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Only Guide to a Winning Bond Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today

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Overview

Larry Swedroe, the author of The Only Guide to a Winning Investment Strategy You'll Ever Need, has collaborated with Joe H. Hempen to create an up-to-date book on how to invest in today's bond market that covers a range of issues pertinent to any bond investor today including: bond-speak, the risks of fixed income investing, mortgage-backed securities, and municipal bonds. The Only Guide to a Winning Bond Strategy You'll Ever Need is a no-nonsense handbook with all the information necessary to design and ...

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Overview

Larry Swedroe, the author of The Only Guide to a Winning Investment Strategy You'll Ever Need, has collaborated with Joe H. Hempen to create an up-to-date book on how to invest in today's bond market that covers a range of issues pertinent to any bond investor today including: bond-speak, the risks of fixed income investing, mortgage-backed securities, and municipal bonds. The Only Guide to a Winning Bond Strategy You'll Ever Need is a no-nonsense handbook with all the information necessary to design and construct your fixed income portfolio. In this day and age of shaky stocks and economic unpredictability, The Only Guide to a Winning Bond Strategy You'll Ever Need is a crucial tool for any investor looking to safeguard their money.

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Editorial Reviews

From the Publisher
"One of the great untold tragedies of modern finance is the mayhem wreaked upon an unsuspecting public in the bond markets. Whether you're a small investor or an institutional player, the odds are that not only have you been savaged by this machine, but that you don't even know it. Few people know fixed income investing as well as Larry Swedroe; "The Only Guide to a Winning Bond Investment Strategy You'll Ever Need" will steer you through these dangerous waters in safety and comfort." —Bill Bernstein, author of The Four Pillars of Investing, The Intelligent Asset Allocator, and The Birth of Plenty

"There's an ol' saying in personal finance and investing: 'You build wealth in stocks, and you preserve it in bonds." Well, here's a book that offers the best of both worlds! These guys show you how bonds can not only preserve your wealth, they can help you build wealth too!" —Paul B. Farrell, JD, PhD, columnist, CBS MarketWatch, author of The Millionaire Code, Lazy Person's Guide to Investing, The Winning Portfolio, and others

"A bond book for our time. Clearly, given that most financial observers believe the equity premium is going to decline over the foreseeable future making bonds a relatively better investment, we need to start focusing more on bonds as an investment vehicle. This book provides an excellent roadmap of the bond markets and bonds as a personal investment." —Edward R. Wolfe, Ph. D., Professor of Finance, and Director of the Financial Planning Program, Western Kentucky University

"A MUCH NEEDED BOND BOOK. In The Only Guide to a Winning Bond Strategy You'll Ever Need, the authors cover the very complex issue of bonds in great detail. This book is a must-read for anyone who's thinking of investing in bonds and really wants to understand what they're all about. Readers will also gain insight into how the bond market works. I feel every bond investor could benefit from reading this book; I know I did. This book definitely should be a part of every bond investor's library." —Mel Lindauer, Forum Leader, Morningstar's Vanguard Diehards Forum and co-author, The Bogleheads' Guide to Investing

"This remarkably clear and well-organized book covers just about everything the typical investor needs to know about bonds and other fixed income securities. A real pleasure to read." —Kenneth R. French, Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth

"Bonds and other types of fixed income investments are very complex and difficult to understand. Larry Swedroe and Joseph Hempen have collaborated in a book about bonds and fixed income investments that even I can understand. In their easy-to-read manner, they take us through the various fixed-income investments and tell us how and why each security may or may not be suitable for our portfolio. The Only Guide to a Winning Bond Strategy You'll Ever Need is destined to become a bond book classic." —Taylor Larimore, Dean of the Morningstar Vanguard Diehard Forum, co-author of BogleheadsGuide to Investing

"At some point — perhaps soon — the Federal Reserve will stop raising interest rates, a decision that is bound to add to the allure of bonds, because bond prices rise as rates fall.

To cater to the potential growing demand for information, Larry E. Swedroe and Joseph H. Hempen, principals at Buckingham Asset Management, an investment firm based in St. Louis, have put together an excellent primer: "The Only Guide to a Winning Bond Strategy You'll Ever Need" (Truman Talley, $25.95)....they cover the bases extremely well. Even better, they lay out a strategy for investing in bonds that will make sense for most people:

-Buy bonds with the highest ratings, or invest in bond mutual funds that do.

-Buy bonds with short to intermediate maturities. "Holding assets with a maturity of about one to two years is the prudent strategy for those investors wishing to maximize the risk-reward relationship," the authors write.

-Avoid buying hybrid securities — like convertible bonds and preferred stocks — because their risks outweigh their potential rewards.

-Don't try to time the market. "Buy and hold" is the safest approach, as with stocks." —The New York Times, Sunday Business Section, 3/5/06

"Coming up with a bond strategy takes time, but it's time well spent. Because the same instruments that are sold as safe and secure hedges against trouble can bite you if you're holding the wrong kind in the wrong way and interest rates turn.

A couple of St. Louis financial advisers, Larry Swedroe and Joseph Hempen, have written a straightforward book to address all of those choices.

The Only Guide To A Winning Bond Strategy You'll Ever Need, to be published in March by St. Martin's Press, may sound a bit hyperbolic.

But it's notable because at least one of the authors, Swedroe, has a reputation as an exponent of the "you can't beat the market" philosophy and the inexpensive stock index-fund investing that typically goes with it.

He typically tells clients that they shouldn't try to beat the market, but instead should hold diversified portfolios of low-cost stock funds for years and years. So it's worth seeing how such a philosophy would translate to bonds.

...[It] is also informative and direct when it comes to making bond investment choices." —Linda Stern (Freelance writer), published on Reuters.com and in Jackson News-Tribune

"You create wealth with stocks; you preserve it with bonds.

Those of us on the wrong side of 50 are starting to pay more attention to an asset class that just doesn't get the respect it merits: fixed income.

A few weeks back, we noted the recent publication of a Canadian-focused primer on bonds: Hank Cunningham's In Your Best Interest.

I noted such books are rare compared to the glut of material on the more glamorous subject of stocks and equity funds. Barely was the ink dry on that column when another bond book came through the transom, from an author I've read and respected for some time: Larry Swedroe.

Swedroe is one of those indexing evangelists who has made the case for indexing equities in such prior books as What Wall Street Doesn't Want You to Know and The Only Guide to a Winning Investment Strategy You'll Ever Need. (St.Martin's Press, New York, 2001 and 2005).

