The Bond Book, Third Edition: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More

THE BOND BOOK

THE BOND BOOK

Everything Investors Need to Know

about Treasuries, Municipals, GNMAs,

Corporates, Zeros, Bond Funds,

Money Market Funds, and More

Third Edition

Annette Thau

Copyright © 2011, 2001, 1992 by Annette Thau. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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TO FRED

CONTENTS

Preface

Acknowledgments

PART ONE THE BASIC BASICS

Chapter 1 The Life of a Bond

First, What Is a Bond?

How Bonds Are Issued and Traded

Key Terms for Bonds

Chapter 2 The Bond Market: An Overview

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

Chapter 3 Volatility: Why Bond Prices Go Up and Down

Interest Rate Risk, or a Tale of Principal Risk

Credit Ratings: How Credit Quality Affects the Value of Your Bonds

A Short History of Interest Rates

The Federal Reserve and Interest Rates

Summary

Chapter 4 How Much Will I Earn, or Basic Bond Math

Bond Cash Flows

The Many Meanings of Yield

Total Return

Duration and Bond Price Volatility

Summary

Chapter 5 What You Need to Know before Buying Bonds

The Bond Market in the Financial Press and on the Internet

The Treasury Market

Yield Spreads and Benchmarks

Investinginbonds.com, FINRA.org/marketdata and EMMA.msrb.org

Summary

PART TWO INDIVIDUAL SECURITIES

Chapter 6 Treasuries, Savings Bonds, and Federal Agency Paper

What Is Unique about Treasuries?

Treasury Bills, Notes, and Bonds

Inflation-Indexed Securities

Buying Treasuries: TreasuryDirect

Zero Coupon Bonds

U.S. Savings Bonds

Federal Agencies

Summary

Chapter 7 Municipal Bonds

What Is Unique about Municipal Bonds?

Should I Buy Munis? (or, Taxable-Equivalent Yield)

Credit Quality: General Obligation versus Revenue Bonds

The Rise and Fall of Bond Insurance

Recalibrations of Municipal Bond Ratings

Municipal Bond Pricing

Shopping for Municipal Bonds Using the Internet

Selecting Municipal Bonds

Summary

Additional References

Appendix: The New York City Default

Chapter 8 Corporate Bonds

What Is Unique about Corporate Bonds?

Risk Factors of Corporate Bonds

Corporate Bonds with Special Features

Junk Bonds

Shopping for Corporate Bonds Using the Internet

Summary

Chapter 9 Mortgage-Backed Securities

Why GNMAs Are Unique

How Prepayments Affect GNMA Cash Flows

The Vocabulary of GNMA Returns

CMOs and Other Sons of GNMA

Agency Backing of Mortgage-Backed Securities: Ginnie, Fannie, and Freddie

Collateralized Debt Obligations (CDOs) and Collateralized Debt Swaps (CDSs)

The Financial Crisis: 2007–2008

Current State of the Mortgage-Backed and Asset-Backed Securities Market

Summary

Additional References

Chapter 10 International Bonds

The International Bond Market: An Overview

Currency Risk

Emerging Markets Debt: Brady Bonds

Buying Individual International Bonds

Is There a Case for Investing in International Bonds?

Obtaining Information on International Bonds

Summary

PART THREE INVESTING THROUGH FUNDS

Chapter 11 Bond Mutual Funds: An Overview

Differences between Bond Funds and Individual Bonds

How Much Will I Earn?

The Costs of Investing in Bond Funds

Why the NAV of Your Fund Will Go Up and Down

Selecting, Buying, and Monitoring Bond Funds

Sources of Information Concerning Bond Funds

Taxes and Bond Funds

Summary

Chapter l2 Money Market Funds and Tax-Exempt Bond Funds

Money Market Funds

Bond Funds Whose Price Goes Up and Down: Plain Vanilla and More Speculative Funds

Municipal Bond Funds

Summary

Chapter 13 Taxable Bond Funds

Domestic Plain Vanilla Taxable Bond Funds

Treasury Inflation Protected Securities Funds

GNMA (and Other Mortgage) Funds

More Speculative Funds

Miscellaneous Funds

Summary

Chapter 14 Closed-End Bond Funds, Exchange-Traded Funds (ETFs), and Unit Investment Trusts

Closed-End Bond Funds

Summary: Closed-End Funds

Sources of Information on CEFs

Exchange-Traded Funds

Advantages and Disadvantages of Bond ETFs

Summary: Exchange-Traded Funds

Unit Investment Trusts

Summary: Unit Investment Trusts

PART FOUR MANAGEMENT OF BOND PORTFOLIOS AND ASSET ALLOCATION

Chapter 15 Management of Bond Portfolios

When Will I Need the Money?

