Archive for the ‘Get Rich Slowly’ Tag

Diversifying your bond portfolio

First, I’d like to welcome any Get Rich Slowly readers still trickling in. Thanks again for visiting the site. There’s a quick summary of what the site’s about here. 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.

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Onward.

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. bond-by-paul-jursa

Today, I’m going to address two areas:

1) How to build a bond portfolio or a bond ladder, and

2) How to actually buy a bond

How to build a bond portfolio

You probably already invest in mutual funds or might even have a portfolio of individual stocks. If so, you’re probably familiar with the concept of diversification. In short, you want to spread your investments among many types of securities to make sure that if any one of them gets hurt, your portfolio doesn’t unduly suffer.

Bond portfolios are no different. Here are the considerations you should have as you pick bonds.

1) Pick only high-grade bonds.

Yesterday, I defined this as a bond with a rating of A3 or higher by Moody’s. You might want to pick an even higher grade. Why? In the current environment, the ratings agencies have been downgrading bonds like crazy. Even Warren Buffett’s Berkshire Hathaway recently lost the highest investment grade rating. If you don’t have much to invest in bonds (Say, $200,000 or less), I would stay with bonds that have a AA rating or higher and whose companies are known as conservative, stable earners.

2) Diversify the maturity dates of your bonds.

Let’s say you’re saving for a son or daughter’s tuition payment that comes in 10 years. The highest yielding bonds that you see are probably ones that mature right around the time you need the money. But that doesn’t mean you should put all of your money in those bonds, even if they’re with highly rated companies.

A bond portfolio’s greatest risk actually isn’t that companies default. It’s that interest rates could rise before the bond matures. Imagine that you bought a 10-year bond yesterday at face value ($1,000) that yields 5%. Today, the Federal Reserve surprises the world by letting its target interest rates rise by 3 percentage points. Now, investors can find corporate bonds similar to the one you just bought that yield 8% instead of 5%. You can’t just sell your bond for $1,000 and reinvest the money. Any investor who buys the lower yielding bond will want to purchase it at below face value to compensate for the lower interest rate.

You’re holding your bonds to maturity. Small investors get ripped off when they try to sell bonds on the secondary market. So the only way that the change in interest rates really hurts you is that your $1,000 is tied up in a bond with a lower yield than what you could get now.

So, instead of buying $100,000 worth of 10-year bonds, the college saver might buy $10,000-worth of bonds that mature in 10 years, $10,000 that mature in 9 years, and each year until next year. That way, even if interest rates go up, you’ll always have bonds maturing whose principal you can reinvest in the higher yielding bonds.

Some folks argue that no one should invest in 10-year bonds right now, because interest rates are most certain to go up. I’d answer that the market should already be pricing those fears into the yields of 10-year bonds (that’s why they’re higher than one-year bonds). If you think you know better than the market, good for you. But for those building a simple bond ladder, since you’re holding bonds until maturity, you’re not going to get hurt if they’re right.

3) Diversify among industries in addition to companies.

You probably already gathered that you wouldn’t want to put all your money into bonds put out by one company. You should also consider spreading your bonds out among as many industries as possible. Your portfolio should not only have industrial manufacturers, but utilities, retailers, foodmakers, and so on.

Buying a bond

I’m just going to say this at the outset: Buying a bond is not as easy as it should be. Whereas stock and mutual fund platforms have gotten easier and easier over the last decade or so, bond buying still has silly impediments that the big brokers either can’t or don’t want to sort out. Until a few years ago small investors couldn’t even find out how much some bonds traded for! It’s gotten better, but not by much.

1) Use a broker who gets most of his business from bond trading. The reason for this is simple: The bonds you can buy will often be limited to what bonds the broker has in his inventory. If he doesn’t trade bonds often, he won’t control many bonds himself and won’t know good sources to find the bonds you’re looking for. As an alternate, you can use an online bond platform, like the one at E*Trade, which will aggregate the inventories of many different bond brokers. But when using a platform like that, you effectively pay two commissions. More on that later.

2)Start with “newly issued” bonds. Investors get better deals on bonds if they buy them right when the company is first asking to be lent money. As a small investor, if you can get in on a new issue, you’ll get a much better price on the bonds than if you bought them on the secondary market. Depending on how much money you have to invest, you might not be able to get in on many offerings, but it doesn’t hurt to ask.