I guess Larry's that much closer to retirement now because he's about to release his fifth investment book and it's focused on bonds. He has teamed up with partner Joseph Hempen to write The Only Guide to a Winning Bond Strategy You'll Ever Need. The publication date is March 7.

Judging from the endorsement the book got from personal finance writer Jane Bryant Quinn — "The bond book for our times" — this one is destined for strong sales. Unlike Cunningham's book, Swedroe's is aimed at American investors. Thus, certain chapters — like the one on tax-exempt municipal bonds — aren't of much relevance to Canadian investors. (More's the pity).

Swedroe lists three reasons to include bonds in portfolios: for liquidity to meet unexpected expenses; to reduce portfolio risk; and to create streams of income to meet ongoing expenses.

He then lists the rules of prudent fixed-income investing: buy only investment-grade bonds rated AA or better; avoid long-term bonds by restricting yourself to bonds with maturities that are short- to intermediate-term; avoid trying to guess interest rates or find mispriced securities; avoid hybrid securities such as preferred stocks or convertible bonds; and invest only in low-cost vehicles.

You'll note both the emphasis on low costs and the point about avoiding market timing reinforces Swedroe's long-established indexing bona fides.

Like Cunningham, Swedroe is critical of how brokerage houses price bonds and disclose broker compensation. Swedroe thinks investors should avoid buying individual bonds from banks or brokerage firms because of large invisible mark-ups and because brokers sell mostly what they have in inventory and wish to dispose of.

Swedroe devotes the early chapters to an overview of how the bond market works and the risks that attend it. He scrutinizes how bonds are priced for retail investors and surveys the dominant species inhabiting the fixed income landscape: government bonds, corporates, international bonds, mortgage-backed securities, money market funds, certificates of deposit (we call these GICs in Canada), and inflation-indexed securities. The latter include U.S. specific iBonds and TIPS (Treasury Inflation Protected Securities), versions of which are called real return bonds in Canada.

But the key chapter is the penultimate eleventh one, which explains how to design and construct a fixed-income portfolio. Here Swedroe looks at the pros and cons of owning bonds through mutual funds or exchange-traded funds, holding individual securities directly or owning bonds in separately managed accounts.

Like Cunningham, Swedroe devotes considerable time to laddering bonds with different maturities. This he describe as "a prudent tactical approach to portfolio construction" that both cuts costs and lets investors balance price risk and reinvestment risk. He also looks at tax efficiency and asset location (as opposed to asset allocation) and describes the importance of getting a financial advisor to craft an Investment Policy Statement (IPS). He suggests investors create a separate Fixed-Income IPS that focuses on investment vehicles, average maturities, minimum acceptable credit ratings and maximum allocation to any one type of debt instrument.

In a canned "interview" the publishers include in a press kit, Swedroe says he wrote the book because "fixed income is a neglected investment tool." As I'd noted when I reviewed Cunningham's book, Swedroe says "there are hundreds of books out there on stocks, far fewer available on fixed income." Too many investors overlook the asset class. That's a mistake because "it's an essential part of a healthy investment portfolio." If a portfolio is a stew, bonds should viewed as a main ingredient like potatoes or carrots, rather than just a seasoning.

From a Canadian perspective, I'd argue Swedroe's book is not the only such fixed-income guide an investor needs. But it makes a good complement to the Canadian-oriented In Your Best Interest.

Buy 'em both."

The National Post

Publishers Weekly
Awkwardly organized and unduly complicated, this book provides a recitation of everything Swedroe and Hempen-co-principals of Buckingham Asset Management-know about bonds, which is a lot. The problem is that their book isn't pitched to a specific enough audience. Sophisticated investors may not mind the authors' heavy reliance on bondspeak and analytical jargon, but they will wonder why so many pages are devoted to explaining Series EE Savings Bonds. And novices will appreciate the extensive glossary, but they'll be frustrated by the book's lack of explanatory diagrams and its tendency to talk about concepts before properly introducing or defining them. The actual strategy discussion alluded to in the title is addressed only in the book's 25-page, penultimate chapter, where Swedroe and Hempen explain how to use standard techniques like laddering to construct a fixed-income portfolio. If only the preceding 10 chapters had been as succinctly written. (Mar.) Copyright 2006 Reed Business Information.
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Product Details

  • ISBN-13: 9780312353636
  • Publisher: St. Martin's Press
  • Publication date: 3/7/2006
  • Edition description: First Edition
  • Pages: 272
  • Sales rank: 633,659
  • Product dimensions: 6.00 (w) x 9.00 (h) x 0.75 (d)

Meet the Author

Larry E. Swedroe and Joe H. Hempen (a bond expert at Buckingham Asset Management) have collaborated to write a definitive bond investing book for the 21st century. This is Swedroe's fifth book with St. Martin's Press. Swedroe lives in St. Louis, Missouri.

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Read an Excerpt

Chapter One

Bondspeak

Good fortune is what happens when opportunity meets with planning. —Thomas Edison

While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to find better advice on living longer than do not smoke, drink alcohol in moderation, eat a balanced diet, get at least a half an hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life. As Charles Ellis points out in Winning the Loser's Game: "Investment advice doesn't have to be complicated to be good." And this is certainly true, as you will learn, about the world of fixed-income investing.

The world of fixed-income investing was once a very simple one. It was also very conservative. When investors thought of fixed-income investing they thought of Treasury bonds, FDIC-insured savings accounts and certificates of deposits, and perhaps the bonds of blue chip corporations such as General Electric. Today, the world is a much more complex one. The research and marketing departments of investment firms regularly create new and highly complex debt instruments. Investors are now deluged with marketing campaigns from bond salesmen urging them to buy instruments such as MBS (mortgage-backed securities), IOs (interest-only bonds), POs (principal-only bonds), and inverse floaters (this one is too complex to describe in a short space).

The complexity of these debt instruments creates huge profit opportunities for Wall Street's sales forces. These complex securities are often sold to investors who generally don't understand the nature of the risks involved. And you can be sure that it is the rare salesman who fully explains the nature of the risks (most couldn't if they had to, as they are trained to sell, not to explain the risks of what they are selling). Thus investors end up taking risks that are not appropriate for their situation. They also incur large transaction costs that are often hidden in the form of markups and markdowns—a subject we will discuss in detail.

