Investing in Bonds

This section serves as a guide for investing in municipal bonds. Whether you are an individual investor or an institutional firm, there is a myriad of information in this section for all to benefit from. Includes the principles of investing in bonds, risk factors, and investor strategies.

Basics of Investing in Bonds

Municipal bonds have long been an attractive investment because of their tax-exempt status; particularly for those who are in the highest tax bracket. The interest that an investor may accumulate on a bond will be exempt from federal tax, and in many cases also exempt from state at local tax. This means that whatever the yield is on the bond, it is actually even higher because it is tax exempt; for the profits gained on interest are not taxed.

One might compare investing in municipal bonds to a simple example of working “on the books” (taxed) and working “off the books” (no taxed). A person working off the books making $10/hr will be taking home the same amount of money as a person working for $12/hr on the books, assuming a tax rate of around 16%. Now, if the person working off the books was making $12/hr as well, their take home amount would be higher than the person working on the books for the same amount. The difference would be the tax rate. The same principle applies to municipal bonds. A municipal bond with a yield of 6% would be much more beneficial to an investor than, let�s say, a Certificate of Deposit (CD) which also yields 6% but its interest is taxed.

There is a fundamental relationship that exists between interest rates and their prices in municipal securities. If interest rates rise, prices of securities will fall. This is to make their overall yield more comparable to recently-issued securities. Prices may also be affected by the supply and demand of bonds at any given time, as this is generally a factor in all markets.

Features to Monitor when Investing

Below are the most important features of a given bond that an investor needs to pay special attention to in order to understand what sort of investment they are making.

Term to Maturity

The term to maturity is the time that it will take a bond to fully mature to its principal. Those with term to maturity of less than 13 months are considered short-term securities. Commercial paper generally matures within 270 days. Short-term bonds may mature anywhere from 1 to 4 years. Medium-term bonds mature between 5 and 12 years and long-term bonds take more than 12 years to mature and may take as long as 100 years. Short-term bonds will typically trade closer to the par amount than long-term bonds due to the fact that the investor will receive the full principal sooner rather than later.

Coupon Rates

The coupon rate is the actual interest rate on a bond, typically redeemable twice a year. The main principle to understand when looking at coupon rates is their relationship to price. When an issue has a high coupon rate, its price movement will be smaller and less susceptible to a great change when market conditions change. On the other hand, a bond with a low coupon rate is much more susceptible to market conditions.

Measuring Yield and Return

In order to figure out the most profitable investment, financial strategists use mathematical formulas to measure yield and return. They take into account present value, which is based upon the time value of money. Higher value is placed on shorter investments, even if they both have the same return. This is due to the fact that an amount of money today is worth more than that same amount tomorrow.

Internal Rate of Return

Say, for example, that an issuer will return an investor one dollar in 5 years based on a loan of 80 cents today. Another issuer will return one dollar in 4 years for a loan of 85 cents today. Which of the two is a better deal? In order to determine the answer, the investor must calculate the internal rate of return. The internal rate of return is the discount rate at which the present value of cash flow from an investment is equal to its price. The only way to find the correct discount rate and yield is through trial and error by estimating an interest rate and applying it to compute the present value of each cash flow; there is no mathematical formula for this calculation. In this case, the internal rate of return would be higher on the 5 year investment at 75 cents.

Total Return

To measure the performance of a given investment in bonds, one should calculate the total return and compare it to the industry benchmark. Total return is the investment’s performance over a given period of time and is comprised of coupon interest, interest on interest, and realized or unrealized gains or losses. After the total return is calculated for one, five, and ten years, for example, it may then be compared to the benchmark total return for that specific type of investment. After comparing these two numbers, it may be determined whether the total return received on an investment is on par with the industry, below it, or above it, thus determining whether one has made a successful investment or not.

Risk Factors

With investments, there are always any number of risk factors to take into account. Investing in municipal securities is no different. Calculating the risk of an investment is essential before any money is actually invested. One must determine the level of uncertainty involved with the investment and take into account the possibility of a financial loss, however minute or great it may be.

Types of Risk

Credit Risk - This is the risk that the issuer will not be able to pay their municipal debt due to credit problems. This risk is shown in bond’s rating, as determined by one of the three major bond rating agencies.
Event and Political Risk - A catastrophic event, such as a terrorist attack or a massive hurricane, the introduction of new regulations, or corporate restructuring may affect an issuer’s ability to repay their municipal debt.
Market Risk - This is the risk that involves the interest rate. The general level of interest rates may affect the price of a bond.
Reinvestment Risk - The risk that investors will not be able to reinvest their interest at the original rate that the bond was issued at.

Strategies of Investment

Once the capital, risk factors, and investment goals of an institutional or individual investor are determined, an investment strategy may be formulated. Below are four types of investment strategies for investing in municipal bonds:

Barbell - Used to manage interest rate risk. Using the barbell strategy, investors acquire municipal securities at both extremes of term to maturity levels; that is to say, they may split their investments between short-term securities (term to maturity of 13 months or less) and long-term bonds (term to maturity over 12 years). This is a useful strategy when trying to preserve capital and working with a limited current income.
Diversification - This strategy is best used to manage credit risk. Diversification refers to keeping a portfolio that contains a well-balanced mix of bonds from many different sectors. In this case, if one sector is performing poorly, it is assumed that the other sectors will pick up the slack and even things out.
Laddering - A laddered portfolio has bonds with term to maturity spread out over all different time periods. The ladder part of the strategy refers to the idea that once one bond comes to maturity, another one is purchased. For example, when a bond with a term to maturity of 1 year matures, another one is purchased at 5 years. A laddered portfolio may have bonds that mature in 1, 2, 3, 4, and 5 years.
Bond Swapping - This strategy refers to selling a bond and instantly purchasing another bond with the proceeds of the sale. Bond swapping is used to change bond maturities, adjust portfolio credit, increase yield, benefit from interest rate changes, and to generate tax losses. Tax losses may be used to offset capital gains or regular income.