3) Try to buy at least 10 bonds of the same company at once. The bigger the purchase of bonds you can make of a company, the better the price you’ll get. Some financial advisors say that an even better increment is $25,000 worth of bonds (about 25 bonds). If you try to purchase smaller amounts, you will get very poor prices.

4) Bond prices are negotiable. Don’t take your broker’s first offer. I can’t emphasize this enough, and this is the primary mistake I hear small investors make. Unlike a stock broker, bond broker’s don’t make a flat commission. In fact, they don’t specify their commission at all! Instead, they make money on the “spread” between what they can buy the bond for and what they sell it to you for. So a broker might buy a bond at a price that yields 6% but sell it to you at a price that yields 4%. His commission is difference in price that causes that 2% spread.

Brokers don’t disclose that difference. So it’s important that you come to the phone call armed with information. You can find the prices that bonds recently traded for here. Click on “Corporate Market At-a-glance” and search for the company whose bonds you’re considering or for the CUSIP (the bond’s id number) if you have that. Once you get to the bond you’re looking for, you should see a list of recent trades of that bond. screen-shot-of-ge-bonds

The “price” on the screen is given in cents on the dollar. So a bond sold at “100.000”, went for $1,000. Under “size” you’ll see how many bonds were bought at once. So in the first line of the preceding image. An investor (or a bond broker, it’s difficult to tell) bought 10 bonds of GE at $1,000 each.

When you negotiate with your broker, try to get a yield as close to what you see at SIFMA’s website as possible. If he wants more than 1.5 percentage points as his commission, look for the bond elsewhere or try for a different bond. Honestly, a 1.5 percentage point hit on an investment-grade bond is already pretty high.

A note on online bond platforms: An online bond platform aggregates many bond brokers onto one site. That’s good because you have access to more inventory. But in exchange, you’ll probably pay a higher commission. The online broker will take the first cut, usually somewhere in the range of $1 per bond. The live-person broker will still earn a commission on the spread. I know E*Trade allows customers to make an offer on a bond and negotiate its price down. But some online brokers don’t let you do that.

5) Monitor your portfolio and reinvest bond payments. One of the biggest mistakes financial advisors tell me they see is that someone sets up their bond portfolio but doesn’t reinvest bond payments or even the bond’s principal as it matures. Unlike with a mutual fund, you can’t instruct your broker to simply reinvest your bond payments. Brokerage accounts generally pay extremely low interest rates. So even though your bond yields 5%, if its bond payments simply sit in the account, your portfolio’s yield will be less.

If you’ve set up a bond ladder by having bonds mature regularly (such as once a year), revisit your portfolio at least that often to find bonds to reinvest in and to keep that income stream coming. Someone who is investing in bonds for income and who wants to keep an average maturity of 5 years, would want to buy a 10-year bond every time one of his bonds comes due. That way, he’ll always have a bond coming due in the next year.

Phew, I hope this post, the two others made yesterday, and the story in Money have given you at least a basic understanding of how bonds work and how to build a portfolio. As you can imagine, there’s more to learn and entire books have been written on the subject. I will recommend two, whose authors I’ve spoken to extensively:

Bonds: The Unbeaten Path to Secure Investment Growth by Hildy and Stan Richelson, and

The Bond Bible by Marilyn Cohen (this one is a little older)

Thanks for reading and hope you come back tomorrow — when I won’t be talking about bonds.

– Joe Light

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

How this blog can help you

Welcome Get Rich Slowly readers! Thanks for stopping over. Let me give you a quick rundown on what this blog is about and how it can help you — whether you’re just interested in learning more about investing or you’re saving for a specific goal, like retirement or a kid’s college education.

My name is Joe Light, and I’m a writer with Money Magazine. This blog is a side project of mine, but much of the material comes from the frequent interviews and research I collect from some of the best investing minds in the business.

Each post (which will come at least once every business day) is designed to help you think smarter about your investments, understand how fees impact your portfolio, and just generally set up a plan so that you can achieve your investing goals, no matter what they might be.

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.

A little later today, I’m going to expand a little bit on some of the basics of bond investing I gave in the post for J.D., and tomorrow I’ll actually go through the process of constructing a bond portfolio for those of you who think you’d like to try.

If you’d like to be clued in on those posts and future updates, subscribe to my feed by clicking here or the button in the upper right corner.

Anyway, I sincerely appreciate you stopping by and hope you come back. Feel free to drop me a line in the comments section. I’m always looking for ideas on what to write about!

Thanks,

Joe Light