The Bond Book, Third Edition: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More (PROFESSIONAL FINANCE & INVESTM) - Hardcover

THAU

Hardcover

ISBN 10: 007166470X ISBN 13: 9780071664707

Publisher: McGraw Hill, 2010

Synopsis

Everything on Treasuries, munis,bond funds, and more!

The bond buyer’s answer book―updated for the new economy

“As in the first two editions, this third edition of The Bond Book continues to be the idealreference for the individual investor. It has all the necessary details, well explained andillustrated without excessive mathematics. In addition to providing this essential content, itis extremely well written.”
―James B. Cloonan, Chairman, American Association of Individual Investors

“Annette Thau makes the bond market interesting, approachable, and clear. As much asinvestors will continue to depend on fixed-income securities during their retirement years,they’ll need an insightful guide that ensures they’re appropriately educated and served.The Bond Book does just that.”
―Jeff Tjornejoh, Research Director, U.S. and Canada, Lipper, Thomson Reuters

“Not only a practical and easy-to-understand guide for the novice, but also a comprehensivereference for professionals. Annette Thau provides the steps to climb to the top of the bondinvestment ladder. The Bond Book should be a permanent fixture in any investment library!”
―Thomas J. Herzfeld, President, Thomas Herzfeld Advisors, Inc.

“If the financial crisis of recent years has taught us anything, it’s buyer beware. Fact is, bondscan be just as risky as stocks. That’s why Annette Thau’s new edition of The Bond Book isessential reading for investors who want to know exactly what’s in their portfolios. It alsoserves as an excellent guide for those of us who are getting older and need to diversify intofixed income.”
―Jean Gruss, Southwest Florida Editor, Gulf Coast Business Review, andformer Managing Editor, Kiplinger’s Retirement Report

About the Book

The financial crisis of 2008 causedmajor disruptions to every sector ofthe bond market and left even the savviestinvestors confused about the safety oftheir investments. To serve these investors andanyone looking to explore opportunities infixed-income investing, former bond analystAnnette Thau builds on the features and authoritythat made the first two editions bestsellersin the thoroughly revised, updated, andexpanded third edition of The Bond Book.

This is a one-stop resource for both seasonedbond investors looking for the latest informationon the fixed-income market and equitiesinvestors planning to diversify their holdings.Writing in plain English, Thau presentscutting-edge strategies for making the bestbond-investing decisions, while explaininghow to assess risks and opportunities. She alsoincludes up-to-date listings of online resourceswith bond prices and other information.Look to this all-in-one guide for information onsuch critical topics as:

• Buying individual bonds or bond funds
• The ins and outs of open-end funds,closed-end funds, and exchangetradedfunds (ETFs)
• The new landscape for municipal bonds:the changed rating scales, the neardemise of bond insurance, andBuild America Bonds (BABs)
• The safest bond funds
• Junk bonds (and emerging market bonds)
• Buying Treasuries without payinga commission

From how bonds work to how to buy and sellthem to what to expect from them, The BondBook, third edition, is a must-read for individualinvestors and financial advisers who wantto enhance the fixed-income allocation of theirportfolios.

About this title

About the Author

Annette Thau, Ph.D., (Teaneck, NJ) is a former municipal bond analyst with the Chase Manhattan Bank and a visiting scholar at Columbia University’s Graduate School of Business.

Excerpt. © Reprinted by permission. All rights reserved.

THE BOND BOOK

Everything Investors Need to Know about Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and MoreBy Annette Thau

The McGraw-Hill Companies, Inc.

Copyright © 2011 Annette Thau
All right reserved.
ISBN: 978-0-07-166470-7

Contents

Chapter One

The Life of a Bond

This chapter

* Defines a bond

* Explains how bonds are issued and traded

* Defines some key terms used in buying and selling bonds

FIRST, WHAT IS A BOND?

Basically, a bond is a loan or an IOU. When you buy a bond, you lend your money to a large borrower such as a corporation or a governmental body. These borrowers routinely raise needed capital by selling (or, using Wall Street vocabulary, by "issuing") bonds for periods as brief as a few days to as long as 30 or 40 years. The distinguishing characteristic of a bond is that the borrower (the issuer) enters into a legal agreement to compensate the lender (you, the bondholder) through periodic interest payments in the form of coupons; and to repay the original sum (the principal) in full on a stipulated date, which is known as the bond's "maturity date."

