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Bonds 101

23K views 70 replies 16 participants last post by  jesseetrent 
#1 ·
Bonds 101

This thread is for educational purposes only and will have no securities offered for sale. It will teach you about investing in bonds. The bond market does not receive the attention of the average investor that the stock market does. We don't have Jim Cramer and the rest of the media with all of their bells and whistles to get peoples' attention. The bond market is much larger than the stock market and should be a part of your arsenal of investment knowledge. There are great opportunities to make substantial returns in both markets and the bond market was brought to the retail investor about 20 years ago. Before then it was more of an investment tool for institutions and the ultra wealthy. There were very few middle and upper middle class individuals who owned bonds and the numbers of them that own bonds today is much lower than it should be due to simple lack of knowledge and media coverage. I believe it's so important that people learn about bonds because they have a date in the future when the issuer has a contract to return the investor's money (make sure you know about credit ratings. I'll post something later in the week). I will try to have an individual bond topic to discuss several times a week, but we'll try to stick to simple bonds. If you have any questions about bonds and fixed income please feel free to ask them here and make sure you speak with your financial advisor before you invest.

What are bonds?

A bond is a debt security, somewhat like a loan that is divided up into $1000 increments and sold to investors. When you buy a bond you are, in essence, lending money to the entity that issued the bonds. Bond issuers can be corporations, national governments, municipalities, government agencies or any other entity wishing to raise capital for operations or improvements. When you buy bonds the issuer is obligated to pay you a specific rate of interest and repay the face value (principal) when it "matures", or comes due.



There are many types of bonds to choose from: U.S. government securities, municipal bonds, corporate bonds, mortgage backed bonds, casino bonds, and many other types. Many mortgage backed bonds pay principal and interest on a monthly basis. You can receive a very strong degree of protection from the sub-prime crash by investing in mortgage backed bonds that are guaranteed by the federal government or a federal agency who guarantee on time payment of principal and interest. Beware, there are AAA rated mortgage backed bonds that are not backed by the government or a government agency that are dangerous.


Important features to consider when investing in bonds.

There are many things that an investor needs to consider before they invest in bonds: credit quality, interest rate, maturity, price, yield, call dates, and tax status. You need to use these factors to decide if a bond agrees with your financial objectives. If you're looking to buy a boat in 5 years and want to put your money to work until you're ready to visit the boat dealer, a bond with a maturity of greater than 5 years would not be consistent with your goals. If you can't afford to lose any money a bond with a high yield and low credit rating is probably not for you due to frisk of default. If you have $1 million saved for your retirement and need $50,000 a year to live happily then a bond that pays less than 5% interest is not the bond that fits your needs. These are just a few examples of how we judge whether an investment is suitable for us. There are many other considerations that you need to discuss with your financial advisor before investing in bonds. I'll post these considerations within the next week or so.
 
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#27 ·
What happened to our credit ratings agencies?

Although I am a staunch supporter of free market capitalism, there is one thing that I think should be taken over by the government. That would be our ratings agencies, S & P, Moody's, and Fitch. Unfortunately, these three credit ratings agencies are private for profit companies that have to answer to shareholders and were willing to bend the rules to look good.

What happened is that an issuer of sub prime bonds would go to a ratings agency, who charges a heavy fee to give a bond issue a rating, and they would say, "We have a group of mortgages that we want to pool into a bond issue and we will have it insured by AMBAC, FGIC or one of the other bond insurance companies. Can you give us an AAA rating on the bond issue?" If the rating agency would say yes the issuer would then say, "What if we add these other mortgages of a lesser credit score into that same pool of mortgages. Can we still get an AAA rating on the bonds this mortgage pool is going to back?" The rating agency would say something along the lines of, "Well your insurer has a strong credit rating and yes we can still give you an AAA rating." This would go on with the issuer putting lower and lower credit quality mortgages into the pool until the ratings agency would say that they could no longer give them an AAA credit rating. The issuer would then say I'm going to go across the street to the other ratings agency to see if they'll give me the AAA rating I'm looking for.