Unfortunately, there are investment firms that prey on retail investors who lack the knowledge to understand the risks involved and how these securities are valued by the market. One reason is that the prices for many fixed-income instruments, unlike those of stocks, cannot be found in the local newspaper, or even on the Internet. The lack of visibility in pricing allows for investor exploitation. Brian Reynolds, former institutional fixed-income portfolio manager at David J. Bradson & Company, commenting on this exploitation, stated: "When I went to buy bonds for myself, I was stunned at the difference between buying them as an institutional investor and as a retail investor."1 Friend, and fellow investment author, William Bernstein put it this way: "The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks."2

As was stated in the introduction, the first objective of this book is to provide you with the knowledge you need in order to make prudent investment decisions regarding fixed-income investments. It is unlikely that Wall Street will ever provide you with this knowledge. In fact, the Wall Street Establishment does its best to follow W. C. Fields advice to "never smarten up a chump." Prudent investors never invest in any security unless they fully understand the nature of all of the risks. If you have ever bought (or been sold) a mortgage-backed security (e.g., a Ginnie Mae) the odds are pretty high that you bought a security the risks of which you did not fully understand. And those risks include paying too high a price.

As you will learn, it is not necessary to purchase complex instruments in order to have a good investment experience. Fortunately, the solutions to complex problems are often quite simple. In fact, the great likelihood is that you will do far better by simply hanging up the phone whenever someone tries to sell you one of these complex securities. The greatest likelihood is that they are products meant to be sold and not bought. A good question to consider asking the salesman is: "If these bonds are such good investments, why are you selling them to me instead of to your big institutional clients?" The answer should be obvious—either the institutions won't buy them, or the firm can make far greater profits from an exploitable public.

A Language of Its Own

Imagine you are an executive for a multinational corporation. You have been offered the position of general manager at your company's Paris office. Unfortunately, you don't speak French. Certainly one of the first things you would do would be to take an immersion course in the French language and culture. Doing so would enable you to more quickly gain an appreciation of your new environment, as well as prevent you from making some embarrassing, and potentially costly, mistakes.

Unfortunately, far too many investors take a trip to the land of bonds without knowing the language. Without such basic knowledge it is impossible to make informed decisions. In order to meet our objective of providing you with the knowledge needed to make prudent investment decisions we need to begin by exploring the language known as "bondspeak."

The world of fixed-income investing has its own language. This brief section defines the terms you need to understand in order to make prudent investment decisions. You will learn the difference between the primary (initial issue) and secondary (after initial offering) markets, and the wholesale (interdealer) and retail (individual investor) markets. You will also learn how bonds are bought from and sold to individual investors and the games broker-dealers play at your expense. After completing this relatively brief section you will have the knowledge required to understand the critical terminology of the world of bondspeak. We begin with some basic definitions.

A bond is a negotiable instrument (distinguishing it from a loan) evidencing a legal agreement to compensate the lender through periodic interest payments and the repayment of principal in full on a stipulated date. Bonds can either be secured or unsecured. An unsecured bond is one that is backed solely by a good-faith promise of the issuer. A secured bond is backed by a form of collateral. The collateral can be in the form of assets or revenue tied to a specific asset (e.g., tolls from a bridge or turnpike).

The document that spells out all of the terms of the agreement between the issuer and the holders is called the indenture. It identifies the issuer and their obligations, conditions of default, and actions that holders may take in the event of a default. It also identifies such features as calls and sinking fund requirements. All of the important terms contained in the indenture are spelled out in the prospectus—the written statement that discloses the terms of a security's offering.

The maturity of a bond is the date upon which the repayment of principal is due. This differs specifically from "term-to-maturity" (or simply term) that reflects the number of years left until the maturity date. While most bond offerings have a single maturity, this is not the case for what is called a serial bond issue. Serial bonds are a series of individual bonds, with different maturities, from the same issuer. Investors do not have to purchase the entire series—they can purchase any of the individual securities. Typically, municipal bonds are serial bonds.

Although there are no specific rules regarding definitions, the general convention is to consider instruments that have a maturity of one year or less to be short-term. Instruments with a maturity of more than one and not more than ten years are considered to be intermediate-term bonds. And those whose maturity is greater than ten years are considered long-term bonds.

Treasuries are obligations that carry the full faith and credit of the U.S. government. The convention is that Treasury instruments with a maturity of up to six months are called Treasury bills. (The Treasury eliminated the one-year bill in 2001.) Treasury bills are issued at a discount to par (explanation to follow). The interest is paid in the form of the price rising toward par until maturity. Treasury instruments with a maturity of at least two years, but not greater than ten, are called notes. If the maturity is beyond ten years they are called bonds. Treasuries differ specifically from debt instruments of the government-sponsored enterprises (GSEs). The GSEs are the Federal Home Loan Banks (FLHBs), the Federal Farm Credit Banks, the Tennessee Valley Authority (TVA), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and a few others. While each was created by Congress to reduce borrowing costs for a specific sector of the economy, their obligations do not carry the full faith and credit of the U.S. government. In fact, Fannie Mae and Freddie Mac are publicly held corporations. In contrast, the securities of the Government National Mortgage Association (GNMA), because it is a government agency, do carry the full faith and credit of the U.S. government.

Par, Premium, and Discount

These terms refer to the price at which a bond is trading relative to its initial offering. Most bonds have a face value (the amount paid to the investor at maturity) of $1,000. They are also traded in blocks of a minimum of $1,000. Par, or 100 percent, is considered $1,000. A bond trading at 95 is trading below face value, and would be valued at $950 for each $1,000 of face value. A bond trading at 105 is trading above par and would be valued at $105,000 for each $100,000 of face value. A bond trading above par, or above 100, is called a premium bond. A bond will trade at a premium when the coupon (stated) yield is above the current market rate for a similar bond of the same remaining term-to-maturity. Consider a corporate bond with a ten-year maturity at issuance that has a coupon of 6 percent. Five years later the yield on a newly issued security from the same issuer, with the same credit rating, and a maturity of five years is being traded at a yield of 4 percent. Since the bond with the 6 percent coupon has the same credit risk and the same term risk it must trade at a higher price since it provides a higher coupon rate. The reverse would be true if in five years the current yield on a newly issued security with a maturity of five years is 8 percent. Since the new issue is yielding 8 percent and selling at 100, the instrument with a coupon rate of just 6 percent must trade below par. A bond trading below par, or 100, is called a discount bond.

From the above examples we can see that changes in the current price of a bond are inversely related to the change in interest rates—in general, rising (falling) interest rates result in lower (higher) bond prices.

