What You Need to Know Before Investing in Bonds

By Markets Fool.com


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When it comes to your retirement investments, don't you want to make sure you are getting a good deal? After all, we're talking about money that you want to last as long as you do.

With your stock investments, it's relatively simple. You can pinpoint the exact price at which you bought or sold an investment, the price that others paid and exactly how much you paid your broker. But with bond investments, you need to do a little more homework. That's because bonds themselves are a little trickier than stocks and because the markets they trade on have some key differences.

First, let's take a look at the markets. The stock market is largely automated. You can log into your online brokerage account or call your broker and instantly get a quote on any given stock. And usually you can trade that stock very quickly at a price at, close to, or even at an even better price than the quote.

The bond market, on the other hand, is more manual. You might be able to check and see the latest quote for many bonds online, but those quotes are generally "indicative" or non-firm, which means that perhaps you can trade at that price, but it's also possible that you won't. That's because an indicative quote can change, for example based on additional information, like the size of the trade. There is no guarantee that you will get that price.

Instead, to find out what price you could actually trade any given bond at, you'd likely need to call up your broker, and have them call around to dealers to see who is quoting what on a trade of the size you are looking to execute in the bond you want to buy. In some cases you may not be able to buy that bond at all and your broker may recommend other similar bonds.

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The bond market is slowly becoming more automated, which will gradually increase the likelihood of being able to trade at a price quoted on the screen in front of you, but in the meantime, it's important to remember these differences.

Beyond that, bonds are simply more complicated than stocks. While any given company will only have one kind of stock (or perhaps two, for companies with preferred shares), a particular company or other bond issuer can have any number of different bonds outstanding with different terms and different coupons at any point in time. Take Johnson & Johnson, for example. The issuer -- one of only three U.S. companies with the highest corporate bond rating -- currently has more than two dozen bonds outstanding.

Those market dynamics and the sheer variability in bonds make it imperative that you do your homework before investing. Bonds can play an important role in your portfolio -- but they can also cost you if you don't know what you are getting into. And there is a lot more information freely available to you than you might even realize.

First and foremost, you need to understand the bond you are buying. All the key information you need is in a bond's prospectus, which you can get from your broker, or for free from FINRA's Market Data Center.

The problem, of course, is that no one knows what they don't know, so here are some variables to consider and important questions to ask when investing in bonds:

  • Credit quality: Every bond is rated based on its credit quality by a ratings agency. Credit quality matters because it indicates how much risk you are taking on in exchange for the interest rate you will be paid. It can also give you an indication of the likelihood that a bond issuer will be able to pay you back at all when the bond matures. In the vast majority of cases historically the interest and principal have been paid to bond holders and a default is relatively rare except on the very lowest credit quality or high yield bonds, but it's important to have a good handle on that risk

    Similarly, you'll also want to know what is backing any given bond. If a bond is secured by an asset, it is more likely that you will get your money back in the event the issuer faces financial trouble that reduces its ability to pay back all its bondholders.

    You'll need to ask: What is the credit quality of the issuer? What is the credit quality of the specific bond in question? Is the bond secured by any particular assets?
  • Maturity: Maturity date is the latest date that the issuer is committed to paying you back the value of the bond. The longer the time to maturity the greater the risk there is in the bond, because something unexpected could affect whether the issuer is able to pay you all of the committed interest and return to you the full value of the bond.

    You'll need to ask: What is the maturity date?
  • Call date: It's important to understand the difference between the maturity date and the call date and how it impacts returns. While the maturity date is the latest date an issuer is committed to pay you back, the call date is a date that is set by the issuer from the outset that gives the issuer the right to buy back the bond from you at a set price. An early call can have a major impact on your portfolio, so don't ignore this very important characteristic.

    You'll need to ask: Is the bond callable by the issuer before the maturity date? If the bond is callable, what is its call date? Are there possible tax implications? What is the call price? How does that compare to its current price? What does that mean for your investment goals?
  • Liquidity: When it comes to liquidity, the bond market is very different than the stock market. Many stocks are heavily traded, which means there is almost always a ready buyer and a known price for which a stock can be sold. That may not be the case with all bonds. In fact, many bonds rarely trade, if ever. If you need to sell your bonds on short notice and there are no or few buyers, your broker may still be willing to buy the bond back from you, but it likely will be done at a much lower price.

    You'll need to ask: How liquid is the bond? In other words, will your broker dealer be able and willing to buy the bonds back at a fair price and in a timely fashion should you need to sell? Does your broker have concerns about the future liquidity of that bond?
  • Price: Because bond quotes are generally indicative, the best way to know is to look at the price that other investors got in the same or very similar bonds. Personally, I would never go into the market today without looking up a bond's price using FINRA's Market Data Center, which pulls information from TRACE, FINRA's reporting facility for fixed income securities, and EMMA, the MSRB's Municipal Bond reporting facility. I encourage all bond investors to make sure they can say the same. If my price is significantly different from similar sized transactions done very recently, I ask my broker why the price is different and if they can get me the better price. If all individual investors did that, it would make trading bonds better for everyone.

    One thing to remember is that interest rate and prices generally move in opposite directions, meaning that when interest rates go up, the price of a bond will generally decline. You should also remember that if you hold your bond to maturity you will still get the principal value of the bond back no matter what the prevailing interest rates are.

    You'll need to ask: At what price did the bond I'm interested in recently trade for a similar-sized transaction? How does that compare to the price my broker is quoting?
  • Yield: You should understand the interest rate yield on any bond you buy. Yields are usually quoted as yield-to-call, yield-to-maturity or yield-to-worst. It's good to know all of these yields and factor them into your decision process. Yield-to-call is the interest rate you will get if your bond is called, yield-to-maturity is the interest rate you will get if you are able to hold your bond to its maturity date, and yield-to-worst is the lowest of those two interest rates.

    Yield is generally a good measure of risk. The higher the yield on a bond relative to other bonds with similar characteristics the more risk you are generally taking on. That's because investors expect greater compensation when there is a greater risk that a company might default.

    Also, keep in mind that the coupon interest rate on a bond is different from the yield. The coupon interest rate tells you the percentage of the face value of the bond that you will be paid periodically. Most bonds sell at a face value, which is also known as par value, of $1,000. That means a 2% coupon says you will get $20 per year for each bond, regardless of the price you paid. Note that price of bonds is quoted as a percentage of the par value, for example a price of 101 for a bond with a par value of $1,000 equates to a dollar price of $1,010.

    You'll need to ask: What are the bond's yield-to-call, yield-to-maturity and yield-to-worst? Am I comfortable with the lowest possible yield situation? How does the yield compare to that of similar bonds of similar maturity and credit quality?

So clearly there are different factors to consider when buying bonds versus buying stocks, and there is a lot to understand and think about. After gathering all of the relevant information and asking lots of questions, it's important to then ask yourself:

  • Am I comfortable with the level of risk exposure?
  • Am I comfortable with the call date? Am I comfortable with the fact that I may be forced to sell at that set price?
  • Am I comfortable with the price and yield I would be buying the bond at?

After you've asked those questions and gathered all that information, you should be better positioned to go into a bond transaction armed with the right knowledge. Sometimes, when you look at that information, you might realize you don't want to invest in a particular bond at all. That's OK. Sometimes your best trades will be the ones you never made.

An Alert Investor is a smarter investor.

The article What You Need to Know Before Investing in Bonds originally appeared on Fool.com.

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