This caused competition for business between the ratings agencies. The ratings agency that was willing to give the AAA credit rating to the crappiest pool of mortgages was going to get the business and make the hefty fee income. This led to some extreme misleading of investors when it came to the actual credit quality of the bonds that they were investing in. I believe that if the ratings agencies were non-profit and government operated, this would no longer be a problem.
 
#29 ·
I'm not really a big fan of TIPS anymore. In the past TIPS had a floor as to how low the interest payment could go. The floor on interest paid by TIPS has been removed and they are currently yielding 0 or close to it. We are in a time of deflation. TIPS have an interest rate that floats up and down with inflation. If inflation is high they will give you a higher return, if inflation is low they will give a low return.

People think that we are going to have mass inflation in 2 years, and I don't think that's the case. I think the big inflation is more like 5 years out. What we have to remember is that we are going through a period of deflation and deflation is continuing to rise. Home prices have not yet stopped falling. If you have a homeowner in California, Florida, or another hard hit state, whose $400,000 house is now worth $250,000, that home price has to get back to $400,000 before we see inflation. Currently that home price is still falling and we can't see inflation while home prices are still falling.

If you really want to invest in TIPS, keep your money in short or liquid investments until that time and when we see home prices get back near where they were in 2006/07 then buy your TIPS.

Here's a great link about TIPS

http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips.htm

This is probably the cheapest place to buy them when you're ready.
 
#31 ·
I was taking that into account when I made the "inflation in 5 years statement". I still believe that you can't have inflation until we're done with deflation. When home prices bottom out and start to go back up we can start looking for it. It may come earlier, but 5 years out is my guess.
 
#32 ·
Predictions for '09 (for informational purposes only)

1. Several major hedge funds and insurance companies will go belly up

2. Short term interest rates will hit 1/2 to 0%

3. Long term rates will be between 1.5 and 3%

4. 30yr Mortgage rates will hit 4 to 4.5%

5. Housing will bottom Q3 '09

6. Gold will top $1100 per oz.

7. Unemployment will hit 8.5%

8. Mark to market will no longer be a driving factor in losses

9. Northern and Western U.S. + Florida municipalities will begin to meltdown

I guess we'll see how this comes out a year from now.
 
#33 · (Edited)
The mother of all bonds

This is a bond that we went over about 5 months ago on this thread that adjusts inversely 25% for every 1% that the Fed moves interest rates. If you look at the bond in the first post it is paying the investor 66% interest ( interest paid to the investor is near the upper right corner of the bond page link) on an AAA rated government agency bond. (Click here to see this bond in August) Now that the Fed has cut interest rates even further the bond is paying over 100% interest to the investor. (Click here to see this bond at it's current 105% interest rate) This bond is not offered for sale. I placed this bond in 2006 when it was paying 0% to the investor. At that time investors paid 100 cents on the dollar for outstanding principal on the bond. The current IDC value on the bond is now close to 200 cents on the dollar. The coupon will go down again when the Fed raises interest rates but I don't think that's going to happen for at least a couple of years. I think its easier to predict where the Fed is headed than it is to predict stock prices. After an investor has made close to 200% on their initial investment I don't think they care if the bond is performing or not once the Federal Reserve raises interest rates. There are a lot of nuances to the bond that are explained if you click (here) and look under "The possibility of high yields with AAA rated Bonds". If you're money is invested for the long term and you don't plan on selling the investment these nuances are of little importance. What is important is the fact that it is possible to make very nice returns with bonds. I know there are a lot of die hard stock investors here. Folks, people don't buy drill bits because they like to collect drill bits; people buy them because they need a hole. People don't buy stocks because they like to collect stocks; they buy them because they want to make money. Right now stocks are not making money and I don't expect them to perform for quite some time. I'm not here to bash the stock market, but it may be a good time to consult with your advisor about bonds.
 