There is an important point to discuss about premium and discount bonds. Many investors avoid premium bonds because they don't want to buy a bond that they perceive has a guaranteed loss built into the price—you pay above par yet receive only par at maturity. This is a major error. In fact, premium bonds offer advantages over discount bonds. First, the higher annual interest payments received offset the amortization of the premium paid. Second, because many investors (both retail and institutional) avoid premium bonds, they often provide a higher return than a comparable bond selling at par. Third, higher coupon bonds are less susceptible to the negative effect of rising interest rates on the price of a bond (we will discuss the reason behind this when we cover the subjects of interest rate risk and duration). Thus premium bonds sometimes offer both higher returns and less risk. Finally, for taxable bonds (not municipals), the IRS allows a one-time election to amortize (write down over time) the premium paid over the remaining life. The ability to deduct the amortized premium improves the after-tax return on the bond.

Investors, on the other hand, often prefer discount bonds, because they perceive an automatic profit—the difference between the discount price they paid and par that they will receive at maturity. However, the ultimate gain is offset by the below current market coupon received. In addition, there is a potential negative to purchasing discount bonds in a taxable account—the discount may be treated as a gain for tax purposes and thus taxable at maturity. This will be the case unless when amortized over the remaining life the discount is less than 0.25 percent per annum. Finally, another negative of discount bonds is that bonds with lower coupons are subject to greater interest rate risk—they are more susceptible to the negative effect of rising interest rates on the price of a bond.

Calls and Puts

Calls

The term call is important to understand as its presence greatly impacts the risks and potential rewards of owning a bond. The failure to understand the risks of owning a bond with a call feature creates the potential for large losses and investors being abused by amoral (though not illegal) practices of broker-dealers (a subject we will cover shortly). Most municipal and agency bonds, as well as some corporate bonds, have a feature that gives the issuer the right, but not the obligation, to prepay the principal (prior to maturity) on a specific date or dates. This feature, known as a call, creates significant risk to investors, for which they do receive a higher coupon (yield) as compensation. The higher yield creates the potential for greater returns but also, depending on the price paid for the bond, the potential for losses. The risk results from the fact that the issuer will only call the bond if interest rates have fallen significantly since the time of issuance (rates need to have fallen sufficiently to overcome the cost of a new issue to replace the original one). For example, investors who originally bought a bond yielding 5 percent will have their bond called at a time when the current yield might be just 3 percent. Thus investors will not have earned 5 percent for the full term of the original bond. When the issuer calls the bond, the principal will be returned. The investor must reinvest the proceeds at the now lower market rate of 3 percent. Another negative feature of a callable bond is that it limits the potential for a bond to appreciate in price if interest rates fall.

A related term is the period of call protection. This is a period during which the issuer cannot call the bond.

There is a specific type of bond that has an implied call feature. Mortgage-backed securities (MBS), sometimes called mortgage pass-through certificates, are debt instruments for which an undivided interest in a pool of mortgages serves as the underlying asset (collateral) for the security. Because borrowers have the right to prepay their mortgage at any time, MBS have an implied call feature. Thus, while MBS have a known maturity, investors can only estimate the timing of the receipt of principal payments. Because of this implied call feature, the estimated maturity is inversely related to interest rates—as interest rates fall (rise), the estimated term of the principal payments shortens (lengthens).

There is another feature that is in the indenture (terms of agreement) of some bonds that is related to the call feature in how it can impact the risks and rewards of bond ownership. This feature is known as a sinking fund.

A Sinking Fund

A sinking fund is a provision in the indenture of a bond that requires the issuer to retire, using a prearranged schedule, a certain amount of the debt each year. Sinking funds are most common for longer-term municipal bond issues. The issuer will either purchase the bonds in the open market if the price is below par (100), or call the bonds at the prearranged price (typically par). The determination as to which specific bonds are to be called is usually done by a lottery.

There are some advantages to a sinking fund provision. First, it improves the credit quality of the issue over time as less debt is outstanding. A second reason for the lower yield is that the sinking fund provision shortens the average maturity of the bond (while not always the case, shorter maturities typically have lower yields—the yield curve is positively sloped).

There are also negatives of a sinking fund feature. First, if interest rates have fallen since issuance and your bond is chosen to be redeemed by the lottery drawing, then you lose the now above market yield, having to replace it with a lower yielding instrument. Second, some bonds with sinking funds have what is called an optional acceleration feature, allowing them to retire more of the debt than scheduled. Of course the issuer will only exercise the option if it is to their advantage to do so, meaning that it is not in the investor's interest. This acceleration feature can even supersede the call protection period.

Puts

A put gives the investor the right, but not the obligation, to redeem the security on a specific date that is prior to maturity. A put is an attractive feature for investors as it offers protection against rising interest rates. A put is thus a form of insurance, for which investors are willing to pay a premium. That premium comes in the form of a lower interest rate.

Zero-Coupon Bond

A zero-coupon bond is a bond that receives no interest payments. It is sold at a discount to par and then accretes (gradually increases) in value over time the imputed (or phantom) interest. Unlike coupon bonds, zero-coupon bonds have no reinvestment risk (to be discussed shortly) because no interest is actually paid out (the "interest" does not have to be reinvested—the reinvestment in effect occurs automatically).

We will now move on to terms that are specifically related to the yield of a bond.

Terms Related to Yield

Yield can be thought of as the price of risk. The risk can be in the form of interest rate risk, credit risk, or liquidity risk. There are many terms related to yield and it is imperative for investors to thoroughly understand each of them. We begin with the term coupon yield. The coupon yield is the stated fixed (or floating) percentage of the face amount (principal) paid as interest each year until maturity. This is specifically in contrast to the current yield—the percentage income you receive in relation to the current price (not the face value). Current yield also differs from yield-to-maturity (YTM).

The yield-to-maturity is a return calculation that takes into account not only the interest payments, but also the change in price of the bond from the time of purchase until maturity. A more precise definition for yield-to-maturity would be the discount rate, when applied to all cash flows, that results in the present value of the bond equal to the price paid. Yield-to-maturity is a far superior, though not perfect, measure of return than current yield or coupon yield. The primary benefit of using yield-to-maturity is that it allows investors to compare securities with different coupons and prices in a more apples-to-apples manner.

