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THE MYSTERY OF CORPORATE BONDS

How many of our fellow Blue Collar Investors understand the concept of corporate bonds?  Probably, not many. I didn’t for many years despite self-educating myself in stocks, options, and real estate. I am always angered when media experts start throwing around terms like indentures, par value, defeasance, yield curve among many others and don’t bother to explain what they mean. Who exactly are they speaking to? It’s as if we don’t exist. Most of us recognize the need to be well diversified in different asset classes. The “big 3” are stocks, bonds, and real estate. As I mentioned in my book and DVDs, I invest in I-Bonds. These are inflation-protected government bonds the interest of which is tax-deferred until redemption. Since we have 30 years to redeem, it functions as another IRA account. This account can be set up directly with the government to avoid paying commisssion to a middle man. For more information go to:

www.treasurydirect.gov

What about corporate bonds? What are they and how do they work? I’ve researched this subject and will include many of those $10 words (in italics) associated with this investment vehicle.

First a definition: Corporate Bonds are transferable long-term debt instruments that pays a fixed interest rate. Issuers must payback principal at maturity to bondholders who DO NOT have ownership rights in the issuing firm.

A corporation can raise capital by borrowing money from investors via bonds rather than selling more stock.
Here are the advantages to the corporation:

1- Company can deduct interest costs.
2- Does not relinquish ownership as it does with stock.
3- Can enhance its credit history.
4- Avoid higher bank rates.
5- Avoid bank’s variable rates.
6- Avoid bank’s shorter term loans.

Under the Trust Indenture Act of 1939, all bonds valued at more than 5 million must be issued by an indenture (legal agreement that spells out the terms) and appoint a trustee to protect bondholders.

A Bond Indenture includes:

1- Amount of issue.
2- Par value or face value, usually $1000. This is what you both pay and get back at
   maturity.
3- Coupon Rate which is the annual interest rate, usually paid semi-annually.
4- Maturity date which is the date that the issuer must repay the entire principal.

Some companies issue a Call Provision where they can buy back the bond prior to maturity. This protects the company from falling interest rates so they can refinance debt at a lower rate. Another way to remove bonds from its books is by Defeasance. Here the company buys newer, higher-yielding securities that cover both the interest and principal payments of the original debt. Some companies will issue bonds with a Put Provision giving investors the right to sell the bond back to the issuer, usually at par ($1000). This helps investors in times of rising interest rates when bond prices are falling. Bonds are returned and the cash is re-invested in higher yielding instruments.

Bond Yield: 3 definitions:

1- Nominal Yield– is the Coupon Rate which never changes. Let’s say we purchase a bond (par value is 1000) @ 7% coupon. We will be receiving $35 interest every 6 months. But what if interest rates increase to 9% the following year? An investor could receive $45 every    6 months. Why would he purchase your bond @ par when he can purchase a newer one @ par and make more money? The price of your bond must move down to bring the bond yield in line with the market. The reverse holds true that had you purchased a 9% coupon and
interest rates dropped, the price of your bond would increase. So the rule is:

               Interest Rates and Bond Prices have an Inverse Realationship.

     Inflation versus Economic Slowdown:

Inflation brings on higher interest rates and therefore lower bond prices as investors  move cash out of bonds. In an economic slowdown, inflation is lowered and more bonds are  purchased as bond prices tend to rise.

     Bond Price Quotes:

   Corporate bond prices are given as a % of par. So 95 means 95% of $1000 or $950.

     Types of Bonds Relative to Par:

   A- Premium Bonds- costs more than face value.
   B- Discount Bonds– Costs less than face value.

2- Current Yield– Rate of return based on current market price. It is more accurate than
   nominal return because it is based on actual cash invested rather than par.

3- Yield to maturity– This is the most accurate calculation of a bond’s return as it
   accounts for fixed interest payments, current market value, and any capital gains or
   losses at maturity ( a premium bond purchased @ $1100 will incur a $100 loss at maturity
   as you will receive par or $1000).

Other factors that affect bond prices:

1- Bond Quality– Ability of issuer to make interest and principal payments throughout the
   life of the bond. Companies with a strong credit history can issue bonds at a lower rate
   than those with a questionnable financial past. Independent agencies such as Standard and
   Poors, Moody’s, and Fitches
provide credit ratings that help us judge the quality of a
   bond. Most of the time, a bond will have the same rating as the company itself. The
   highest ratings are called Investment Grade and the lower ones are called Speculative or
   Junk Bonds.
The latter are higher yielding but much riskier. Note that a change in the
   company’s rating while holding a bond can effect the value of your bond as investors re-
   evaluate the creditworthiness of the issuing company.

2- Secured versus Unsecured BondsSecured Bonds pledge a tangible asset as collateral. This
   can be in the form of real estate, equipment, or negotiable securities. Unsecured Bonds
   are called Debentures and are issued on the stregth of a company’s name and credit
   history. Some companies make unsecured bonds more attractive by offering a conversion
   feature. These Convertible Bonds allow the bondholder to exchange the bond for common
   stock This positive feature allows the issuer to pay a lower coupon rate.

