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Reply #114: OK. a few things about bonds first, then a little about Bond Mutual Funds. This is a little long! [View All]

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A HERETIC I AM Donating Member (1000+ posts) Send PM | Profile | Ignore Fri Oct-21-11 01:06 AM
Response to Reply #34
114. OK. a few things about bonds first, then a little about Bond Mutual Funds. This is a little long!
Edited on Fri Oct-21-11 01:54 AM by A HERETIC I AM
The primary reason to invest in bonds is for the income they produce. For the most part (and when I say "for the most part" I mean basically "overwhelmingly". I am going to use that phrase several times because it means what I am saying is almost always the case, but there are exceptions, OK?) bonds issued in the USA, be they government, corporate or Municipal pay a so called "Coupon" payment that is paid bi-annually, on the date the bond will mature and 6 months later. In other words, if a bond matures on July 1st, 2025 it will pay its coupon payments every year on July 1 and February 1st. Regardless of what the coupon rate is, this payment is split into these two payments. In other words, if the coupon is 5%, you are going to get half on Feb 1st and the other half July 1st.

For the most part bonds issued in the US have a "Par" or face value of $1,000.00. Regardless of what they are purchased at, when they mature, the issuer will give the holder $1000.00 back, provided of course, that there is no default.

The coupon rate is ALWAYS figured from this par value, so if a bond has a coupon of 5% it means it pays $50.00 per year in interest split into two payments of $25.00 each paid 6 months apart.

This regular, reliable income is why bonds are often referred to as "Fixed Income investments". The amount of money you will receive on an annual basis is fixed. It doesn't change.

What CAN change with bonds is yield. What that refers to is the difference between the cost of the bonds and it's coupon payment on an annual basis.

Example;

ABC Company issues a 5% coupon bond that matures in ten years. Since ABC Co. is a well known and respectable company that pays its bills on time, its bonds are rated "Triple A". Once the bond issue is underwritten and they begin to trade, they hold their value and sell for exactly their Par value. If you bought one of these bonds, your coupon is 5% and your yield is 5%.

If these bonds FALL in price and you are able to buy them for less than Par, your yield will be higher because not only are you going to get your $50 per year in interest, you will get the grand back when they mature. If you were able to buy them for ...say $900, you will make $100 in gain when they mature, PLUS your annual interest, therefore the bond yields more than its coupon.

If the contrary is the case and the bonds are bid UP - to say $1100 and you buy them, your yield will be LESS than the coupon rate for exactly the same reasons stated above.

Clear?

The primary advantage to owning bonds is the interest payments.
The primary advantage to owning Municipal Bonds is the tax free interest.

So how do Bond Mutual funds work?

All Mutual Funds are basically a portfolio (or basket, if you like) of various stocks and/or bonds, selected by the fund manager to achieve a specific purpose. In the case of bond funds, these might be things like high income, high credit rating, overseas issues, etc., and this is stated in the fund Prospectus.

So here's a hypothetical bond fund for clarification;

ABC Mutual Fund company forms the "Steady Freddy Bond Fund". The manager purchases 100 each of 100 different bonds, all with a 5% coupon and all of them purchased at par. He has 10,000 bonds in his portfolio. 10,000 X $1000 means the "Net Asset Value" (NAV) of the fund is $10,000,000 divided by the total number of shares issued. He sells shares to investors like you and me. Lets say there are 1000 investors and each of us buys an equal number of shares. We now own an equal share of those 100 issues and therefore we each own an equal share of those 10,000 bonds. Now lets also assume that these bonds have similar maturities - ten years but they mature in different months so that there is an almost constant stream of interest payments coming in almost every month of the year. If they all have that 5% coupon then it is easy to calculate that there is $500,000 in interest payments coming in every year. This interest money is transferred directly to the shareholders. In the case of Mutual Funds, you are given the option of receiving that money as cash or having it re-invested into the mutual fund and more shares are purchased. Therefore, your initial purchase of 1000 shares grows quickly with each successive interest distribution.

Here's where the problems begin with Bond funds. For the most part, bonds trade "Over The Counter" and are priced each time they trade. Since these trades happen all the time, the market price of a given issue can and will change regularly. Since the share price of a mutual fund is valued essentially like I describe above - the aggregate value of all the issues held by the fund divided by the number of shares issued equals the NAV. This is calculated each business day for every single mutual fund out there. That means the price of your bond fund can go down or it can go up, but since ALL bonds mature at Par and their price doesn't vary that wildly on a day-to-day basis, the share price of a bond fund doesn't fluctuate nearly a much as a pure stock fund or even a blended fund. Most bond funds price between $10 and $20.00/share, typically between $12.00 & $14.00. The thing is, they just don't go up in value as a general rule. They tend to hold a steady share price, varying by only a few cents on a daily basis unless something dramatic happens in the bond market and/or with a specific issue the manager has taken a large position with. The other thing that can change is the yield, as the manager may be selling and buying various bonds in and out of the fund all the time, doing his best to keep it in line with the objective stated in the prospectus. Since he is trading bonds into and out of the fund, he is getting bonds with different coupon rates and therefore different payments. This affects the amount of income being brought in by the fund and as a consequence, the amount paid to the shareholders.