It is crucial to understand that for bonds with call features, yield-to-maturity is not the only measure that should be used. Investors need to also consider measures known as "yield-to-call" and "yield-to-worst." The yield-to-call is a return calculation that treats the call date as the maturity date. An example will illustrate the point. A bond is issued in 2000 with a 6 percent coupon with a maturity of 2020. However, the indenture allows the bond to be called in 2010 at par. By 2005 interest rates have fallen substantially so that the issuer could replace their old obligation with new debt with the same maturity at a rate of just 4 percent. If rates remain unchanged the issuer will then call the bond in 2010. Thus the expected maturity is no longer 2020 (remaining term of fifteen years), but is instead 2010 (remaining term of just five years.) Because the coupon of 6 percent is above the current market rate, the bond will trade above par. Let's assume that the bond is trading at 112. The yield-to-maturity must be less than 6 percent because the investor is paying 112 and will only receive 100 at maturity. The twelve-point premium must be amortized over the remaining life (fifteen years) to determine the yield-to-maturity. Once the premium is considered, the yield-to-maturity falls to about 4.7 percent. However, the call date is just five years away. If the bond were to be called in 2010 the ten-point premium the investor paid will have to be amortized over just five years, instead of fifteen. The result is that the yield-to-call will be much lower—about 3.5 percent. The market will treat the bond as if it has just five years left to maturity.

If a bond involves one or more call dates, then a calculation must be made for what is called yield-to-worst. Yield-to-worst is a return calculation that considers the yield-to-call for every possible call date. The call date with the lowest yield-to-call is the one with the yield-to-worst. Yield-to-worst is especially important when purchasing a bond with a sinking fund as you cannot be sure of the maturity.

The next term we need to discuss is generally used in reference to tax-exempt bonds. Since income from most municipal bonds is exempt from federal taxes (and generally from state and local taxes when buying bonds from one's home state) a mechanism is needed to provide a comparison of yields on a pretax basis. (Interest on bonds issued by the U.S. territories of Puerto Rico, the Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands is also exempt from federal, state, and local income taxes.)

The tax equivalent yield (TEY) tells an investor the rate of return that would have to be earned on a taxable bond in order for the taxable bond to provide the same after-tax rate of return. The formula is relatively simple and provides a good approximation (due to differences in how states treat municipal bond interest) of the TEY. The tax equivalent yield is equal to the yield on the municipal bond divided by 100 percent minus the applicable tax bracket.

TEY=Y / (100%-effective federal and state tax rate)

Keep in mind that interest on U.S. government obligations is exempt from state and local taxes, but interest on other taxable bonds (i.e., corporate bonds) is not. Thus if the investor's residence is one in which there is a state income tax, the investor would require different yields from a Treasury bond and a corporate bond of the same maturity—the corporate yield would have to be higher. This example explains why part of the higher yield investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment. The other reasons for the higher required return are credit risk and liquidity risk.

There is another yield term that is specifically related to the yield on fixed-income mutual funds. The SEC yield is a standard yield calculation that is required to be used by mutual funds. Its purpose is to allow investors to make accurate comparisons between mutual funds. It considers the return over the prior thirty days, changes in the price of bonds as they move toward par over the period, and the fund's expenses. Note that one limitation of the SEC yield is that it is not useful when considering funds that buy securities denominated in foreign currencies and simultaneously hedge the currency risk. The reason is that the SEC doesn't consider the hedge, only the interest, in the calculation. In addition, it can be a very misleading measure of the return the investor will earn over time, as it measures only the yield over the past thirty days. Mutual funds know that investors, because they do not fully understand the risks of fixed-income investing, are often attracted solely by a measure such as the SEC yield (thinking the higher the better). A fund can drive up the SEC yield by purchasing very high coupon bonds. However, if those bonds are likely to be called, the SEC yield will prove very misleading. The fund could also drive up the yield by purchasing riskier credits.

We now move on to what is called the yield curve—a curve that graphically depicts the yields of bonds of the same credit quality but different maturities. The yield is depicted on the vertical axis and the maturity on the horizontal. The yield curve depicts what is called the term structure of interest rates. The most commonly referenced yield curve is the one reflecting the term structure of U.S. Treasury instruments. Yield curves can be constructed for other instruments such as municipal bonds and corporate bonds. Curves can also be constructed for more narrowly defined sectors of the market. For example, there is a different curve for AAA-rated and BBB-rated corporate bonds.

Normally the yield curve is upward (positively) sloping—the longer the maturity, the higher the interest rate demanded by investors. This reflects the demand for a risk premium—the longer the maturity of a bond, the greater it is subject to price risk, and, therefore, the higher the return required to bear that risk. However, there have been periods of both flat yield curves (rates are similar across the curve, from short to long) and inverted (negatively sloping) curves (when short-term rates are higher than long-term rates). An inverted curve generally occurs when the Federal Reserve Bank engages in a severe tightening of the money supply in order to fight inflation. This drives short-term interest rates up sharply. However, investors expect that the sharp rise in short-term rates will lead to a slowing down of both inflation and the economy. Thus they anticipate that interest rates will eventually fall. The result is that long-term rates are lower than short-term rates.

There is one more critical point we need to cover in relation to the yield curve. The riskier the investment, the steeper the yield curve is likely to be because credit risk is positively correlated with maturity (the longer the maturity, the greater the credit risk). For example the spread (the difference in yields) between one- and thirty-year U.S. Treasuries will be less than the spread between one- and thirty-year AAA-rated corporate bonds, which will in turn be less than the spread between one- and thirty-year BBB-rated bonds.

Now that you have an understanding of the basic terms related to fixed-income investing we can move on to the risks of investing in debt securities.

Copyright © 2006 by Larry E. Swedroe and Joseph H. Hempen

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Table of Contents

1 Bondspeak 7
2 The risks of fixed-income investing 22
3 The buying and selling of individual bonds 40
4 How the fixed-income markets really work 57
5 The securities of the U.S. treasury, government agencies, and government-sponsored enterprises 85
6 The world of short-term fixed-income securities 103
7 The world of corporate fixed-income securities 121
8 The world of international fixed-income securities 142
9 The world of mortgage-backed securities 154
10 The world of municipal bonds 165
11 How to design and construct your fixed-income portfolio 187
12 Summary 212
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First Chapter

Chapter One

Bondspeak

Good fortune is what happens when opportunity meets with planning. ---Thomas Edison

While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to find better advice on living longer than do not smoke, drink alcohol in moderation, eat a balanced diet, get at least a half an hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life. As Charles Ellis points out in Winning the Loser's Game: "Investment advice doesn't have to be complicated to be good." And this is certainly true, as you will learn, about the world of fixed-income investing.

The world of fixed-income investing was once a very simple one. It was also very conservative. When investors thought of fixed-income investing they thought of Treasury bonds, FDIC-insured savings accounts and certificates of deposits, and perhaps the bonds of blue chip corporations such as General Electric. Today, the world is a much more complex one. The research and marketing departments of investment firms regularly create new and highly complex debt instruments. Investors are now deluged with marketing campaigns from bond salesmen urging them to buy instruments such as MBSs (mortgage-backed securities), IOs (interest-only bonds), POs (principal-only bonds), and inverse floaters (this one is too complex to even describe in a short space).