Portfolio Structures

Finding Attractive Buy Points

Swaps

Managing a Bond Portfolio for Total Return

Chapter 16 Portfolio Allocation

Portfolio Allocation

Asset Allocation

The Case for Bonds Revisited

The Current Environment and the Bond Market

Conclusion

Index

PREFACE

This is the third edition of a book that was initially published in December of 1991. After working for a number of years as a credit analyst, I had started personally investing in bonds. At the time, I looked for a book that would explain in clear English some of the basic concepts used by professionals to manage bond portfolios; and that would contain detailed information about the various types of bond investments available to individual investors. None of the books I found fit that description. Most books that dealt seriously with bonds were not comprehensible to anyone who was not a finance professional. Years later, I decided to write the kind of book I would have liked to have read. Evidently, it would fill a need. Little did I imagine when the first edition was published that I would be revising this book again, for the third time, almost 20 years later.

Over the past 20 years, both the bond market and the stock market have had dramatic ups and downs. Investor psychology toward the bond market has also had its ups and downs. For example, the second edition of this book was written around the year 2000. In retrospect, that was almost the last year of the great bull market in stocks that had started in 1982. At that time, pundits were proclaiming that we were in a new era. Experts were recommending that individuals invest 100% of their portfolios in equities (or perhaps keep a small percentage, say 10%, in cash), and nothing at all in bonds. The decade between 2000 and 2010 proved the experts wrong. Between 2000 and 2010, the stock market suffered two devastating bear markets: in 2002 and in 2008. Even though many sectors of the bond market suffered significant declines during the financial panic of 2008, for that decade, investments in many sectors of the bond market had positive returns and enabled investors to ride out a lost decade in the stock market.

Investor psychology seems to have changed once more: for the past year, more money has been flowing into bond funds than into stock funds. But if these flows reflect the search for a safe harbor, then some investors may be in for an unpleasant surprise. Investors need to be aware that all sectors of the bond market are not equally safe and predictable. Many bonds and bond funds are as volatile and unpredictable as stock funds, posting equity like returns one year, and dismal losses the next. Indeed, some steep losses have occurred in bond funds that had been initially marketed as very low risk investments.

This book, like prior editions, is intended to be a complete introduction to the bond market and to the different types of investments in bonds: individual bonds, as well as different types of bond funds.

There is virtually no section of this book that has not been heavily or totally rewritten. My emphasis has been on changes that have occurred since the 2000 edition. One of the more important changes is that investors can now access a great deal of information, such as pricing data, that in the past was available only through brokers. That information is available on the Internet, and it is free. In addition, all chapters on individual securities include new information. The chapters on bond funds have been totally rewritten. They include a detailed analysis of the performance of all types of bond funds, during and since the financial panic of 2008, as well as ten-year returns through December 2009. There is also a new section on bond exchange-traded funds (ETFs) as well as an expanded section on closed-end bond funds.

This book is divided into four parts. The first part is introductory, and it is basic to understanding everything that follows. It explains the fundamentals of bond investing, including the basic vocabulary of bond investments; how bonds are brought to market and sold; bond pricing and markups; how to research the price history of bonds; why the price of bonds (and bond funds) goes up and down; key concepts used to measure bond returns; and much more. That part of the book should be read first, in entirety.

The second part of the book discusses individual securities: Treasuries, municipal bonds, corporate bonds, GNMAs and other mortgage-backed securities, and international bonds. One chapter is devoted to each security. The third part of the book analyzes the major types of bond funds: open end mutual funds; as well as closed-end bond funds and the newest kids on the block, ETFs. The fourth part of the book deals in a more general way with the management of bond portfolios. Parts 2, 3, and 4 may be read in any order desired.

While much of the material in the book is new, my initial orientation remains the same. This book assumes little or no knowledge of any bond investment, but it explains the critical information required to buy any security, be it a Treasury bond, a municipal bond, or a bond fund.

