President Perceptive Business Solutions Inc.
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Why Is Buying Bonds So Confusing for Investors?

Many clients want to buy bonds, but doing so can be confusing. Here's what you can tell them to ensure they make an informed purchase.

Dec 2nd 2019
President Perceptive Business Solutions Inc.
Columnist
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Expanding to include financial advising services
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Some things just aren’t simple. In a recent article, “What Accounting Professionals Should Know About Bonds," I covered the basics on advising clients with extra cash who are seeking income. A reader wrote in, bringing up one of the points that make buying fixed income instruments confusing for ordinary investors. As an objective accounting professional, you can help them.

When clients buy bank certificates of deposit, they invest a certain sum, expecting to get back the exact same amount at maturity, collecting interest payments along the way. A simple example is a $ 1,000 CD paying interest every six months, then returning $1,000 at maturity.

Most bonds are issued with a face value of $1,000. They mature at the same amount. However, most bonds are trading in the secondary market when retail investors buy them. Think used cars: They’ve had a previous owner. These aren’t listed securities in most cases. Firms maintain an inventory.

Bonds are marked to market to reflect changes in interest rates. A bond with a high coupon (rate of interest it pays on $1,000), trading in a low interest rate environment, is usually trading at a premium, or an amount over the $1,000 face value. A bond with a low coupon, in a high interest rate environment, trades at a discount.

This leads to the concept of yield to maturity. The interest from the “coupon” is enhanced or reduced by the discount or premium to the face value. This brings the bond in line with the rate new issues would be expected to pay.

This is important because clients might see a high coupon, get excited and buy the bond, not realizing they bought at a premium to par value and won’t be getting back the same amount as they invested.

This becomes an issue when the client is buying municipal bonds. The interest might be tax free, but the premium or discount is a taxable event.

If interest rates fall, homeowners refinance their mortgages. Cities want to do the same with their outstanding bonds. US Treasury bonds are non-callable. Most municipal bonds can be paid off early. Bond holders usually want call protection, so they know they are collecting interest for at least several years.  A 30-year bond might have 10-year call protection from the date of issue. This means it can’t be paid off early. The call price is often at a premium, perhaps $1,020 per $1,000 invested.

It’s pretty obvious some bonds with high coupons will be refinanced and paid off at the first moment it’s permitted. To reflect this in the current market pricing, the bond is priced at its “Yield to Call,” indicating it’s not a long-term bond. 

Some bonds, like US Treasuries, payoff at maturity. Others have a sinking fund, or a provision where a certain amount of bonds are paid off at periodic intervals. The bondholders aren’t specified, it’s similar to a lottery. Gradually over time, there fewer and fewer of these bonds outstanding. The buyer might have expected to hold it for 30 years, yet they run the risk of being cashed out early.

This value can be mathematically calculated, giving the “average life” of a bond issue. It’s also called the weighted average maturity or the weighted average life. This is a major concern with mortgage-backed bonds, because people refinance their mortgages or pay them off if they sell their house.

As a hypothetical example, if a four-year bond has a provision to pay 40 percent of the issued amount off in the first year, 30 percent in the second year, 20 percent in the third year and 10 percent in the fourth year, the average life is two years. This makes sense when you see only 30 percent of the outstanding bonds are still around in year three and 10 percent in year four. This need to be calculated and explained by a professional.

Fixed income can be very confusing. It's why bond buyers need professional advice.

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