The complexity of these debt instruments creates huge profit opportunities for WallStreet's sales forces. These complex securities are often sold to investors who generally don't understand the nature of the risks involved. And you can be sure that it is the rare salesman who fully explains the nature of the risks (most couldn't if they had to, as they are trained to sell, not to explain the risks of what they are selling). Thus investors end up taking risks that are not appropriate for their situation. They also incur large transaction costs that are often hidden in the form of markups and markdowns---a subject we will discuss in detail.

Unfortunately, there are investment firms that prey on retail investors who lack the knowledge to understand the risks involved and how these securities are valued by the market. One reason is that, the prices for many fixed-income instruments, unlike those of stocks, cannot be found in the local newspaper, or even on the Internet. The lack of visibility in pricing allows for investor exploitation. Brian Reynolds, former institutional fixed-income portfolio manager at David J. Bradson & Company, commenting on this exploitation stated: "When I went to buy bonds for myself, I was stunned at the difference between buying them as an institutional investor and as a retail investor."1 Friend, and fellow investment author, William Bernstein put it this way: "The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks."2

As was stated in the introduction, the first objective of this book is to provide you with the knowledge you need in order to make prudent investment decisions regarding fixed-income investments. It is unlikely that Wall Street will ever provide you with this knowledge. In fact, the Wall Street Establishment does its best to follow W. C. Fields advice to "never smarten up a chump." Prudent investors never invest in any security unless they fully understand the nature of all of the risks. If you have ever bought (or been sold) a mortgage-backed security (e.g., a Ginnie Mae) the odds are pretty high that you bought a security the risks of which you did not fully understand. And those risks include paying too high a price.

As you will learn, it is not necessary to purchase complex instruments in order to have a good investment experience. Fortunately, the solutions to complex problems are often quite simple. In fact, the great likelihood is that you will do far better by simply hanging up the phone whenever someone tries to sell you one of these complex securities. The greatest likelihood is that they are products meant to be sold and not bought. A good question to consider asking the salesman is: "If these bonds are such good investments, why are you selling them to me instead of to your big institutional clients?" The answer should be obvious---either the institutions won't buy them, or the firm can make far greater profits from an exploitable public.

A Language of Its Own

Imagine you are an executive for a multinational corporation. You have been offered the position of general manager at your company's Paris office. Unfortunately, you don't speak French. Certainly one of the first things you would do would be to take an immersion course in the French language and culture. Doing so would enable you to more quickly gain an appreciation of your new environment, as well as prevent you from making some embarrassing, and potentially costly, mistakes.

Unfortunately, far too many investors take a trip to the land of bonds without knowing the language. Without such basic knowledge it is impossible to make informed decisions. In order to meet our objective of providing you with the knowledge needed to make prudent investment decisions we need to begin by exploring the language known as "bondspeak."

The world of fixed-income investing has its own language. This brief section defines the terms you need to understand in order to make prudent investment decisions. You will learn the difference between the primary (initial issue) and secondary (after initial offering) markets, and the wholesale (interdealer) and retail (individual investor) markets. You will also learn how bonds are bought from and sold to individual investors and the games broker-dealers play at your expense. After completing this relatively brief section you will have the knowledge required to understand the critical terminology of the world of bondspeak. We begin with some basic definitions.

A bond is a negotiable instrument (distinguishing it from a loan) evidencing a legal agreement to compensate the lender through periodic interest payments and the repayment of principal in full on a stipulated date. Bonds can either be secured or unsecured. An unsecured bond is one that is backed solely by a good-faith promise of the issuer. A secured bond is backed by a form of collateral. The collateral can be in the form of assets or revenue tied to a specific asset (e.g., tolls from a bridge or turnpike).

The document that spells out all of the terms of the agreement between the issuer and the holders is called the indenture. It identifies the issuer and their obligations, conditions of default, and actions that holders may take in the event of a default. It also identifies such features as calls and sinking fund requirements. All of the important terms contained in the indenture are spelled out in the prospectus---the written statement that discloses the terms of a security's offering.

The maturity of a bond is the date upon which the repayment of principal is due. This differs specifically from "term to maturity" (or simply term) that reflects the number of years left until the maturity date. While most bond offerings have a single maturity this is not the case for what is called a serial bond issue. Serial bonds are a series of individual bonds, with different maturities, from the same issuer. Investors do not have to purchase the entire series---they can purchase any of the individual securities. Typically, municipal bonds are serial bonds.

Although there are no specific rules regarding definitions, the general convention is to consider instruments that have a maturity of one year or less to be short-term. Instruments with a maturity of more than one and not more than ten years are considered to be intermediate-term bonds. And those whose maturity is greater than ten years are considered long-term bonds.

Treasuries are obligations that carry the full faith and credit of the U.S. government. The convention is that Treasury instruments with a maturity of up to six months are called Treasury bills. (The Treasury eliminated the one-year bill in 2001.) Treasury bills are issued at a discount to par (explanation to follow). The interest is paid in the form of the price rising toward par until maturity. Treasury instruments with a maturity of at least two years, but not greater than ten, are called notes. If the maturity is beyond ten years they are called bonds. Treasuries differ specifically from debt instruments of the government-sponsored enterprises (GSEs). The GSEs are the Federal Home Loan Banks (FLHBs), the Federal Farm Credit Banks, the Tennessee Valley Authority (TVA), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and a few others. While each was created by Congress to reduce borrowing costs for a specific sector of the economy, their obligations do not carry the full faith and credit of the U.S. government. In fact, Fannie Mae and Freddie Mac are publicly held corporations. In contrast, the securities of the Government National Mortgage Association (GNMA), because it is a government agency, do carry the full faith and credit of the U.S. government.

Par, Premium, and Discount

These terms refer to the price at which a bond is trading relative to its initial offering. Most bonds have a face value (the amount paid to the investor at maturity) of $1,000. They are also traded in blocks of a minimum of $1,000. Par, or 100 percent, is considered $1,000. A bond trading at 95 is trading below face value, and would be valued at $950 for each $1,000 of face value. A bond trading at 105 is trading above par and would be valued at $105,000 for each $100,000 of face value. A bond trading above par, or above 100, is called a premium bond. A bond will trade at a premium when the coupon (stated) yield is above the current market rate for a similar bond of the same remaining term to maturity. Consider a corporate bond with a ten-year maturity at issuance that has a coupon of 6 percent. Five years later the yield on a newly issued security from the same issuer, with the same credit rating, and a maturity of five years is being traded at a yield of 4 percent. Since the bond with the 6 percent coupon has the same credit risk and the same term risk it must trade at a higher price since it provides a higher coupon rate. The reverse would be true if in five years the current yield on a newly issued security with a maturity of five years is 8 percent. Since the new issue is yielding 8 percent and selling at 100, the instrument with a coupon rate of just 6 percent must trade below par. A bond trading below par, or 100, is called a discount bond.