#34 ·
The consumer spending bubble (1995 - 2008)

There is one bubble out there that they don't really discuss on the news. This bubble, which just burst, may have the biggest negative effect on the market of them all. First we saw the tech bubble burst, and it took the DOW 7 years to recover from the tech bubble. The NASDAQ has never recovered from it. Then we had the housing and commodities bubbles. The most serious bubble of them all will probably be the consumer spending bubble. During the consumer spending bubble, much of the money that was spent with DOW companies was borrowed money. Borrowed money to will not be so easy to come by in the future. From the late 90's until just a few months ago it was so easy for a person to obtain credit that almost anyone could do it. Now lenders realize that it was a huge mistake to lend money to many of the people that borrowed from them. American Express, whose card holders are viewed as having stronger credit than those of the other card companies, has reported a rise in delinquencies and a decrease in borrowing. They have reported that they will take a $440 million dollar charge against their fourth quarter earnings and their stock value has fallen over 50% since September.

This spending that brought us to such high levels in the stock market will not happen again any time soon if the financial companies that lend us money do their jobs and lend money only to those who can pay it back. During the consumer spending bubble we saw people that could not afford homes, who bought them anyway just because they could borrow the money. Along with those homes came the purchase of furniture and all kinds of goods to put in the house. Oh yeah, we can't forget the overpriced luxury auto that went in the garage. All of this personal spending contributed in a huge way to the stock markets reaching astronomical levels. The days of spending more than we can afford on credit will never come again if lenders do the right thing and keep an eye on who they are lending to. If times like the consumer spending bubble come again, then times like the current one will happen again too.
 
#36 ·
So how do we make money off of a collapse in the consumer credit market?
I think the time to short the banks and credit card companies has come and gone. The stock market is just too volitile to pull the trigger on anything right now. There was a money manager in California who found a way to short subprime loans and made over 1200%. Since it's not really my cup of tea, I didn't look for a way to profit from it.
 
#37 ·
Bond of the day

Click here to see the bond of the day

This bond will pay investors 18.53% interest and is issued by Fannie Mae which is currently backed by the U.S. government. It holds about the same credit quality as a treasury bond. Why does it give us 18.53% interest if a 30 yr treasury bond is paying less than 4%? Like we discussed earlier in this thread there are risks we can take other than the risk of losing our money. If an investor holds this bond to maturity they will get all of their money back. So, what's the risk we're taking to get paid 18.53% interest? This bond floats opposite short term interest rates. For every 1% short term interest rates move up, this bonds interest will go down by 3.33%. What are the chances of the Fed raising short term interest rates any time soon? Slim to none. If they raised interest rates in the near future they would damage the economy more than it already is.

This bond pays principal and interest every month. It is backed by non sub-prime mortgages that have guaranteed on time payment of principal and interest by Fannie Mae. If a Mortgage holder is late on their monthly payment Fannie will pay that principal and interest on time, every month. If a mortgage holder defaults on their mortgage the bondholder will receive all outstanding principal for that portion of the bond and their last interest payment.

This bond is backed by hundreds of 30yr mortgages. Why would we buy a bond that will come to maturity in 30 years? If this bond was going to pay me 18.53% interest for 30 years that would be great. I'd buy it and make high interest on an AAA rated bond every year for 30 years, but it won't always pay 18.53% interest. The truth of the matter is that most of this type of bonds will last 7-12 years and the investor will have all of their money back. The average American family lives in a home for 7 years. Once a home is sold the investor in the bond that holds that particular mortgage gets their pro-rata portion of the principal paid back to them. If a home is destroyed, defaulted on or refinanced, that causes the bond holder to be repaid that portion of the principal. Therefore, this type of bond is usually much shorter than its stated final maturity. With the government trying to get a 4% mortgage rate for American homeowners a huge refinancing wave is possible. This would cause this type of bond to pay off (come to maturity) very quickly, possibly before the Fed raises rates. The worst case scenario would be for short term interest rates to go through the roof and the bonds interest paid to the investor would go to 0%. Even in the worst case scenario the investor gets all of their money back at maturity. The best case scenario is for the bond to pay off before rates go up. If the government gets these 4% mortgages through to the american homeowner, this bond will probably pay down very quickly. I'd rather risk interest payments than risk my initial investment in the current rough stock market. No one can say that an 18.53% return is a bad one in this market.
 
