Finding bonds to invest in

If you’re arriving from Get Rich Slowly, welcome, and enjoy the site. You can see a quick summary of what this site’s about here. Or go ahead and subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

Now to building a bond portfolio:

Hopefully, you’ve read my summary of how bonds work at Get Rich Slowly and maybe even seen the basics of deciding whether or not to buy individual bonds here. If not, you might want to check those out, because this post assumes at least a rudimentary understanding of how bonds work and that you’ve decided you want to consider individual bonds (the linked stories will let you explore both those issues).

This story will tackle two issues:
1) How to find bonds to invest in, and

2) Understanding the risks in the bond

Tomorrow I’ll write about:
3) Constructing a bond portfolio/bond ladder, and

4) Finally, the process of actually buying a bond

How to find bonds to invest in

Unfortunately, it’s not nearly as easy as looking up a few ticker symbols on Yahoo! Finance and signing into your broker to buy them. Fortunately, it is a lot easier than it used to be, for what that’s worth.

The bond universe is tracked by the Securities Industry and Financial Markets Association at their website. While you can search for corporate bonds or municipal bonds by the name of the issuer at SIFMA’s site, it might actually be easier to start with a bond screener like the one on FINRA’s website, which is powered by MarketWatch.

This is what the initial bond screen page will look like.

This is what the initial bond screen page will look like.

We’re looking for corporate bonds right now. So under “Select Bond Type”, pick “Corporate”.

The rest of the selections will depend on your personal requirements for the bond. Here’s a quick rundown of each category, skipping ones that I’d leave blank:

Search by maturity: Select a range of dates by which you want to get your principal back. If you need the money for a tuition payment by April 1, 2014, for example, you might pick a range between today and that date. Don’t pick a maturity date past when you need the money. Selling a bond is difficult and costly for small investors. If interest rates go up after you purchase the bond, the bond’s value will also be much lower in a resale.

Coupon type: For the purposes of this exercise, select “Fixed.” This means the yearly payments that you receive will be set in stone. “Variable” rates will move depending on the terms of the bond. For example, they might be pegged to a popularly tracked interest rate like that of Treasury bonds. “Zero”-coupon bonds don’t make regular interest payments. Instead, you make money on the value of the actual bond going up and from the accumulated interest all at once, when it matures. You receive no payments in the interim.

Moody’s Rating (Or Fitch Rating or S&P Rating): Select “A3” or higher as the “Lowest” . This is the credit quality of the bond, as measured by the three big bond rating’s agencies. It’s basically their guess as to how likely it is that the company won’t be able to make all of its payments. The higher the letter grade, the more safe the bond (at least, according to the agency). Each of the agencies have a different ratings system, but the form on the website presents the letters in top-down order.

Industry Group: Leave it as “All” but understand that when you build your portfolio, you’ll want bonds from across industries, in the same way that you would diversify a stock portfolio.

Callable and Putable: Select “Exclude Callable” and “Exclude Putable”. Callable bonds can be “called back”, or paid off, by the company issuing the bond before the stated maturity date. A company might do this if interest rates go way down and the company wants to refinance its debt. Putable bonds, on the other hand, let you choose to sell the bonds back to the issuer. There are situations where you might still buy a callable or putable bond, but let’s keep things simple.

Convertible: Exclude for simplicity’s sake. Convertible bonds give you (or sometimes, the issuer) the option to convert the bond into the company’s stock at a predetermined price. It can add value if the conversion rate is better than the current stock price.

Run the screen, and you should get a list of several hundred bonds.

This is what the bond screen results page should look like.

This is what the bond screen results page should look like.

How do you choose among these? Well, for one, your inventory might be limited based on what your broker has available.

If you have a live-person broker, call him up and give your criteria. He’ll be able to quickly call up what bonds he has available that meet it. You can then compare the yields in his list to the ones you found in your own screen. If his inventory seems very limited, try another broker.

If you have an online broker, the online site’s inventory will most likely be a network of many different brokers (if it even has a bond component! Some don’t.). Keep in mind that with online brokers, you’re basically paying TWO commissions — the per bond commission (maybe $1) that the online broker charges and the commission to the broker in its network. Bond broker commissions are different than stock broker commissions. I’ll tackle those tomorrow or you can see the difference described in my Money article.

Understanding the bond’s risk

You screened out many risky bonds by selecting A3 or higher for the Moody’s rating (honestly, you might want to go even higher than that). But unfortunately, the credit agencies are often slow to update their ratings to reflect recent company announcements or new risks that have become apparent. Sometimes, it’s easy to see when they’ve been slow. In my screen (where I used the above criteria and April 1, 2014 as the latest maturity date), the highest yielding bond in the list pays 608%! Now which do you think is more likely, that the ratings agency is wrong or that the market just happened to leave such a sweet deal lying around?

A good rule of thumb is that the corporate bonds you buy should not yield more than a few percentage points above that of comparable Treasury bonds. You can see what treasury bonds are yielding here. If you did my screen, you’ll notice that that excludes the first 20 pages or so of bonds. The names of the issuers on those pages (almost all financial or auto companies) shouldn’t be surprising. And if you want to exclude them from the outset, you can do so on the original screen page.

I’d personally recommend picking a company that you recognize and whose business you can understand. Then, you can research that company in the same way you’d research its stock. You need to pick companies that are likely to survive until the maturity date. So when looking at a company’s balance sheet, you want low amounts of debt and high free cash flow. It’s hard to be more specific than that without getting into something complicated, but look here for a summary of how to read a balance sheet.

If you’re very uncomfortable with reading balance sheets and evaluating companies, you might want to leave it up to an investment professional or even just stick with a bond mutual fund or something guaranteed, like CDs or Treasury bonds. Otherwise, if you’re still interested, check out my post tomorrow on building the bond portfolio and actually buying bonds.

Thanks for reading,

Joe Light

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3 comments so far

  1. Looking forward to reading the rest of this series. Keep up the excellent content.

  2. Bozo on

    I’m not a big fan of using target retirement funds for proper bond allocations. As we all know, Jack Bogle (the founder of Vanguard) recommends an asset allocation of “age in bonds”. Ironically enough, Vanguard doesn’t follow his maxim. Take the 2010 Target Retirement Fund, for example. It should be for folks on the cusp of Social Security’s “full retirement” this year. Let’s pick age 65 in 2009. According to Bogle, that person should have 65% in bonds. What does TR 2010 have? Try 47% in bonds, 53% in stocks. How about Vanguard’s Target Retirement Income Fund (for folks 66+)? It has 30% in stocks. And it doesn’t get any more conservative as you age.

    So much for “age in bonds” and re-balancing.

    I’m also not too keen on the “one size fits all” composition of the bond holdings in TR funds, but that’s a subject I broached in my comment over at GRS. Even in my bond allocation, I’ve gravitated toward CDs more as I got older. I found a simple formula to be: age in bonds X age = CD%. Example: A fifty year old has 50% in “bonds” (loosely defined) X 50(%) = 25% of total AA in CDs (i.e., 50% stocks, 25% bonds other than CDs, 25% CDs/cash).

    One thing some folks don’t consider is that CDs are just nominal bonds. I like them because I can ladder them easily and find that “hot money” specials are really easy to find these days (even in this rate environment).

    Except as part of my balanced fund over at Vanguard (VBIAX), all my bond allocation in my IRAs is in my CD ladder. Why I shy away from TIPS and I Bonds is a subject for another day.

    Bozo

  3. […] Yesterday, I wrote a basic intro to bonds for J.D.’s site, and a follow-up, slightly more complicated post on how to screen for and choose bonds. […]


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