Trading Corporate Bonds:

Most are traded in the OTC Market (computers etc.). Bid and ask prices are quoted in the Yellow Sheets and trading activity is found in the financials of most newspapers. They are quoted on a % of par. For example, 96 = $960.

How are they Taxed?

Interest is taxed as ordinary income for the year it is received. You also must factor in capital gains or losses previously alluded to.

Main Risks:

1- Credit Risk– company can default on princiapl and interest payments.
2- Interest Rate risk– bond loses value if interest rates increase.
3- Marketability– may be difficult to sell in the future.

So there you have it. Corporate Bonds made simple (I hope). As you can see, there is much due diligence required when investing in corporate bonds. We all must factor in the amount of time we can spend on our investment homework and where to put it. I devote most of mine to stock options because of the impressive returns I generate. Since I do recognize the importance to be diversified into this asset class, I dollar cost average into I-Bonds which requires virtually no time commitment.

But knowledge is power and that is why I decided to research and share this information with you.

A word about the bailout:

As many of you know, I have been away the last 2 weeks presenting seminars for Norwegian cruise Lines. I have been keeping a close eye on the economic news of the day. What’s transpiring in our economy is unprecedented, certainly in our lifetime. I have temporarily stopped selling options (but retained most of my equities) until it becomes clearer when our economy will stabilize.

I wish you all strength during these trying times.

Alan

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

4 Responses to “THE MYSTERY OF CORPORATE BONDS”

  1. admin October 2, 2008 3:17 pm #

    Mark-to market accounting:

    We’ve heard a lot of talk about this mark-to-market accounting as it relates to the Emergency Economic Stablization Act of 2008 (rescue plan, bailout, whatever). This is an accounting methodology whereby a financial instrument is assigned a value based on the current market price. For example, if you bought 100 x XYZ @ $50 per share and now the stock trades @ $30 per share, the mark-to-market value would be $3000, not $5000. This is the value it could claim in the current market.

    In the Rescue Plan, the SEC has the ability to suspend Mark-to-Market Accounting if it (along with consulatation with The Federal Reserve Board and the Department of the Treasury) determines that it is the public inetrest and protects investors.

    Many financial institutions that own Mortgage Backed Securities (MBS) were forced to deeply mark-down the value of the MBS due to the inability to sell them. This resulted in margin calls from investors. You would receive a margin call from a broker if one or more of the securities you had bought (with borrowed money) decreased in value past a certain point. You would be forced either to deposit more money in the account or to sell off some of your assets.

    However, potential cash flows from many of these securities suggested a much higher value. Because the SEC feels that the market may not be “orderly” at this time, fair value standards should be more liberally applied to reflect expected cash value. This would then protect investors from margin calls at a time when additional cash is hard to come by.

    Alan

  2. Tony C. October 8, 2008 6:22 am #

    Alan, what exactly is a (MBS)? do they have a name on the market? and how did these mortgages go from a bank or a mortgage broker to the financial institutions to be sold in the first place?
    Tony

  3. Alan October 8, 2008 3:26 pm #

    Tony,

    An MBS is a type of asset-backed security that is covered by a collection of mortgages. They are also referred to as “pass-through certificates”.
    Individual mortgages are pooled, repackaged, and sold to the public as collateralized securities. They are issued by government agencies (Ginnie Mae, Fannie Mae, Freddie Mac) and represent an investor’s ownership in a mortgage pool and the cash flows arising from that pool. You are in essence lending money to a homebuyer and receiving principal and interest in return ususally in coupon form.

    They are issued to “select” broker-dealers known as “fiscal agents” and are normally sold to institutional investors. They do trade in the secondary market exclusively in the OTC market (computerized markets) and sold in $25,000 and up increments.

    The process is called “securitization” whereby an illiquid asset (mortgage) is converted to a liquid one like a bond (in this case a MBS).

    Tony, that’s pretty much the extent of what I know about these securites. If you were considering investing in this arena I would contact someone with more expertize in the field.
    Alan

  4. BOB BELTON October 31, 2008 9:03 pm #

    Hi Alan,
    I have been thinking outside the box and have a question. AMGN closed friday at 59.89. It meets our stock selection critera for ratings and earnings was Oct 22, and stock selector 10. I can STO NOV 57.50 for4.25 which would net 1.86. (4.25-2.39) which would earn about 3% for the next 18 days. But my thought on this. I can STO a put for 57.50 for 1.80 and net about the same 3% and not have to put up the $5989 to purchase the stock. I know that selling naked puts is dangerous. Is there a way to get out of the put if the stock reverses from its upward trend before it reaches the 57.50 price. At present it has a 2.39 cent cushion. I haven’t ever sold a naked put and I know they can go to zero but this is one of our premier stocks. If there is a reasonable exit is it feasable.

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