#38 ·
When is the inflation coming?

We are still way underwater in the real estate markets and I don't see any let up coming until the third quarter of this year, if then. As we all know the largest durable goods market in the world is still the United States housing market. If prices in this market don't find their bottom the economy is going to have a very difficult time finding its bottom. Banks don't want to give long term loans on depreciating assets (homes) and the lack of lending is causing a drop in employment. At this point we can buy goods (houses) in the world's largest market with less money than we were able to buy them with a year ago, hence deflation. I still don't think we will see inflation in the dollar for quite some time to come. When inflation time comes 5 to 7 years in the future, will quantitative easing help us? It's hard to say. We know the American consumer needs to save more than they were over the last decade. Printing more money will be of no help if that money is not lent out and spent by consumers. At current, the money is just staying with the banks. The first phase of the quantitative easing can't even come to fruition. The government has printed billions and the banks can't lend it out. I've talked to several bankers over the last couple of months and they say loan demand just isn't there. People don't want to borrow because they are unsure about their jobs, and the banks don't want to lend because they are unsure of the borrowers ability to pay the money back. This whole mess is a circle of stupidity that is difficult to break.
 
#40 ·
LIBOR is set by 16 of the worlds biggest banks that opperate in Europe, BOA, Citi, Wells, Santander, HSBC, etc.... They all do business here too. All the govt has to do is get them all in a room and say "Hey!! we have over $50 trillion in adjustable debt tied to LIBOR in the U.S., knock it off." That's what happened the last time it started to float away from fed funds.
 
#41 ·
Did high leverage really cause problems with the market?

There are not a whole lot of bonds out there today. So I guess, to fight off some of the office boredom, I'll write the next segment of bonds 101and share my boredom with all of you who read along.

If we take a look at how CDO's and Asset backed securities were leveraged, we really don't need to look to deep to find out that no matter how little leveraging was used, the problem would have still existed. If these people would have leveraged high credit quality mortgages it would have worked out like a dream. They would have been making more money on a deal that was still paying them.

We need to take a look at how some of these deals were engineered to see that no mater how much leverage was used, the deal would have fallen apart even without leverage. Let's say we have mortgage pool of $100 million in sub prime mortgages that were divided up as follows.


Senior: $ 80 million paying investors 5.45%

Mezzanine: $ 12 million Paying investors 6.00%

Subordinate: $ 4 Million paying investors 8.00%

Equity: $ 4 Million


With $4 million in equity we can consider this being leveraged 25X. The way this works is that all of the principal and interest paid by mortgage holders are lumped into the same group and paid to investors every month. The holders of the senior traunch will receive the principal paid by all traunches until they get the $80 million principal investment back. The Mezzanine and Subordinate traunches will receive interest only after the senior traunch is paid off. Then the mezzanine and subordinate traunches will receive principal respectively.

We have 4 million that we are allowed to leverage to the total amount of principal which will give us 25 X leverage on the deal. At current time the defaults on this type of sub-prime mortgages have been so great that the principal of the senior traunches of this CDO is now diminished to about 3 cents on the dollar. It doesn't matter how much we have leveraged anything here. If you leverage sub-prime mortgages you will have the same outcome that you would if you didn't leverage them. The underlying assets are worthless or worth very little. If you have assets worth $0.00 you get the same outcome if you leverage $0.00 X 25.

 
#42 ·
An interesting little tid-bit.

