Part 2 – Buying a Bond

Hi everybody, I’m Marc Lichtenfeld, the editor of Oxford Bond Advantage. Welcome back to my bond tutorial series.

The publicized parts of the money world are dominated by stocks: stockbrokers, stock analysts, “stockheads.” But going to stockbrokers to buy bonds is like going to Best Buy for snacks. They may be able to sell you the bond, but they probably won’t be very helpful.

With that in mind, let’s talk about how to buy a bond. Below is a recommendation I copied from one of our past alerts for a Service Properties Trust position.

Action to Take: Buy the Service Properties Trust (CUSIP 44106mar3) June 15, 2023, 4.5% coupon bonds for $101 ($1,010 per bond) or lower. You should be aware that the name of the legal entity on the bonds is actually “Hospitality Pptys Tr.”

At the current price, you will lock in an annualized yield to maturity of 5.25%. The bond is rated BB. It will go in the Conservative Portfolio.

The first thing you need to focus on is the price.

I typically give a limit price on bonds. I don’t want you paying too much for them and not earning enough income on your capital.

Two things to mention here:

• Never chase a price above that upper limit. The market makers watch me closely, and in most cases, they raise bond prices as soon as I put out a “Buy.” Wait them out. If you give it some time – and it may take two weeks – the price comes back down to my limit nine out of 10 times. Yes, you may miss a recommendation or two that way, since the price does stay high occasionally. But it’s better than paying too much for a bond. I make more than 20 picks per year, so take your time and wait for your price.
• Some brokers also inflate bond prices. It’s not unusual to see them raise a bond by three or four points. The bond market isn’t as closely controlled as the stock market in this regard. So if you find your prices are always above the ranges I give, it might be time to look for a new bond broker.

Next is the yield to maturity. The yield to maturity is the expected annual total return of the bond if held to maturity. However, you should know that the calculation includes reinvesting the interest payments at the same interest rate.

You’ll find that is not always possible. Unlike a stock, where you can automatically reinvest dividends, you cannot automatically reinvest bond interest payments.

That’s why in the portfolio, I also include a metric called minimum expected annual return, or MEAR.

This figure does not include reinvesting the interest payments. MEAR is a proprietary measurement, so your broker will not be familiar with it, and you won’t see it written about in the mainstream financial press. But it’s a more accurate indicator of what you’ll actually earn.

With that established, let’s move on to the rating. Service Properties Trust is rated BB, which is a pretty good rating. It’s not investment grade, but it’s still near the top of the high-yield ratings.

Speaking of ratings, I try to find the highest-rated bonds possible – with the highest yields. However, since we’re in an ultra-low interest rate environment, in order to obtain higher yields, we sometimes have to buy lower-rated bonds.

If I’m recommending a bond, it’s because I believe you will receive all of your interest payments and capital back at maturity. However, occasionally I will recommend a speculative bond – one that has a very low rating – or a bond that is distressed, which means that its price has fallen dramatically. These bonds will have very high yields.

If I recommend a speculative bond, I will make it very clear that these are high-risk bonds. If I do recommend a speculative bond, you can be sure you will be compensated well for taking on that risk.

Diversification

It’s important to not buy bonds based solely on yield, ignoring ratings, risk, diversification, etc.

You can fight this temptation using position sizing, which concerns how much you should own in any given bond. This is one of Oxford Bond Advantage’s primary tenets.

In short, own small positions in as many bonds as you can manage in order to spread any risk around. That way, if we take a hit – which we do occasionally – it won’t be a significant loss.

Now, I know “small” is a relative term. I can’t give you personal advice, so I can’t say “Buy two-bond lots” or “Buy five-bond lots.” But basically, as the rating of a bond goes down, own fewer of them. So in the A and BBB range, you can own more of a position than you would with a B rated bond.

Think of it as a funnel. At the widest part are the BBB bonds. As the funnel narrows into the BB and BB- bonds, you want to own a few fewer per position. And by the time you get to the narrowest part – the B rated picks, which usually pay much higher returns – you should be owning as few as one or two per position, if any at all.

If you’re the type who can’t stand price fluctuations, or if you can’t afford to take any losses, stay with the BB bonds and above.

Don’t let a big MEAR or yield to maturity lure you into an area outside your comfort zone. The extra yield isn’t worth the stress a dip in the market can create.

Of course, this is all relative to how much money you have to work with. The bigger the amount you have to invest, the more you can own per position. Just never get overloaded on one bond.

This brings up the idea of how to buy one-bond and two-bond positions.

It’s rare for there to not be sellers offering one- and two-bond lots. It does happen occasionally, but not very often. The reason brokers say otherwise is that there’s so little commission in bonds that it’s not worth it to them.

The easiest way to fix this is to use one of the brokers I list, or one of the bigger houses such as Vanguard or TD Ameritrade, which both get good marks from subscribers.

By the way, I don’t receive any compensation for mentioning them. I just do that to help you.

If you use the online format to enter your trades, you may be required to buy at least 10 bonds at a time. So ask to speak to your broker’s corporate bond desk. If small lots are available, you’ll be able to get them there.

Selling a Bond

The last thing I want to go over is selling a bond.

If the price of a bond goes up enough that we exceed the MEAR or yield to maturity by a significant amount, we’ll sell long before maturity and make a whole lot more than expected.

So please remember that if I list the MEAR of a bond, it’s not how much we can make. It’s the minimum we can expect if all we do is wait for maturity.

This way, you’ll know the exact minimum you’ll earn, along with when you’ll receive your interest and $1,000 in principal per bond.

That’s it for Part 2. See you in the next installment.

← Part 1 – Bond Basics