluctuate in the secondary market due to changing interest rates. When bonds are first issued, bond dealers assist the issuer (a company or governmental body) in selling the bonds to the public, and for this they are paid a commission from the proceeds of the sale.

Older bonds are sold through brokers on the secondary market. The secondary market consists of the over-the-counter (OTC) market, including the NASDAQ, and stock exchanges such as the New York Stock Exchange (NYSE). Most bonds are sold over the counter. The OTC market consists of hundreds of financial institutions and brokerages that buy and sell over the phone or via computer networks. Brokerage firms that deal in bonds have latitude to set prices for bonds they sell. However, all prices are negotiable. Bonds sold on the OTC market are usually sold in amounts greater than $5,000 at a time.

Financial publications such as The Wall Street Journal publish prices of bonds traded on the exchanges each day. However, very few bonds are actually traded on a daily basis. A broker's advice can be invaluable in helping you select and purchase the bonds that meet your investment objectives..

Bond Pricing Terminology

There are many things to consider when judging a bond's market value. Understanding the various factors that impact bond prices can help you track how your bonds change in value, and when the time is right to buy or sell.

The face value of a bond is known as its par. A bond's par is its price when it is issued, which is the same price that will be repaid when the bond matures.

A bond's coupon rate is the annual percentage rate that will be paid to the owner of the bond, based on the bond's original face value. A bond with a coupon rate of 5% pays 5% of the bond's face value each year. Bond interest is usually paid twice a year.

Here are a few more pricing tips:

  • You can sell your bond on the secondary market before it reaches maturity. The price you get for the bond before it matures is known as its market price.
  • When the price of a bond goes above its face value, it is said to be a premium bond.
  • When the price is below its face value, it is known as a discount bond.

When you buy a bond on the secondary market, you are probably going to pay a price above or below the par of the bond. This will affect your yield-to-maturity, a calculation based on the bond's original purchase price, redemption value, time to maturity, coupon rate, and the time between interest payments. For example, if you buy a bond and then sell it after interest rates have risen, you will get a lower price for the bond than what you originally paid for it. The second buyer will get a higher yield than you because he or she paid less for the bond, but the buyer will still get its full par value when it matures.

Bonds that are traded on the secondary market can have prices that are quite different from the prices at which they were originally issued. Traders look at a number of factors when assessing the market prices of bonds.

Bond Trading Transaction Costs


No matter where you decide to buy or sell your bonds, you should be prepared to pay a transaction cost. The costs you will pay depend on the market on which you buy your bonds.

The difference between the price a broker-dealer pays for a bond and the price at which it is sold to you is known as the bond's markup. The markup is a transaction cost. With new issues, the broker-dealer's markup is included in the par value, so you do not pay separate transaction costs.

Everyone who buys a new issue pays the same price, known as the offering price. If you are interested in a new issue, you can get an offering statement describing the bond's features and risks.

Instead of charging you a commission to perform the transaction for you, the broker-dealer marks up the price of the bond to above its face value.When you buy or sell bonds through a broker-dealer on the secondary market, the bonds will have price markups. Instead of charging you a commission to perform the transaction for you, the broker-dealer marks up the price of the bond to above its face value. Markups are usually from about 1% - 5% of the bond's original value. Bond dealers generally charge higher markups on smaller bond sales than larger ones. If you are buying a Treasury bond over the counter, you may have to pay a small, additional flat fee.

If you sell a bond before it matures, you may receive more or less than the par value of the bond. Either way, your broker-dealer will mark down the price of your bond, paying you slightly less than its current value. He or she will then mark up the price slightly upon resale to another investor. This is how broker-dealers are compensated for maintaining this active secondary market.

Bonds bought on the exchanges generally have much higher markups than bonds bought over the counter. It is difficult to know how much of a markup you are paying, because the markup is built into the price of the bond.

Buying Bonds Indirectly

Having trouble choosing the right bonds for your portfolio--or coming up with the funds to buy them all? The answer may be one of the indirect ways for investors to profit from the bond market.

The benefit of a unit investment trust is that you know exactly how much you'll earn from the trust when the bonds mature.One conservative option to explore is a unit investment trust, or UIT. A UIT gives you the opportunity to buy a wide variety of bonds in a portfolio that never changes. Some unit investment trusts also specialize in only one type of bond.

The benefit of a UIT is that you know exactly how much you'll earn from the trust when the bonds mature. You earn interest during the life of the trust on the amount you initially invest as well as on the trust's income. The bonds in the trust remain fixed until your initial investment is completely returned to you when the bonds mature. A trustee supervises the bonds in the trust, but the trustee cannot sell or add new bonds.

Another way to invest in bonds is through a bond mutual fund. A bond fund is a portfolio of bonds managed by an investment professional. The big advantage to a bond fund is that your investment buys shares of a diversified managed portfolio of bonds, which lowers your overall risks. Interest, dividends, and capital gains from a bond fund can be paid or reinvested in the fund. Open-end funds let you buy into or sell out of the fund whenever you wish. Bonds are actively added and sold from the fund by the fund manager. There is no maturity date to a bond fund. Most funds charge a modest manager's fee and some charge for buying or selling fund shares.

UITs and mutual funds offer the benefits of a bond portfolio and more affordable buy-in costs for investors who want the rewards of bonds without having to trade them directly.

Doing Your Homework Before Buying Bonds

As an educated investor, you should know what to look for when buying a bond, what costs to expect, where to buy bonds, and the different ways you can buy them, such as individually, through trusts, or in funds. Depending on your investment needs, you might consider short-term or long-term bonds, and you might choose between new issues and bonds purchased at a premium or discount on the secondary market.

Quiz 103
There is only one correct answer to each question.

1 What is the term for the time at which you are paid back for a bond?
a. Value
b. Yield
c. Maturity
2 What is the highest credit rating a bond can receive?
a. A
b. AAA
c. C
3 Which organization sells the most bonds?
a. The Federal Reserve
b. The over-the-counter market
c. Stock exchanges
4 What is the face value of a bond known as?
a. Premium
b. Par
c. Coupon rate
5 What do you call the price you pay for a new issue?
a. Markup
b. Commission
c. Offering price
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