From the above examples we can see that changes in the current price of a bond are inversely related to the change in interest rates---in general, rising (falling) interest rates result in lower (higher) bond prices.

There is an important point to discuss about premium and discount bonds. Many investors avoid premium bonds because they don't want to buy a bond that they perceive has a guaranteed loss built into the price---you pay above par yet receive only par at maturity. This is a major error. In fact, premium bonds offer advantages over discount bonds. First, the higher annual interest payments received offsets the amortization of the premium paid. Second, because many investors (both retail and institutional) avoid premium bonds, they often provide a higher return than a comparable bond selling at par. Third, higher coupon bonds are less susceptible to the negative effect of rising interest rates on the price of a bond (we will discuss the reason behind this when we cover the subjects of interest rate risk and duration). Thus premium bonds sometimes offer both higher returns and less risk. Finally, for taxable bonds (not municipals), the IRS allows a one-time election to amortize (write down over time) the premium paid over the remaining life. The ability to deduct the amortized premium improves the after-tax return on the bond.

Investors, on the other hand, often prefer discount bonds, because they perceive an automatic profit---the difference between the discount price they paid and par that they will receive at maturity. However, the ultimate gain is offset by the below current market coupon received. In addition, there is a potential negative to purchasing discount bonds in a taxable account---the discount may be treated as a gain for tax purposes and thus taxable at maturity. This will be the case unless when amortized over the remaining life the discount is less than 0.25 percent per annum. Finally, another negative of discount bonds is that bonds with lower coupons are subject to greater interest rate risk---they are more susceptible to the negative effect of rising interest rates on the price of a bond.

Calls and Puts

Calls

The term call is important to understand as its presence greatly impacts the risks and potential rewards of owning a bond. The failure to understand the risks of owning a bond with a call feature creates the potential for large losses and investors being abused by amoral (though not illegal) practices of broker-dealers (a subject we will cover shortly). Most municipal and agency bonds, as well as some corporate bonds, have a feature that gives the issuer the right, but not the obligation, to prepay the principal (prior to maturity) on a specific date or dates. This feature, known as a call, creates significant risk to investors, for which they do receive a higher coupon (yield) as compensation. The higher yield creates the potential for greater returns but also, depending on the price paid for the bond, the potential for losses. The risk results from the fact that the issuer will only call the bond if interest rates have fallen significantly since the time of issuance (rates need to have fallen sufficiently to overcome the cost of a new issue to replace the original one). For example, investors who originally bought a bond yielding 5 percent will have their bond called at a time when the current yield might be just 3 percent. Thus investors will not have earned 5 percent for the full term of the original bond. When the issuer calls the bond, the principal will be returned. The investor must reinvest the proceeds at the now lower market rate of 3 percent. Another negative feature of a callable bond is that it limits the potential for a bond to appreciate in price if interest rates fall.

A related term is the period of call protection. This is a period during which the issuer cannot call the bond.

There is a specific type of bond that has an implied call feature. Mortgage-backed securities (MBS), sometimes called mortgage pass-through certificates, are debt instruments for which an undivided interest in a pool of mortgages serves as the underlying asset (collateral) for the security. Because borrowers have the right to prepay their mortgage at any time, MBS have an implied call feature. Thus while MBS have a known maturity, investors can only estimate the timing of the receipt of principal payments. Because of this implied call feature, the estimated maturity is inversely related to interest rates---as interest rates fall (rise), the estimated term of the principal payments shortens (lengthens).

There is another feature that is in the indenture (terms of agreement) of some bonds that is related to the call feature in how it can impact the risks and rewards of bond ownership. This feature is known as a sinking fund.

A Sinking Fund

A sinking fund is a provision in the indenture of a bond that requires the issuer to retire, using a prearranged schedule, a certain amount of the debt each year. Sinking funds are most common for longer-term municipal bond issues. The issuer will either purchase the bonds in the open market if the price is below par (100), or call the bonds at the prearranged price (typically par). The determination as to which specific bonds are to be called is usually done by a lottery.

There are some advantages to a sinking fund provision. First, it improves the credit quality of the issue over time as less debt is outstanding. A second reason for the lower yield is that the sinking fund provision shortens the average maturity of the bond (while not always the case, shorter maturities typically have lower yields---the yield curve is positively sloped).

There are also negatives of a sinking fund feature. First, if interest rates have fallen since issuance and your bond is chosen to be redeemed by the lottery drawing, then you lose the now above market yield, having to replace it with a lower yielding instrument. Second, some bonds with sinking funds have what is called an optional acceleration feature, allowing them to retire more of the debt than scheduled. Of course the issuer will only exercise the option if it is to their advantage to do so, meaning that it is not in the investor's interest. This acceleration feature can even supersede the call protection period.

Puts

A put gives the investor the right, but not obligation to redeem the security on a specific date that is prior to maturity. A put is an attractive feature for investors as it offers protection against rising interest rates. A put is thus a form of insurance, for which investors are willing to pay a premium. That premium comes in the form of a lower interest rate.

Zero-Coupon Bond

A zero-coupon bond is a bond that receives no interest payments. It is sold at a discount to par and then accretes (gradually increases) in value over time the imputed (or phantom) interest. Unlike coupon bonds, zero-coupon bonds have no reinvestment risk (to be discussed shortly) because no interest is actually paid out (the "interest" does not have to be reinvested---the reinvestment in effect occurs automatically).

We will now move on to terms that are specifically related to the yield of a bond.

Terms Related to Yield

Yield can be thought of as the price of risk. The risk can be in the form of interest rate risk, credit risk, or liquidity risk. There are many terms related to yield and it is imperative for investors to thoroughly understand each of them. We begin with the term coupon yield. The coupon yield is the stated fixed (or floating) percentage of the face amount (principal) paid as interest each year until maturity. This is specifically in contrast to the current yield---the percentage income you receive in relation to the current price (not the face value). Current yield also differs from yield-to-maturity (YTM).

