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 Bond Basics
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.
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.
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.
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?