"Goldman Sachs reported a profit of $1.8 billion in the first quarter, and plans to sell $5 billion in stock and get out of the government's clutches, if it can.
How did it do that? One way was to hide a lot of losses in not-so-plain sight.
Goldman's 2008 fiscal year ended Nov. 30. This year the company is switching to a calendar year. The leaves December as an orphan month, one that will be largely ignored. In Goldman's earnings statement, and in most of the news reports, the quarter ended March 31 is compared to the quarter last year that ended in February.
The orphan month featured - surprise - lots of write-offs. The pretax loss was $1.3 billion, and the after-tax loss was $780 million."
http://norris.blogs.nytimes.com/2009/04/14/the-case-of-the-missing-month/
 
#43 ·
Nobody talks about that black hole on TV or how bad the fundamentals are right now. All they want people to believe is that the good times have returned and Investing market has arrived again. They are recreating the same storm they did all through the 08 time period. No cynicism on the TV except for some of the better market analysis (not shieff) gurus they let talk from time to time. I heard no less than 20 times that you are missing the bottom and you better get back in if you want to make money. Maybe after the big boys take the money again the self proclaimed investment gurus will understand the subtle differences between an investment market and a traders market. I doubt it tho. Thanks for posting that Bond.
 
#44 ·
Are your corporate bonds still safe investments?

During this mess we've noticed that most of the AAA issuers of corporate paper have been downgraded and there are now very few left. Corporate paper has recently attracted a slew of new bond investors that have been lured in by attractive returns paid to bondholders. Even though the percentage of defaults has gone up the extra yield seemed like it was worth the risk to many of us.

I've always been a government bond guy, and had thought about using short, high credit quality corporate bonds until now. We have a new peril to worry about with what is now becoming widespread use of the Collateralized Loan Obligation (CLO). A CLO is a vehicle that is used to pool corporate loans together and sell them to investors as securities. Now a lending institution can lend $100 million dollars to a corporation without breaking the bank. They will just package the loan into a CLO and sell it to investors. After the CLO is sold to the investor they have their $100 million back in the vault and ready to lend out again.

The CLO gives corporations a cheaper way to borrow money. In days past, when corporations wanted to borrow money they would issue bonds. It was much simpler than going to a bank for a loan of any magnitude. In the past, loans to a corporation usually made up a very small portion of their debt.

We need to remember the order in which a corporation's liabilities are paid off in the event of a bankruptcy.

1.) Employees
2.) Creditors
3.) Senior Debt holders ( bond holders )
4.) Preferred Stock Holders
5.) Common Stock Holders

CLOs have given corporations the ability to now take on more debt from creditors and less debt from bond investors. What the CLO has done to corporate bond holders is pushed them down the ladder in the event of bankruptcy. If a corporation has more debt to creditors that will leave less money to pay senior debt holders when there is a bankruptcy liquidation of assets. Companies that are not heavily in debt to creditors could become heavily indebted to creditors at any time in the future. Just because we bought bonds before the advent of the CLO does not mean that we are grandfathered in. It's almost like corporate bonds are no longer senior debt.
 
#45 ·
originally posted by: OffShore Man


Nobody talks about that black hole on TV or how bad the fundamentals are right now. All they want people to believe is that the good times have returned and Investing market has arrived again. They are recreating the same storm they did all through the 08 time period. No cynicism on the TV except for some of the better market analysis (not shieff) gurus they let talk from time to time. I heard no less than 20 times that you are missing the bottom and you better get back in if you want to make money. Maybe after the big boys take the money again the self proclaimed investment gurus will understand the subtle differences between an investment market and a traders market. I doubt it tho. Thanks for posting that Bond.
You're right about that. Before the late 60's the news media was not responsible for its ratings. It was just a bunch of reporters that would report on what they thought was important to the public for 30 commercial free minutes each night on the national networks. After '68 I believe, they were held responsible for their ratings and began to report on what they thought would attract the most viewers, so they could sell their advertising time for more money. This continues on a larger and dumber scale today. Now the talking heads are saying that we may be headed for a "jobless recovery". As far as I'm concerned, there is no such thing as a jobless recovery. I'm sure the jobless would agree.