The yield-to-maturity is a return calculation that takes into account not only the interest payments, but also the change in price of the bond from the time of purchase until maturity. A more precise definition for yield-to-maturity would be the discount rate, when applied to all cash flows, that results in the present value of the bond equal to the price paid. Yield-to-maturity is a far superior, though not perfect, measure of return than current yield or coupon yield. The primary benefit of using yield-to-maturity is that it allows investors to compare securities with different coupons and prices in a more apples-to-apples manner.

It is crucial to understand that for bonds with call features yield-to-maturity is not the only measure that should be used. Investors need to also consider measures known as "yield-to-call" and "yield-to-worst." The yield-to-call is a return calculation that treats the call date as the maturity date. An example will illustrate the point. A bond is issued in 2000 with a 6 percent coupon with a maturity of 2020. However, the indenture allows the bond to be called in 2010 at par. By 2005 interest rates have fallen substantially so that the issuer could replace their old obligation with new debt with the same maturity at a rate of just 4 percent. If rates remain unchanged the issuer will then call the bond in 2010. Thus the expected maturity is no longer 2020 (remaining term of fifteen years), but is instead 2010 (remaining term of just five years.) Because the coupon of 6 percent is above the current market rate the bond will trade above par. Let's assume that the bond is trading at 112. The yield-to-maturity must be less than 6 percent because the investor is paying 112 and will only receive 100 at maturity. The twelve-point premium must be amortized over the remaining life (fifteen years) to determine the yield-to-maturity. Once the premium is considered the yield-to-maturity falls to about 4.7 percent. However, the call date is just five years away. If the bond were to be called in 2010 the ten-point premium the investor paid will have to be amortized over just five years, instead of fifteen. The result is that the yield-to-call will be much lower---about 3.5 percent. The market will treat the bond as if it has just five years left to maturity.

If a bond involves one or more call dates, then a calculation must be made for what is called yield-to-worst. Yield-to-worst is a return calculation that considers the yield-to-call for every possible call date. The call date with the lowest yield-to-call is the one with the yield-to-worst. Yield-to-worst is especially important when purchasing a bond with a sinking fund as you cannot be sure of the maturity.

The next term we need to discuss is generally used in reference to tax-exempt bonds. Since income from most municipal bonds is exempt from federal taxes (and generally from state and local taxes when buying bonds from one's home state) a mechanism is needed to provide a comparison of yields on a pretax basis. (Interest on bonds issued by the U.S. territories of Puerto Rico, Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands is also exempt from federal, state, and local income taxes.)

The tax equivalent yield (TEY) tells an investor the rate of return that would have to be earned on a taxable bond in order for the taxable bond to provide the same after-tax rate of return. The formula is relatively simple and provides a good approximation (due to differences in how states treat municipal bond interest) of the TEY. The tax equivalent yield is equal to the yield on the municipal bond divided by 100 percent minus the applicable tax bracket.

TEY=Y / (100%-effective federal and state tax rate)

Keep in mind that interest on U.S. government obligations are exempt from state and local taxes, but interest on other taxable bonds (i.e., corporate bonds) is not. Thus if the investor's residence is one in which there is a state income tax, the investor would require different yields from a Treasury bond and a corporate bond of the same maturity---the corporate yield would have to be higher. This example explains why part of the higher yield investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment. The other reasons for the higher required return are credit risk and liquidity risk.

There is another yield term that is specifically related to the yield on fixed-income mutual funds. The SEC yield is a standard yield calculation that is required to be used by mutual funds. Its purpose is to allow investors to make accurate comparisons between mutual funds. It considers the return over the prior thirty days, changes in the price of bonds as they move toward par over the period, and the fund's expenses. Note that one limitation of the SEC yield is that it is not useful when considering funds that buy securities denominated in foreign currencies and simultaneously hedge the currency risk. The reason is that the SEC doesn't consider the hedge, only the interest, in the calculation. In addition, it can be a very misleading measure of the return the investor will earn over time as it measures only the yield over the past thirty days. Mutual funds know that investors, because they do not fully understand the risks of fixed-income investing, are often attracted solely by a measure such as the SEC yield (thinking the higher the better). A fund can drive up the SEC yield by purchasing very high coupon bonds. However, if those bonds are likely to be called, the SEC yield will prove very misleading. The fund could also drive up the yield by purchasing riskier credits.

We now move on to what is called the yield curve---a curve that graphically depicts the yields of bonds of the same credit quality but different maturities. The yield is depicted on the vertical axis and the maturity on the horizontal. The yield curve depicts what is called the term structure of interest rates. The most commonly referenced yield curve is the one reflecting the term structure of U.S. Treasury instruments. Yield curves can be constructed for other instruments such as municipal bonds and corporate bonds. Curves can also be constructed for more narrowly defined sectors of the market. For example, there is a different curve for AAA-rated and BBB-rated corporate bonds.

Normally the yield curve is upward (positively) sloping---the longer the maturity, the higher the interest rate demanded by investors. This reflects the demand for a risk premium---the longer the maturity of a bond, the greater it is subject to price risk, and, therefore, the higher the return required to bear that risk. However, there have been periods of both flat yield curves (rates are similar across the curve, from short to long) and inverted (negatively sloping) curves (when short-term rates are higher than long-term rates). An inverted curve generally occurs when the Federal Reserve Bank engages in a severe tightening of the money supply in order to fight inflation. This drives short-term interest rates up sharply. However, investors expect that the sharp rise in short-term rates will lead to a slowing down of both inflation and the economy. Thus they anticipate that interest rates will eventually fall. The result is that long-term rates are lower than short-term rates.

There is one more critical point we need to cover in relation to the yield curve. The riskier the investment, the steeper the yield curve is likely to be because credit risk is positively correlated with maturity (the longer the maturity, the greater the credit risk). For example the spread (the difference in yields) between one- and thirty-year U.S. Treasuries will be less than the spread between one- and thirty-year AAA-rated corporate bonds, which will in turn be less than the spread between one- and thirty-year BBB-rated bonds.

Now that you have an understanding of the basic terms related to fixed-income investing we can move on to the risks of investing in debt securities.

Copyright © 2006 by Larry E. Swedroe
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  • Anonymous

    Posted December 17, 2008

    A superb guide

    Swedroe's book provides a very thorough education on bond investing for the individual investor. The only additional information/guidance I'd ask Larry to provide would be to give his views on what spread over Treasuries is appropriate compensation for investing in non-Treasury securities. For example, he suggests that to extend out the yield curve, an investor should obtain additional compensation of 15 to 20 b.p. per year. That's very good and practical advice. But, how much of a spread over Treasuries, for example, justifies investment in corporate bonds? In MBS, etc.?

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  • Anonymous

    Posted May 7, 2011

    No text was provided for this review.

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