Tuesday, April 25, 2006

Investing in Bonds

:: THIS BLOG HAS MOVED TO SuckyBlog.com ::
A few friends have asked lately about where to buy Treasury and California Municipal Bonds, so I am posting a little primer here. A quick word of warning: I am not a professional investor, so use the information below at your own risk!!!

Treasury bonds you can buy directly from the government at TreasuryDirect. You can also buy them through most brokers, like Vanguard or Fidelity or whatever company you use. For new issue auctions (when the government issues new bonds and sells them directly to investors like you and me), the brokerage may add a small fee of $10 or so, but sometimes it's worth it to do that just so you can have everything in one place to ease the record keeping.

Brokerages usually also sell secondary bonds, which are previously issued bonds that the brokerage now owns and offers to sell to their customers. The price will be different (not $1,000 like most new issue bonds) depending on what interest rate the bond pays vs current rates. For example, if today's prevailing rate for a 5 year bond is 4%, and a broker has a 7 year bond in its inventory that matures in 5 years (meaning it was issued 2 years ago) but that bond pays 4.25%, they will want more than the original $1,000 for it since it pays a higher coupon than the current yield for the same maturity. Treasury securities are exempt from state income taxes but not federal taxes.

For California municipal bonds, you can also go through your broker. Large brokers will have a decent sized inventory of munis that they can sell you. These are almost always secondary purchases. Bear in mind that there is no "exchange" for bonds like there are for stocks. Since there's no common market for bonds, sometimes pricing can vary between brokers and you have to check a few sources before buying. Treasuries are very safe (if the federal government goes down, we've got much bigger problems than lost savings, so they're considered essentially risk-free), but munis can vary in quality (remember OC went bankrupt in the mid 90s). You have to check the credit rating and whether the bond is insured, among other factors. That information is available from your broker.

CA municipal bonds for us CA residents are completely tax free at both the state and federal levels, which makes them an excellent deal if you are in a high tax bracket. To calculate the taxable-equivalent yield (i.e. how the tax-free yield of a particular muni compares to the yield of a taxable bond of comparable risk and maturity), it's:
tax-free yield/(1-tax rate) = taxable-equivalent yield

Most people will ladder bonds- take the chunk of money they want to invest, and split it into 5-10 equal parts to invest in bonds that mature every year out to 10 years or so (for example, if you have $100,000 to invest, you will buy $10,000 of bonds that mature in each of 1, 2, 3, 4, 5, 6, 7, 8, 9, & 10 years). And then when the 1 year bond matures and returns the principal to you, you would simply take that money and buy a new 10 year bond with it at the prevailing interest rate. This method allows you to average out short- and long-term rate exposure, and also protects you from adverse interest rate environments because you have money coming back at least once a year that you can reinvest at the prevailing rate at the time.

Now lately short term rates have been rising very quickly (the Federal Reserve sets short term rates, although they seem to have little control over long term rates), so recently there has not been much difference between the yield on a short term money market account and a 10 year bond, or at least not so much of a difference that you would be willing to lock up your money for 10 years. As a result, a lot of people I know are not investing in long term bonds at all and just watching the short term rates in their money market accounts go up every few months. The Fed has recently announced that they will likely cool down on raising short term rates, and long term rates do look like they're rising, so hopefully sometime in the next few years we will be in a more normal market with a regular yield curve where the long term rates are materially higher than short term rates.

Again, this is all based on my rudimentary knowledge- I have enough experience with these things that a lot of friends ask for advice on topics like this one, but I do not profess to be an expert in personal investing, nor is this meant to be a complete tutorial on bond investing (there are a lot of variations that would bore most people to tears if I were to post them all). A great resource with tutorials and calculators is Bankrate.

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Anonymous Neil said...

Great. But first I need to learn how to save some money.

7:59 PM  
Blogger jackt said...

Neil: Easy!

Income - Spending = Savings


Spending < Income -> Positive Savings!!!


8:35 PM  
Blogger rick james said...

Jack Sucky Blog Greenspan !

Jack, you are a GREAT writer cause this is the first time that someone has actually made the topic of bonds somewhat bearable...

i'm all about risk, the only time we mention Bonds is when the topic of perfomance enhancing drugs are involved...

8:59 PM  
Blogger jackt said...

DCCF: It's funny you say that. Sometimes I am astonished that Suze Orman gets paid to state the obvious, but then one day I realized that a lot of people really hate topics like investing and capital markets. So she gets paid a lot to spoon feed easily found information and knowledge to her audience. Brilliant!

I wish I could write about 'roids, but unfortunately for me I am deficient in my knowledge of sports.

9:15 PM  
Anonymous Anonymous said...

muni bonds are not necessarily tax free if you are subject to the AMT. see this for more info.

10:50 PM  
Blogger jackt said...

anon: Yes, that is very true. Much thanks for mentioning that. There are so many little twists to all this stuff (there are also munis, I believe, that aren't exempt from certain taxes because of the way they are structured).

Anyway, if anyone is reading this and it gets your investing juices flowing, please do consult professional sources so you are well-armed with the info you need. This was just meant to be a starting meant and not comprehensive (as I mentioned in the post).

11:18 PM  
Blogger yoony said...

thanks for this post jack! i really need to start thinking about how to handle my personal finances. now that i'm all grown up and have to move out of my parent's place. any advice for other short-term investments?

10:46 AM  
Blogger jackt said...

Yoony: Yeah! Money market funds and high yield savings accounts! Start with those for short-term. Rates are going up! These banks have high yielding savings accounts and are FDIC insured, meaning the Federal government guarantees all deposit accounts up to $100,000. They don't have branches and ATM machines though, but they are convenient for savings if you're comfortable with online banking:

ING Direct
Emigrant Direct

11:10 AM  

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