In my hypothetical fund above, the fund is receiving interest payments of $500,000 per year divided by 12 months = roughly $41,667 per month. But what happens if he sells 25 of those 5% coupon issues and buys 25 issues that have a 4.5% coupon? Now the monthly income has fallen and as a consequence, all the shareholders will get less next month than they got this month. In that scenario, 25% of the portfolio now has a 4.5% coupon and 75% of the portfolio has a 5% coupon. It lowers the funds yield a bit. Also, what if those new bonds were bought at a discount to Par? Their price is now going to drop the share price of the fund. This is a bad thing for you if you want to sell your shares now, but a good thing for new buyers, as they are getting a better price than you did for almost the same yield.

Here is the Morningstar quote page one of the largest Bond Mutual Funds in existence;

http://quote.morningstar.com/fund/f.aspx?t=abndx">American Funds Bond Fund of America

That page shows the price range per share over the last 52 weeks has only varied by $.56. Compare that to an average all stock mutual fund like American Funds http://quote.morningstar.com/fund/f.aspx?t=aivsx">Investment Company of America (one of the oldest Mutual Funds in existence, formed in 1934) whose price has varied by over $6.00 per share over the course of the last year.

BTW, all "Closed End" Mutual Funds have a 5 letter ticker symbol and it always ends in "X". You may want to bookmark that Morningstar page for future reference on funds you have in your own 401(k). If you come across a Mutual Fund with a 3 letter ticker, it is a "Closed End" fund (CEF). Also, "Exchange Traded Funds" (ETF) can also be thought of, and are sometimes referred to as Mutual Funds, but they exist under different rules and ETF's and CEF's trade on an exchange like a stock does. Open End Mutual Funds do not trade on an exchange. They are issued and redeemed strictly by the Mutual Fund company. Each time you buy a share of an open end Mutual Fund, you are essentially buying a new issue of a security. That's why you are given a prospectus.

The thing is, people tend to flee to bonds and bond funds when the market is shaky and/or falling. At times like this, bond prices are almost always higher and yields are lower (as is the case right now). This forces the manager to buy bonds at a premium to Par generally, in order to fill out the fund portfolio to accommodate the new investors. When things start looking better in the stock market, the money flows the other way, but by that time, prices for bonds have typically fallen and yields have risen. When people sell out of bonds and bond funds, it forces the manager to generally take less than he paid for the bonds and it forces the price of the fund down.

The best way to look at holding a bond fund is for the LONG TERM, much like with any Mutual Fund. Re-invest the interest and just grow the number of shares. Just don't expect to buy shares for $10 and sell them for $100. It isn't going to happen with bond funds.

As far as municipal bonds are concerned,

Since most states have a state income tax (only 7 do not, and my state (FL) is one of them), the income produced by Munis issued by OTHER states is taxable. However, it is almost always the case that interest paid by bonds issued in your home state are NOT taxable. This is, BTW, one of the small advantages of living in a state with no state income tax, as you can buy Munis issued anywhere and get the interest tax free.

There is a specific class of Municipal bonds whose interest payments ARE taxable and those are so-called "Private Use" bonds. That means things like issues for a pro sports stadium, for instance, or a road network inside an industrial park. The municipality may have a vested interest in building the stadium or those roads, but at the end of it, they are for the use of a private entity and therefore the IRS and the states don't allow the interest to be tax free.

NOW.....there is absolutely NO ADVANTAGE WHATSOEVER in owning Municipal bonds inside a 401(k) or an IRA or ANY kind of tax deferred account. It is pointless because interest paid by any bond or dividend paid by any stock held inside these types of accounts are not taxed on an annual basis anyway, so holding Munis inside these accounts makes no sense and no 401(k) provider that I am aware of offers them.

Obviously they aren't FDIC insured ...
No, not FDIC, but many if not most Municipal bonds ARE insured against default. Few do, however.

... but how do they rank in terms of "safety"?
Depending on how much faith you have in the rating agencies and the ratings they assign to bonds - there's your answer! For the most part, investing in bonds tends to be safer than investing in equities. You just get a lower return on your investment as a result.

I ask wondering if a 401K investing in a bond mutual fund still has one futzing about in the stock market and subject to the uncertainties of what seems anymore to be high stakes gambling?
No, not really. As I said above, one should think of bond funds strictly as a way to generate income. Inside a 401(k) you are going to simply re-invest the interest payments and build shares that way.

Also, is there any such thing as "The Complete Idiot's Guide To Investing" which contains really useful information?
Sure. Plenty. A visit to either Amazon or your local large bookstore will have lots of them.

Hope that wasn't too long, too boring and was at least of some help.
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