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The Basics of Purchasing Individual Bonds

We talked previously about buying individual bonds not being something you should take lightly. However, for those that ultimately decide to proceed, this post will talk about purchasing individual bonds. If you recall the big difference is diversification.  Buying individual bonds you cannot depend on the Credit Agencies ratings, but instead need to dive into the finances of the issuer to determine your real risk of the issuer going bust. This post assumes you know how to do this. Any investment as always is something you do of your own accord and Full Time Finance is for entertainment purposes only.

Introduction to the Basics of Purchasng Individual Bonds

This post will introduce you to bond buying basics. Depending on interest to this post I am contemplating writing a more indepth follow-on regarding types of bonds. Many categories of individual bonds echo that of bond funds so I will not rehash the differences between tax exempt/taxable and debt ratings here. Instead I will focus this post on particularly important individual bond aspects.

Bond Premiums and Discounts

The first thing to be aware of is when you buy a bond you can do so at the principle, or face value.  You can also purchase it at a premium or discount to that value. So say I wanted to buy a thousand dollar bond. If it sold for 980 dollars then there would be a 20 dollar discount on the principle. If it sold for 1020 dollars there would be a 20 dollar premium. This is important to understand for a few reasons. The first thing is this discount or premium can add or subtract to the return of the bond.

If you bought a bond and spent 100 dollars more then the face value, then if held to maturity your total return over the life of the bond is 100 dollars less than the same bond bought at face value. That 100 dollars reduces your return by 100 dollars divided by the number of years until maturity.  Second, it increases the size of your investment by 100 dollars.  Finally, if you’re​ talking about a tax free bond, then despite the coupons being tax free you still pay taxes on the discount as capital gains.

Bond Coupon

In addition to the discount or premium the other impact to your return is the coupon rate. The coupon rate is the interest the bond pays out yearly on the principle/face value deposited. So looking at coupons, they pay out in some set period throughout the year, perhaps annually, by the half, or even quarterly. To compare like bonds, you want to roll this return into an annual percentage yield, which we talked about previously regarding mortgages, which gives you the annual return. So if you get 2% a half with no compounding you get 4% a year in APY.

Bond Return Held to Maturity

Now putting the two together if you have a bond with a 10 year maturity (Denoted by the Maturity Date on a Bond offering) worth 1000 dollars with the aforementioned coupon that trades at face value then holding to face value your return is 4% a year. However, if it had a bond trading at a premium of 100 dollars this would mean instead of paying 1000 dollars you paid 1100. That extra 100 dollars would reduce your return evenly (in theory) over the remaining life of the loan.

You thus would have a reduction of 10 dollars of the return from your 4% (40 dollars) to give you 30 dollars a year interest.  Adding to that, the divisor would now be 1100 since you invested 1100 dollars for that 30 dollar coupon.  As such your effective Yield to Maturity would be 2.7%.  The total return given your current purchasing situation including your premium or discount appears on a bond offering as the Yield to Maturity (YTM).

Bonds with a Call Option

Bonds also can have the concept of a call option. This is a set point of time before maturity where the bond may be closed out by the issuer at their discretion, probably so they can take a loan at a lower rate. This typically but not always is at the face value of the bond. Your loss is still the premium (or gain the discount). However, because the bond was held a shorter time period than its maturity the number of years you spread the discount or premium against your coupon declines. A call effectively can lower your bond return. Typically, if you’re​ looking at a bond term sheet this situation would be termed Yield to Worst (YTW). This and the bonds financial status probably comprise the two most important values to watch when attempting to purchase an individual bond.

Bond Insurance

Some larger Bond issuances are insured by a bond insurance company. This was especially common in the pre 2008 Mortgage Backed Securities Market. Sadly, the insurance companies in many cases went under with the bonds themselves meaning the insurance was not particularly helpful to the buyer. Unless you know the situation of the insurer, do not count on this to overcome a low financial quality Issuer.

Purchasing Individual Bonds and Liquidity

Something to keep in mind is in general it is better to purchase individual bonds to hold to maturity. Typically individual issuances transact on the market in low volumes and thus have low liquidity(with the exception typically being treasury bonds).  Depth of book is a term that helps you determine what the liquidity situation is for a bond. It can show you the quantities that are changing hands of the bond, and thus help you to understand how easy or hard it will be to unload the bond at a later date. By how hard it is important to realize this could take 2 forms:

  • Not being able to find a buyer at all.
  • A gap between the actual value of the bond and what it sells for (referred to as the spread) which would be the discount you would need to attract a buyer. This could be significant for a low volume issuance as such causing you significant return.

