Part 1 – Bond Basics

Hi, everybody. I’m Marc Lichtenfeld, the Editor of Oxford Bond Advantage. Today, I’m going to give you a basic understanding of how to make money in corporate bonds. My goal isn’t to make you a bond expert. It’s to get you to the point where you can properly evaluate your risk tolerance, buy a bond that’s appropriate to it and avoid common pitfalls.

As we go along, you’ll realize that buying bonds isn’t brain surgery. There are some new terms and ideas to learn, but it’s mostly common sense.

Let’s start with some of the basic rules of the road…

First, and most importantly, almost all of you are new to the world of bonds, which are some of the most misunderstood investments out there. Good information about them is rare.

There are no dumb questions, so feel free to ask. My email is listed on every alert: editor@oxfordbondadvantage.com. And I read and respond to every message I get.

If you feel unsure about something, don’t act until you are certain. And don’t be in a hurry to fill all the slots in your portfolio. This isn’t a race, and patience pays. A little cash on the side is always a good idea. I know that goes contrary to most portfolio theories, but it works in bonds.

This service isn’t just a list to cherry-pick. It’s a complete system. You have to read all the introductory information and the entire alerts – not just the recommendations – and follow all my instructions about position sizing, portfolio structure, etc.

Let’s look at how a bond is listed by a broker.

On the screen is the listing of a Delta Airlines (CUSIP: 247361zp6) bond. Most listings look very similar to this one, but there can be minor differences.

The first thing you have to be certain about is having the right bond. Make sure the name matches exactly. The name of this one is Delta Air Lines Inc. In some cases, there will be variations, but these are not the same bonds, so be careful. You may think you’re buying Ford Motor but are actually looking at Ford Motor Credit, which is different. So confirm the bond you’re looking at is the right one. The CUSIP will help you do this.

The CUSIP is the bond’s symbol. It’s a combination of nine numbers and letters. It’s not shown in this quote from a major broker. Some brokers do show the CUSIP in the quote.

The coupon is the percentage yield based on the original price of the bond, which is almost always $100. The coupon in the bond above is 3.8%. This means that an investor, no matter what price they pay for the bond, will receive $38 per year in interest in biannual payments ($19 per payment). That amount is cast in stone and cannot change. No matter what the market price of a bond does, you will receive that dollar amount in interest.

Why $38? Because even though bonds are priced at $100, they are actually sold in increments of $1,000. So an investor who pays $100 for a bond actually buys $1,000 worth of bonds. That $100 price – or $1,000 total value – is known as “par.”

An investor who gets a price of $95 actually pays $950. A bond priced at $110 will cost the investor $1,100. You simply multiply the price by 10 to calculate how much money you will pay or receive when buying or selling bonds.

So the 3.8% coupon is based on the $1,000 cost of the bond. And 3.8% of $1,000 is $38. If your coupon was 5%, you’d receive $50 in interest. But remember, when it comes to interest payments, it doesn’t matter what you paid for the bond. You will receive $38 per year regardless of whether you paid $100, $110 or $20.

The next number to the right is the maturity: in this case, April 19, 2023. That’s when we’re paid our last interest payment and get back our $1,000 principal. As with the coupon, this will happen no matter what we paid for the bond or how much it has fluctuated in price while we held it. We could have paid $800, but we’d still get $1,000 back at maturity.

The following column is the next call date. You’ll notice in the description of the bond that it says “call make whole.” That means the company has the right to call, or buy back, its bond at or after specific dates at a specific price.

In this case, “make whole” means Delta will pay $1,000 per bond no matter where the bond is trading. Sometimes companies will pay a small premium above $1,000. The next call date is the next time Delta is allowed to call the bond. These dates are set in the contract when the bonds are originally sold. Bondholders receive the $1,000 plus any accrued interest.

After that, we have the rating. According to the S&P, this bond is rated B+, while Moody’s lists it as Baa3. I use the former because it’s easier for most people to understand.

The S&P ratings are AAA, AA, A, BBB, BB, B, CCC, CC, C and D; and each grade can include plus or minus signs. For example, there’s BB+, BB and BB-, as well as BBB+, BBB and BBB-. BB is a good rating. It’s just below investment grade, which is BBB- and above. I’ve never had a problem with a bond rated BB.

The price is always stated as a percentage. So the “96.681” above is 96.681% of par ($1,000), or $966.81.

That column also shows you the quantity and the minimum available. Bonds are not like stocks. When you buy or sell a stock, you can always buy or sell as much as you want because you are sending your order to the broad market.

Bonds are different. Every broker will have their own prices and quantity available depending on their own inventory or a larger inventory that they have access to. So one broker may have 100 bonds available and another broker won’t have any. You can always call your broker and ask them to “work the order” and not just rely on their own inventory in order to get you a price or an execution on your trade.

In this example, there 100 bonds available to be bought (you can sell 100), but the “2” in parentheses means the minimum amount you can sell is two bonds. So if you wanted to sell only one bond, this broker wouldn’t allow you to do so online. You’d have to call them and tell them to work the order. Should that happen, you will likely not get the same price you see online.

Next is the ask, the price a buyer will pay. In this case, you can see that it’s $97.105. That means the buyer will pay $971.05 for the bond. There are five bonds available, and you have to buy all five – you can’t buy just one or two.

Again, you can call the broker and ask them to go out into the market and find one or two bonds for you, but you would likely have to pay more than $971.05.

The yield to maturity (YTM) is a very important figure. It is the annual rate we’ll earn as long as we hold the bond. In this case, if all we do is hold the bond until it expires, we’ll earn a 5.028% annual return. YTM includes interest payments and any capital gains or losses when the bond is redeemed at $1,000.

We always assume we’ll hold a bond to maturity when we buy it. Sometimes we’ll exit our bonds much sooner for higher returns, but always assume we’ll hold until maturity. In this case, that’s a 5.028% return on maturity, which isn’t bad.

Yield to worst is the lowest annual return you’ll get. In this case, it matches the yield to maturity. But often when the call dates are well before the maturity date, it can drastically affect the return bondholders receive.

Some brokers list current yield, which is how much we earn in income per year based on our purchase price of $97.105. Because the bond is trading at a discount to the $1,000 par value, we actually earn a higher yield than the coupon, or less than par, which is $1,000. Just divide the coupon by the price to get the current yield… 3.80 / 97.105 = 3.91%.

Another item you should be familiar with is accrued interest (AI).

A bondholder is entitled to all the interest earned from the day they take possession until the bond is sold, called or matures. Unlike a dividend stock, where you get all of the dividend as long as you own the stock by the ex-dividend date, interest from a bond is accrued from Day One, as soon as your account registers the bond and is owed to whoever owned the bond up until that day.

It’s like when you buy a house: You don’t owe 100% of the property tax for the year you bought it. The seller is responsible for the tax for the time they owned it during that tax year. If they already paid the full year’s tax, you reimburse them the percentage you’ll owe. If they haven’t paid any of it, the seller will pay you their share.

For example, if this bond pays interest every 180 days and you bought it 90 days before the last payment, you’d owe the seller half of the accrued interest, in this case $9.50 (half of $19). If you sold the bond 18 days before the interest payment is paid, the buyer would pay you an extra $17.10 (18 is 10% of 180 days, which means you held the bond for 90% of the time, so you’d get 90% of the interest).

Just keep in mind: When you buy a bond, you’ll owe the current owner some interest, but you’ll get that back on the first payment after you take possession.

That’s it for today. In the next section, we’ll get into how you actually buy a bond.