HOW BONDS ARE ISSUED AND TRADED

The process of issuing bonds is complex. Because the sums involved are so large, issuers do not sell bonds directly to the public. Instead, bonds are brought to market by an investment bank (the underwriter). The investment bank acts as an intermediary between the issuer and the investing public. Lawyers are hired by both parties (that is, the issuer and the underwriter) to draw up the formal terms of the sale and to see to it that the sale conforms to the regulations of the Securities and Exchange Commission (the SEC).

To illustrate the process, let us say that the State of New Jersey needs to borrow $500 million in order to finance a major project. New Jersey announces its intention through trade journals and asks for bids. Underwriters (major broker-dealer firms such as Merrill Lynch, Goldman Sachs, Morgan Stanley, etc.) or smaller, less well-known firms (there are dozens of them) compete with each other by submitting bids to New Jersey. A firm may bid for the business by itself in its own name. More often, firms form a group called a syndicate, which submits a joint bid. The State awards the sale to the firm or syndicate which submits the bid which results in the lowest interest cost to the state. The underwriters then get busy selling the bonds.

The underwriter (or the syndicate) handles all aspects of the bond sale, in effect buying the bonds from the issuer (New Jersey) and selling them to the investing public. The investing public is made up of large institutions such as banks, pension funds, and insurance companies as well as individual investors and bond funds. The large institutional investors are by far the biggest players in the bond market.

Once the bonds have been sold, the underwriter retains no connection to the bonds. Payment of interest and redemption (repayment) of principal are—and will remain—the responsibility of the issuer (New Jersey). After the sale, the actual physical payment of interest, record-keeping chores, and so forth are handled for the issuer by still another party, a fiduciary agent, which is generally a bank that acts as the trustee for the bonds.

KEY TERMS FOR BONDS

The exact terms of the loan agreement between the issuer (the State of New Jersey) and anyone who buys the bonds (you or an institution) are described fully in a legal document known as the indenture, which is legally binding on the issuer for the entire period that the bond remains outstanding.

First, the indenture stipulates the dates when coupons are paid, as well as the date for repayment of the principal in full; that is, the bond's maturity date.

The indenture then discusses a great many other matters of importance to the bondholder. It describes how the issuer intends to cover debt payments; that is, where the money to pay debt service will come from. In our example concerning the State of New Jersey, the indenture would specify that the State intends to raise the monies through taxes; and in order to further document its ability to service the loan, there would be a discussion of the State's economy. The indenture also describes a set of conditions that would enable either the issuer or the bondholder to redeem bonds at full value before their stipulated maturity date. These topics are discussed in greater detail in the sections dealing with "call" features and credit quality.

All of the major terms of the indenture, including the payment dates for coupons, the bond's maturity date, call provisions, sources of revenue backing the bonds, and so on, are summarized in a document called a prospectus. It is a good idea to read the prospectus. Until recently, a prospectus was available only for new issues. Bond dealers were allowed to destroy a prospectus six months after a bond was issued. The prospectus of all new municipal bonds, as well as many older issues, is now archived and available online (see Chapter 5).

When the prospectus is printed before the sale, it is known as a "preliminary prospectus," or a "red herring"—that term derives from the printing of certain legal terms on the cover of the prospectus in red ink. After the sale, it is sometimes called an official statement, or OS.

The most elementary distinction between bonds is based on who issued the bonds. Bonds issued directly by the U.S. government are classified as Treasury bonds; those issued by corporations are known as corporate bonds; and those issued by local and state governmental units, which are generally exempt from federal taxes, are called municipals or "munis" for short. The actual process of selling the bonds differs somewhat from sale to sale but generally conforms to the same process.

Many bonds are issued in very large amounts, typically between $100 million and $500 million for corporates and munis; and many billions for Treasuries. To sell the bonds to the public, the investment bank divides them into smaller batches. By custom, the smallest bond unit is one bond, which can be redeemed at maturity for $1,000. The terms par and principal value both refer to the $1,000 value of the bond at maturity. In practice, however, bonds are traded in larger batches, usually in minimum amounts of $5,000 (par value).

Anyone interested in the New Jersey bonds may buy them during the few days when the underwriter initially sells the bonds to the investing public (this is known as buying "at issue") or subsequently from an investor who has decided to sell. Bonds purchased at the time of issue are said to have been purchased in the "primary market." Bonds may be held to maturity, or resold anytime between the original issue date and the maturity date. Typically, a bondholder who wishes to sell his bonds will use the services of a broker, who pockets a fee for this service.