Several basic themes run through the book. First, I explain in detail the risks that underlie the purchase of any security. The main reason for this is that it is patently silly to lose money because you are buying a security thought to be riskless only because the risk factors are unknown. After you read this book, this will no longer happen. Equally important, while it is not possible to forecast where interest rates are going, if you understand the risks of specific bond investments, then you can control the amount of risk you take. If you want to be sure that you are investing in the safest corners of the bond market, then this book will clearly explain what those are. If you want to speculate in the riskier corners of the bond market, this book will point what those are.

Second, this book will define areas of opportunity. Just as you can lose money because you don’t realize that an investment is risky, you can also earn less because you are restricting yourself unnecessarily. There may be areas of opportunity that you just don’t know are out there.

Third, at minimum, any investor needs to understand enough technical information to be able to discriminate between sound analysis and hot air. You will learn a lot of technical terms and concepts so that, in the future, no one can intimidate you. If you sound like an informed investor, the next time you talk to a bond salesman, he will be much more likely to be honest with you and less likely to try to sell you a bill of goods.

Fourth, another theme is how to obtain information. Many chapters contain sample tables and graphs along with explanations on how to interpret them. The most useful information is now found on the Internet. References for additional research are listed at the end of many chapters. If you wish to pursue any topic in greater depth, you will know where to look.

I kept in mind that investors differ both in the amount of time they have to devote to investing and the amount of personal interest. Throughout the book, I have pointed out techniques that minimize risk for safety-minded investors who have limited time to devote to investing.

Above all, this book is intended to be practical and to answer fundamental questions such as: Should I invest in individual bonds or in bond funds? How do open-end funds differ from closed-end funds, or from ETFs? Should I invest in taxable or in tax-exempt bonds? If I am right about a particular investment in bonds, how much can I earn? And if things go wrong, how much can I lose? For all types of bond investments, it will address what is perhaps the most fundamental question in the bond market: What risks am I taking in order to earn a higher yield? Ultimately, this book should enable you to select fixed-income investments that match your tolerance for risk and your overall investment goals and strategies.

Some vocabulary notes are in order. First, a word about the term bond: the term designates any debt instrument or fixed-income security available on the market. No single term exists to cover this type of instrument. For the sake of variety, the terms bond, fixed-income security, or debt instrument are used interchangeably throughout the book. Second, it was necessary to decide how to deal with gender to refer to men and women as investors, or as salespeople. I considered using he/she but rejected it as too clumsy. Instead, I decided to use either he or she in random fashion. This should introduce some variety in the text.

Finally, I have no ax to grind. This is not a book for bonds or against bonds. Bond investments are more complex and less predictable than is generally realized. This book will explain how and why. You may, after reading it, decide to allocate more of your portfolio, or less, to bonds. My objective in writing this book is to enable you to navigate the bond market—whatever its future shape turns out to be—in a more informed manner.

So, many happy returns!

ACKNOWLEDGMENTS

I have been fortunate when writing each edition of this book to be able to benefit from the many insights, suggestions, and knowledge of many people within the industry who were kind enough to take time out from busy working lives in order to help me put this book together. Once again, I would like to acknowledge and thank those individuals whose help made this book possible.

I would like to thank, first of all, those individuals who read portions of the manuscript and who made valuable suggestions for changes. They include Maria Crawford Scott, former editor of the AAII Journal; Cecilia Gondor, Executive V.P., Thomas Herzfeld Advisors; Matt Tucker, Managing Director in BlackRock’s Fixed Income Portfolio Management Group; and Chris Shayne, CFA, Manager of Marketing Communications, BondDesk Group, LLC.

I would also like to acknowledge and thank the many individuals who not only provided data but who spent time answering innumerable questions and discussing fine points of certain securities. They include Cecilia Gondor, Executive V.P., Thomas Herzfeld Advisors; Chris Shayne, CFA, Manager of Marketing Communications, BondDesk Group, LLC; Dominic Maister, Executive Director at Morgan Stanley; Christine Pollak, Vice President, Morgan Stanley; Professor Edward Altman, Professor, New York University Salomon Center; Christine Hudacko, Director, BlackRock Corporate Communications; Kathryn Edmundson, Team Leader, Investinginbonds.com; and Justin Pica, Director, Uniform Practices Group, at EMMA.msrb.org.

I would like to single out for particular thanks Jeff Ttornejoh, Research Manager for the United States and Canada of the Lipper organization (now Thomson Reuters) not only for generously supplying data on bond funds but also for being particularly unstinting with his time both for this book and for prior writing projects.