The truth of the matter is, they spend all of their time giving hype to the stock market because it's full of drama and it attracts viewers. Yes, people can make money there, but the truth of the matter is, it's no longer a true place of wealth creation. Don't get caught holding the bag. If you're out before everyone else, you make money, if not, you lose money. With PE ratios where they are, there is no wealth being created. It's just one investor taking another investors money. Thanks media people, but I'd prefer to stay out of that mess. Sorry, my money and drama don't mix. If I want drama I can buy tickets to the movies. They never report on some of the new scary politics, and they never report on the bond market which is exponentially larger and more important to our way of life than the stock market. I guess they'll just keep on reporting about what Britney Spears is wearing while we're kept in the dark about what's important for our well being. I guess we can now use the famous mushroom analogy. Most of the mainstream media watching public is truly in the dark.
 
#47 ·
Off the wires yesterday. Look at those green shoots.LOL

FANNIE MAE REPORTS FIRST-QUARTER 2009 RESULTS
*FANNIE MAE SAYS LIQUIDITION PREFERENCE TO RISE TO $35.2B
*FANNIE DOESN'T SEE OPERATING 'PROFITABLY' IN FORESEEABLE FUTURE <------
*FANNIE MAE SAYS LIQUIDITION PREFERENCE OF PFD ROSE TO $16.2B
*FANNIE MAE PROVISION OVER NET CHARGE OFFS OF $3.4B BY $17B
*FANNIE CAN'T ENTER NEW COMP PACTS W/OUT FHFA, TREASURY CONSENT
*FANNIE MAE SEES LOSSES CONTINUING :FNM US
*FANNIE SEES CREDIT LOSS RATIO IN 2009 OVER 2008 :FNM US
*FANNIE SEES CREDIT LOSSES IN 2009 OVER 2008 LEVEL :FNM US
*FANNIE MAE RECEIVED $15.2B UNDER TERMS OF SR PFD PURCHASE PACT
*FANNIE MAE 1Q PROVISION FOR CREDIT LOSSES $20.3B :FNM US
*FANNIE MAE SEES CREDIT LOSSES IN 2009 EXCEEDING '08 :FNM US
*FANNIE MAE RECEIVED $15.2B FROM TREASURY MARCH 31 :FNM US
*FANNIE SEES HOME PRICES DOWN 7-12% ON NATL BASIS IN 2009
*FANNIE MAE SAYS FHFA SUBMITTED REQUEST FOR $19B FROM TREASURY
*FANNIE SEES INDEBTNESS $210.7B OUR REVISED DEBT LIMIT :FNM US
*FANNIE SEES MULTIFAMILY DEFAULTS, LOSS SEVERITIES UP IN 2009
*FANNIE LEVEL 3 RECURRING ASSETS $52.2B :FNM US
*FANNIE NOT REQUIRED TO SUBMIT HOUSING PLAN FOR NOT MEETING GOAL
*FANNIE 2009 PROPOSED GOAL LOW-MODERATE INCOME HOUSING 51%
*FANNIE SAYS SHORT-TERM DEBT HAD BEEN 38% OF TOTAL DEC. 31
*FANNIE SAYS SHORT-TERM DEBT REDUCED TO 32% OF TOTAL OUTSTANDING
*FANNIE MAE SAYS RISE TO $35.2B TO ELIMINATE 1Q NETWORTH DEFICIT
*FANNIE SAYS FHFA PROPOSED RULE LOWERING 2009 HOUSING GOALS
*FANNIE MAE 1Q INCL $623M BENEFIT FOR FEDERAL INCOME TAXES
Fannie Mae First-Quarter Loss Per Share $4.09 (Correct)
 
#52 ·
I don't want to dilute your thread with stock stuff, bond. You got a lot very useful and important info on this thread. People need to take a look at what you are doing with your clients, if they want to have a half decent retirement. Especially those of us in our forty's. But I do enjoy BS's with ya and always learn something useful for trading.LOL whether that was your intention or not.
 
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