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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.
|Publisher:||St. Martin's Press|
|File size:||342 KB|
About 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.
Larry E. Swedroe graduated from New York University with an MBA in finance. The author of books including What Wall Street Doesn't Want You to Know, he lives in St. Louis, Missouri.
Joe H. Hempen is a bond expert at Buckingham Asset Management and co-author with Larry E. Swedroe of The Only Guide to a Winning Bond Strategy You'll Ever Need.
Read an Excerpt
The Only Guide to a Winning Bond Strategy You'll Ever Need
The Way Smart Money Preserves Wealth Today
By Larry E. Swedroe, Joseph H. Hempen
St. Martin's PressCopyright © 2006 Larry E. Swedroe and Joseph H. Hempen
All rights reserved.
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." Friend, and fellow investment author, William Bernstein put it this way: "The stock-broker services his clients in the same way that Bonnie and Clyde serviced banks."
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 & 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
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).
Excerpted from The Only Guide to a Winning Bond Strategy You'll Ever Need by Larry E. Swedroe, Joseph H. Hempen. Copyright © 2006 Larry E. Swedroe and Joseph H. Hempen. Excerpted by permission of St. Martin's Press.
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Table of Contents
Two: The Risks of Fixed-Income Investing,
Three: The Buying and Selling of Individual Bonds,
Four: How the Fixed-Income Markets Really Work,
Five: The Securities of the U.S. Treasury, Government Agencies, and Government-Sponsored Enterprises,
Six: The World of Short-Term Fixed-Income Securities,
Seven: The World of Corporate Fixed-Income Securities,
Eight: The World of International Fixed-Income Securities,
Nine: The World of Mortgage-Backed Securities,
Ten: The World of Municipal Bonds,
Eleven: How to Design and Construct Your Fixed-Income Portfolio,
Most Helpful Customer Reviews
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.?