Finally, there are a number of individuals whose help I cannot acknowledge due to policies of the firms that employ them. They know who they are, and that their help was greatly appreciated; and they also know that I regret I cannot thank them by name.

To one and all who made this book possible: Thank you! The opinions expressed in this book are my own. Any omissions or errors are, of course, entirely my own responsibility.

PART ONE

The Basic Basics

This part of the book is introductory and basic to understanding all that follows. Its purpose is to explain the fundamentals of bond investing. The idea behind these introductory chapters is to familiarize you, the reader, with concepts that will enable you to understand potential returns of different types of investments in the bond market, as well as the risks you are taking with those investments.

Chapter 1 defines bonds and explains how they are originated and sold.

Chapter 2 is an overview of the bond market. It also introduces key terms used in discussing bonds and the bond market.

Chapter 3 is at the heart of the book. It explains why bond prices go up and down through a detailed discussion of the two major risks in the bond market: namely, interest rate risk and credit risk. It also includes a brief history of interest rates as well as a brief discussion of the role of the Federal Reserve in determining interest rates.

Chapter 4 is an introduction to basic bond mathematics. It defines the key concepts used to measure return (that is, what you will actually earn) from investments in bonds, as well as bond cash flows. The chapter also introduces duration, which can help you evaluate the riskiness of investments in bonds.

Chapter 5 discusses topics and data commonly used in the press and on the Internet to analyze what is happening in the bond market. It also introduces three Web sites which have been developed by several regulatory and trade agencies: FINRA.org/marketdata, Investinginbonds.com, and EMMA.msrb.org. These Web sites make information available to investors that in the past was available only to brokers, including, for example, trade data about bonds within 15 minutes of a trade. Finally, Chapter 5 introduces some guidelines to shopping for individual bonds.

CHAPTER 1

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 2

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 ¼ 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.

HOW BONDS ARE SOLD: DEALERS, BROKERS, AND ELECTRONIC PLATFORMS

Dealers and Brokers

The process of actually identifying, selecting, and buying bonds is also very different from that of buying stocks. To begin with, when you buy a stock, you have probably identified a specific stock that you want to buy, say Apple. You can then look up the ticker symbol and the most recent price at which Apple stock sold; it is displayed on a tape in real time. If you decide to buy the stock, whether you purchase it from a full-service broker, a discount broker, or online, whether you are buying 10 shares or 1,000 shares, the price per share will be the market price.

When you buy bonds, on the other hand, chances are that you will not be shopping for a specific bond. Rather, you will put together a bunch of criteria; and then shop for a bond that satisfies those criteria. Suppose, for example, that you decide to invest in tax exempt municipal bonds. Your criteria may include: the state in which the bond was issued (to avoid state taxes); the approximate maturity of the bond; the bond’s credit rating; a target yield and perhaps, whether or not the bond is callable. But chances are that at the outset, you do not have a specific bond in mind. Instead, you will search a variety of sources to find bonds that satisfy the criteria you have established.

It is now possible to buy bonds from many of the same sources as stocks including full service brokers, discount brokers, and financial advisers. And in fact, it is now possible to buy and sell many types of bonds completely online, without having to call a broker to complete the trade. But similarities with buying stocks end there.

When you are shopping for bonds, you will find that the availability of bonds varies widely from dealer to dealer, particularly in the less liquid sectors of the market such as corporates and municipals. You cannot just assume that any firm you approach will have or can get specific bonds. In fact, there may be times when you cannot find bonds that match your criteria. Moreover, if you approach a number of firms in all likelihood, you will be offered not only different bonds, but also bonds differing in price, in maturity, in coupons, and in yields, all nonetheless apparently matching your criteria.

One reason for this state of affairs is the structure of what, for want of a better term, I will call the dealer community. Although often the terms dealer and broker are used virtually interchangeably, in the bond market, the word dealer has a very specific meaning. A dealer is someone who puts his own money at risk to buy and sell bonds. This is also known as taking a position in certain bonds, or being a principal. Maintaining an inventory is risky. The dealer does not know how long he will have to hold the bond before finding a buyer; and the future price of the bond is uncertain. As we will see in Chapter 3, bond prices go up and down. Among dealers, the bid/ask spread, or markup, is viewed in part as compensation for the risks taken to buy and maintain an inventory. Dealers mark up their bonds indepently: the same bond may be sold by different dealers at different prices.