Both essentially mean you typically do not want to sell individual bonds before maturity.

Other Important Considerations for Purchasing Individual Bonds

Some other important things to remember when purchasing individual bonds

  • Bonds typically sell in units of 1000 dollars. When you buy 1, you’re buying 1 bond of 1000 dollars. Pay attention to how much you’re buying.
  • Sinking Fund and Sinking Fund Protection are similar to callable bonds in a way. Basically the issuer will set aside some funds at some specific date before maturity to buy some of the bonds issues. The protection would keep you from being the holder of one of the portions that are rebated.
  • Every so often a bond has a special feature where coupon rates follow a step function, raising on certain dates. This just makes it more difficult to calculate your return. This is called a bond with a step up provision.

Hopefully this post gives you an idea of the things to keep an eye out for when looking at while purchasing an individual bond.   Do you purchase individual bonds?

13 Comments

  1. I often hear that everyone should have a certain percentage of their portfolio in bonds. I don’t discount that advice, but I have two factors that I think it’s better suited to my situation. I am still young, so I can be a bit more aggressive and put all my money in stocks. Secondly, I believe that If I want to own bonds, I’ll just buy my own bonds (paying off my mortgage). I can choose when to buy and don’t have to worry about another company’s insolvency.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 5, 2017

      I treat my mortgage as a bond as well, so I get the rationale. What is your mortgage rate?

      • Leo T. Ly
        Leo T. Ly May 6, 2017

        When I first got my mortgage 10 years ago, it was 5%+. After refinancing a few times, my average rate is les than 3% now.

  2. Kevin Drevik
    Kevin Drevik May 5, 2017

    Good intro article. Individual bonds always seem to be an issue with “do it yourself” investors. Even those of us willing to trade stocks seem to hold back when we talk about bonds.

    I’ve been interested in buying my own, but I still haven’t found any good reading material which helps me evaluate companies and determine if their bond issue is good. A lot of info on stock analysis, not too much on bonds.

    I also won’t touch municipal bonds now with a 10ft pole. Too many cities and states are in horrible financial shape, and its going to get worse.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 5, 2017

      Thanks KD, it’s definitely a challenge to find analysis information for bonds. I liked munis when people were truly concerned about the state of the market. Finding a state with a good financial situation potentially provided a mispricing option due to liquidity. However those concerns are now less prominent, and such the rates are less appealing.

  3. I don’t have any individual bonds. I’m invested in a bond index fund and that’s good enough for now.

    If I had 100s of thousands of dollars to throw around, maybe I’d do it, specifically in munis to get a tax advantage, but for now, I’m focused on building my nest egg.

  4. Mustard Seed Money
    Mustard Seed Money May 6, 2017

    Previously I used my mortgage as my bond. Now that it’s paid off I continue to buy passive index funds. The rising interest rates scares me when thinking about bonds at this point and I feel more comfortable with equities.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 6, 2017

      We still primarily use our mortgage as our bond.

      That being said, at least in the near term I suspect the fear of interest rates impact on bonds is probably overblown. Just like with stocks, the fear is already priced into bonds.

  5. Is there really any reason for a “regular” investor to buy individual bonds? I would recommend people just invest in mutual funds that have a bond component if they want exposure to bonds. I don’t think it really makes sense for an individual investor to go out and buy them piecemeal.

    • fulltimefinance@fulltimefinance.com
      [email protected] May 6, 2017

      I largely agree with some specific exceptions. I do personally hold one or two original issue muni bonds for my home state. The reason in my case is that my state is so small there just is not a lot of diversity to be had in General Obligation muni bonds. They are however small portions of my portfolio, maybe 2 percent of my bond portfolio with the rest either in my mortgage or index funds.

  6. Troy @ Market History
    Troy @ Market History May 6, 2017

    Never have and never will. If I do purchase bonds, it will probably be TIPS (Treasury Inflation Protected). That way I can prevent inflation from eating away at my portfolio if I ever do plan on retiring.

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