There is a market in older issues, called the "secondary market." Some bonds (for example, 30-year Treasuries) enjoy a very active market. For many bonds, however, the market becomes moribund and inactive once the bonds have "gone away" (that is an expression used by traders) to investors. It is almost always possible to sell an older bond; but if the bond is not actively traded, then commission costs for selling may be very high. Pricing, buying, and selling bonds, as well as bond returns, are discussed in greater detail in Chapters 2 and 4.

During the time that they trade in the secondary market, bond prices go up and down continually. Bonds seldom, if ever, trade at par. In fact, bonds are likely to be priced at par only twice during their life: first, when they are brought to market (at issue), and second, when they are redeemed, at maturity. But, and this is an important but, regardless of the purchase price for the bonds, they are always redeemed at par.

But, you may well ask, if the issue price of a bond is almost always $1,000, and the maturity value is always $1,000, why and how do bond prices change? That is where the story gets interesting, so read on.

Chapter Two

The Bond Market: An Overview

This chapter discusses

* The bond market: an overview

* Bond pricing: markups and commissions

* How bonds are sold: dealers, brokers, and electronic platforms

* Terms used in buying, selling, and discussing bonds

THE BOND MARKET: AN OVERVIEW

While people speak of the bond market as if it were one market, in reality there is not one central place or exchange where bonds are bought and sold. In fact, unlike stocks, bonds do not trade on an exchange. Consequently, there is also no equivalent to a running tape, where prices are posted as soon as trades occur. Rather, the bond market is a gigantic over-the-counter market, consisting of networks of independent dealers, organized by type of security, with some overlaps.

The core of this market consists of several dozen extremely large bond dealers who sell only to institutional buyers such as banks, pension funds, or other large bond dealers. Among these dealers, there is a network of "primary dealers." These are the elite dealers: They buy Treasuries directly from the Federal Reserve in order to then sell them to the largest banks and to large broker-dealer firms. The broker-dealer firms, in turn, resell bonds to smaller institutional investors and to the investing public. Whereas stocks sell ultimately on one of three independent exchanges (the New York Stock Exchange, the American Stock Exchange, or the Nasdaq), many bonds continue to be sold dealer to dealer. Surprising as it may seem, many bond trades, even those involving sums in the millions, are still concluded by phone, person to person. (One exception to this is a small—and dwindling—number of corporate bonds, which are listed and sold on the New York Stock Exchange.)

This market is so vast that its size is difficult to imagine. Although the financial media report mainly on the stock market, the bond market is actually several times larger (estimates of its actual size vary). Overwhelmingly, this is an institutional market. It raises debt capital for the largest issuers of debt, such as the U.S. government, state and local governments, and the largest corporations. The buyers of that debt are primarily large institutional investors such as pension funds, insurance companies, banks, corporations, and, increasingly, mutual funds. These buyers and sellers routinely trade sums that appear almost unreal to an individual investor. U.S. government bonds trade in blocks of $1 million, and $100 million trades are routine. The smallest blocks are traded in the municipal market, where a round lot is $100,000. Another way of characterizing this market is to call it a wholesale market.

Enter the individual investor. In the bond market, individual investors, even those with considerable wealth, are all little guys, who are trying to navigate a market dominated by far larger traders. Indeed, many of the fixed-income securities created over the last two decades were structured to suit the needs of pension funds and insurance companies. Their structure makes them unsuitable to meet the needs of individual investors.

In the bond market, the individual investor faces many disadvantages when compared to institutions. Commission costs are higher. In addition, institutions have developed a vast amount of information concerning bonds, as well as mathematical models and sophisticated trading strategies for buying and selling bonds, which are simply not available to individual investors.

BOND PRICING: MARKUPS AND COMMISSIONS

Buying bonds differs in many respects from buying stocks. One of the main differences concerns the cost of actually buying and selling bonds, in other words, markups and commissions.

"Bid," "Ask," and "Spread"

Markups and commission costs for buying or selling bonds are hidden much of the time. The price is quoted net.

In the bond market, among traders, bond prices are quoted in pairs: the "bid" and the "ask," also known as the "offer." The difference between the "bid" and the "ask" is known as the "spread." The spread is a markup: it is the difference between what a dealer pays to buy a bond, and the price at which he wants to sell it. (Let us note, in passing, that the term "spread" is used a lot in the bond market. We will encounter many other meanings of the same word.)