A broker, on the other hand, is someone who executes a trade (whether a buy or a sell) for a customer, and in doing so, earns a commission. The broker is not required to own the bond that is being traded. And many brokers do not own the bonds they sell. Both discount brokers and financial advisers rely primarily on electronic platforms to sell bonds. (Platforms are discussed at greater length in the section entitled electronic platforms, later in the chapter). The broker, in legal terms, merely acts as an agent for the customer. In other words, unlike a dealer, a broker does not put principal at risk.

This is not merely an academic distinction. Rather, it is one of the reasons that differences exist in the availability and pricing of bonds. Firms that sell bonds vary enormously. Dealer firms, whether large or small, maintain inventories of bonds. But many firms that sell bonds (for example, discount brokers and financial advisers) do not maintain inventories. If you buy a bond from a discount broker, or from a financial adviser, that firm has to locate the bond in order to sell it to you. Increasingly, this is done through the use of electronic platforms.

Electronic Platforms

Electronic platforms (also called e platforms) have been a growing presence in the bond market over the past decade. You may not be aware of their existence. But if you have searched for bonds online, or if you have purchased any fixed income security online, then you have been doing so through an electronic platform.

How Electronic Platforms Work

Electronic platforms are businesses that supply data: they gather lists of bonds that dealers want to sell, and transmit that information to brokerage firms. In the dark ages prior to computers, that function was performed by inter-dealer brokers, who would call hundreds of firms daily to find out what bonds they owned, and wanted to sell. They would then compile and fax master lists that would be circulated among dealers and brokers. In effect, these lists became central databases. With the advent of computers, and the development of software, these master lists became searchable databases. The next step was to make them available to online brokers. When you are searching for bonds on the Web site of an online broker, most often, what you are searching is the database supplied by an electronic platform.

At their inception, electronic platforms enabled investors only to search for bonds online. But with very few exceptions, online brokers required investors who wanted to purchase a bond to place the order with a broker. This is no longer the case. Many online brokers now allow investors to complete the purchase entirely online. What investors may not realize is that when they complete the purchase entirely online, they are in effect trading entirely through the electronic platform. Unless you actually consult a broker prior to completing a trade, the online firm whose Web site you are consulting is acting almost entirely as an intermediary. And since that firm does not buy or otherwise hold the bonds in inventory, that brokerage firm is essentially engaged in a riskless transaction.

At its most basic level, an electronic platform can be described as an electronic bulletin board where hundreds of sellers (dealers, banks, pension funds, etc.) list bonds for sale and the price at which they are offering them. But electronic platforms supply a great deal of additional information and software. That includes disclosure information, analytic details about specific bonds, yield and price information; as well as sophisticated software that enables investors to conduct targeted searches for bonds meeting specific criteria.

Electronic platforms list fixed income securities from virtually every corner of the bond market: Treasuries, Agencies, corporate bonds, municipal bonds, CDs, and more. The listings of many of the major online discount brokers such as E Trade, Schwab, or Fidelity consist primarily or perhaps almost entirely of feeds from one or more electronic platforms. But dealer firms also may augment their own inventories with feeds from one or more electronic platform.

The mechanics of these listings are not obvious. First, the listed dealer price includes at least one, and sometimes several markups. That is because that price is marked up based on the instructions of the listing dealer. It is also marked up based on the instructions of the listing broker. Both dealer and broker markups vary. What this means is that you may see the same bond listed by one broker Web site at a price of 100; on another at 102; and on still another at 103. And oh yes, of course, the platform also gets a cut (I am told a small cut).

One reason you may not be aware that you are consulting an electronic platform is that all online brokers have distinctive formats. In addition, many firms apply proprietary screens to filter the offerings of electronic platforms. As a result, different brokers, even those using the same electronic platforms, may wind up with totally different lists of bonds. Some firms filter out bonds whose price is deemed to be too high: for example, 3% above the most recent inter-dealer price. But some brokers exclude the bonds of certain dealers just because they don’t like those dealers, or for other idiosyncratic reasons. In any case, these screens are one of the reasons availability of bonds differs so widely from broker to broker.

Buying bonds online is relatively straightforward. You see a bond you like, click on the bond, and a ticket is created. But note that electronic platforms are dynamic: the price can change throughout the day, as the market moves. Some online Web sites acknowledge this with a disclaimer that Prices, yields and availability are subject to change with the market.

When you submit a bid for a bond, a ticket is created. If the price has changed compared to the original posting, you are not