Technically, the bid is what you sell for; the ask, the price at which you buy. It is not difficult to remember which is the "bid" and which is the "ask." Just remember this: If you want to buy, you always pay the higher price. If you want to sell, you receive the lower. For example, a bond may be quoted at "98 bid/100 ask." If you are buying the bond, you will pay l00; if you are selling, you will receive 98.

When you are quoted a price for a bond, however, the spread is hidden. The price of the bond is quoted net. The markup is not broken out. That has been the case since time began and, perhaps surprisingly, much of the time, it continues to be the case.

Spreads vary widely. One of the chief factors in determining the spread is the demand for a particular bond, that is, how easy it is to sell. If you are selling an inactively traded bond (and that description applies to many bonds), then the broker makes sure that she buys it from you cheaply enough so that she will not lose money when she resells.

For an individual investor, the spread typically ranges from 1/4 of 1% (or even less) for actively traded Treasury issues to as much as 4% on inactively traded bonds. The spread varies for many reasons

* The price the dealer pays and his customary markup

* The type of bond being sold (Treasury, muni, mortgage-backed, or corporate)

* The number of bonds being traded (that is, the size of the lot)

* The bond's maturity

* Its credit quality

* The overall direction of interest rates

* Demand for a specific bond

* Demand for a particular bond sector

As a rule, bonds that are desirable or low risk, or higher quality, sell at narrower (that is, lower) spreads. Bonds that are perceived as being riskier, or lower quality, sell at wider spreads. Typically, the wider the spread, the higher the yield. But one important rule to remember is that, in the world of bonds, higher yield means higher risk.

The size of the spread reflects what is known as a bond's liquidity; that is, the ease and cost of trading a particular bond. A narrow spread indicates high demand and low risk. Conversely, a wide spread indicates an unwillingness on the part of a dealer to own a bond without a substantial price cushion. Any characteristic that makes a bond less desirable, such as lower credit quality, or longer maturity, increases the size of the spread.

Spreads and liquidity vary widely. They vary first of all, based on the sector of the bond market in which bonds trade. Treasuries are considered the most "liquid" of all bonds. Consequently, they sell at the narrowest spreads. For any maturity, Treasury yields are lower than those of any other bonds. Municipals and corporates are considered far less liquid. They sell at much wider spreads than Treasuries. Consequently, for any maturity, they have higher yields than Treasuries. Note that liquidity also varies within each sector, again based on credit quality and maturity length.

Let's illustrate with some concrete examples. Treasury bonds sell at the narrowest spreads (as low as between ¼% and ½% for Treasuries with short maturities) no matter how many bonds, or the direction of interest rates. High-quality intermediate munis (AA or AAA, maturing between three and seven years) sell at spreads of between 1% to perhaps 2%. Thirty-year munis sell at spreads of between 2% and 4%. The more strikes against a bond, the more difficult it is to sell. Trying to sell a long maturity, low credit quality bond in a weak market is a worst-case scenario because you may have to shop extensively just to get a bid. Similarly, an unusually wide spread (4% or more) constitutes a red flag. It warns you that at best, a particular bond may be expensive to resell and, at worst, headed for difficult times. The dealer community, which earns its living buying and selling bonds, has a very active information and rumor network that is sometimes quicker to spot potential trouble than the credit rating agencies.

Spreads and liquidity also vary over time. In strong markets, spreads tend to narrow; in weak markets, they widen. During the financial panic of 2008, spreads widened so far beyond the norm that many bonds could not be sold at any price. In fact, for a short period of time, only bonds with the highest credit quality found buyers, and those found bids only at fire sale prices.

Note, in passing, that when you buy a bond at issue, even though the spread is built into the deal, the spread is usually closer to what a dealer would pay for the bond, at that point in time, than when bonds trade in the secondary market. Hence, the individual investor may receive a fairer shake by buying at issue than by buying in the secondary market.

(Continues...)

Excerpted from THE BOND BOOKby Annette Thau Copyright © 2011 by Annette Thau. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: McGraw Hill
• Publication date: 2010
• Language: English
• ISBN 10: 007166470X
• ISBN 13: 9780071664707
• Binding: Hardcover
• Edition number: 3
• Number of pages: 448