E-Bonds: An Introduction to the Online Bond Market

E-BONDS

An Introduction to the Online Bond Market Jake Wengroff

JOHN WILEY & SONS, INC.

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E-BONDS

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E-BONDS

An Introduction to the Online Bond Market Jake Wengroff

JOHN WILEY & SONS, INC.

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Copyright © 2002 by Jake Wengroff. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-7622974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. ISBN: 0-471-21086-2 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1

Contents

1 2 3 4 5 6 7 8

Acknowledgments

vii

The Case for Bonds

1

Bond Basics

5

The E-Bond Industry: Bond Distribution to Individuals 15 Who’s Buying Bonds on the Internet?

37

Bond Psychology: Why Investors Haven’t Taken to Bonds 55 Learn about Bonds 69 Selecting an Online Broker 91 Municipal Bond Overview v

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Contents

9 10 11 12

Buy Munis and Treasuries Online 107 Bond Mutual Funds Online 117 Scripophily

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Final Thoughts

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Appendix A Bond Funds versus Individual Bonds 139 Appendix B Your Investment Profile 143 Glossary 157 Bibliography 217 Index 219

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Acknowledgments

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wish I could reward the individuals and companies who have helped me complete the research and writing of this book with more than just a brief mention here. A special thanks to CFO magazine editor Marie Leone, with whom I had worked at an ill-fated Internet start-up, who gave me my very first print writing assignment and who also introduced me to Jeanne Glasser, acquisitions editor at John Wiley & Sons in New York. Without Marie’s help and guidance, this book would not have been written, edited, printed, bound, and distributed to readers. Special thanks to the analysts who provided a wealth of industry data: Andy Nybo of TowerGroup, Dan Burke of Gomez Advisors, Todd Eyler of Forrester Research, Shaw Lively of IDC, David Furlonger of Gartner, Ravi Bhojwani of Datamonitor, Justin Hughes of Robertson Stephens, and Rich Repetto of Putnam Lovell Securities. Thanks to John Collins of the Investment Company Institute and Don Cassidy of Lipper for substantial mutual fund industry vii

Acknowledgments

information. Thanks to Michael Dorfsman, Michael Decker, and Jon Teall of the Bond Market Association, Bob Kerstein of Scripophily.com, Kristin Aguilera of the Museum of Financial History, Cassandra Bayna and Tim Rogers of Briefing.com, and Marilyn Cohen, author of the Bond Bible. Thanks to the pioneers of the e-bond industry whose passionate words and never-ending enthusiasm helped buoy my excitement in the subject matter: John Ladensack of Charles Schwab, John Demitroff of Tradeweb, Brad Wendt of BondDesk.com, David Landes of Bondsonline, John Durrett of MuniDirect.com, and John Pigott of ValuBond. And thanks to countless unnamed others who have stood by and watched me complete my first book, offering encouragement and support throughout the many months of the book’s creation. My biggest supporters have always been my parents, Richard and Sheila Wengroff, and my brother, Sean. And thank you, Gordon, for being there when I needed you.

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1

The Case for Bonds

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he mere mention of the word “bonds” elicits either a groan or confusion. Why does the financial instrument credited for building the U.S. government, the country’s cities and municipalities, airports, highways, and bridges, and major global corporations cause such a negative response? The most likely answer is that bonds are not as glamorous as other types of investing, and have an image of being “old school”: dull, stodgy, and way too complicated. This book is intended to help you understand more about the goings-on in the fixed-income marketplace, with a special emphasis on information and transactions carried out online. It will

Most brokers tell investors that bonds are too difficult to understand—and that they must rely on their expert wisdom in order to properly invest in them. This way of thinking is on the way out. —John Pigott, CEO, ValuBond

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review bond basics, as well as cover some important milestones in the e-bond industry as this sector continues to evolve and offer untold opportunities for the individual investor.

Why Bonds? It is important to remember that bonds are not a replacement for stocks—they are a separate asset class with unique characteristics that provide a level of risk and return complementary to that of stocks and other securities. The advantages of bonds over stocks is that they provide a predictable stream of income, while the return from stocks in the short or medium term can be low or fluctuate wildly. Bonds are also good for meeting large, anticipated long-term expenses such as education, real estate, and retirement. Many of the fixedincome instruments available are marketed to individuals precisely for this type of investment goal—long-term government bonds, or T-bonds, for example. The predictive nature of bonds, therefore, makes them an attractive investment.

How Much Should I Invest in Bonds? Any advisor will tell you that a portfolio should be allocated to bonds based on three characteristics: • Age • Risk tolerance • Time horizon until the funds are needed (usually a life event, like retirement or college-bound children) 2

The Case for Bonds

The “E-Z” method of allocating bonds has always been this: The older you are, the higher your allocation should be. The thinking is that risk is presumably reduced as bonds are added to the portfolio as one ages. This isn’t a bad rule of thumb, but investing should never follow a cookie-cutter method. To avoid this pitfall, you can use the Internet to learn as much as you can about different portfolio strategies and asset allocation. The chapters that follow will identify web sites for the online brokerages that generally offer exhaustive asset allocation information. But caveat emptor: They present this information because they want to move you into a sale. In this book you will see how all of the information you need to make informed decisions is not available solely via the sites of the brokerage firms. Click around to a number of sites for the best uncompromised information available.

The Real World Any investment carries risks, no matter how safe and secure the investor thinks it is. Even municipal bonds, long called “widow and orphan investments,” can be risky—consider the case of Orange County, California’s bailout in 1995—tossing aside the idea that an investment in bonds equals an investment in safety. I feel that the biggest investment risks lie with the investor who is misinformed, who willfully places all of his or her faith and trust into the hands of others, without bothering to learn at least a tiny bit of how the money is being invested. We are all busy in our daily lives trying to work for our money in the first place—shouldn’t we take a little time to learn about how our money is working for us? 3

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Enter the Internet Thanks to the World Wide Web, we can check movie times, prices on DVD players, and list prices of used cars. We can verify zip codes, check the weather, and buy airline tickets. We can comparison shop quickly and efficiently with a few clicks of the mouse. Shouldn’t we be able to do the same for bonds and other securities? The answer is yes, and although the information may seem insurmountable at first, one has to start somewhere. After reading this book, you will better prepared for direct investing in bonds on the Internet.

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Bond Basics

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his chapter provides readers with a quick refresher course in bonds and a review of basic bond types. Simply put, a bond is nothing more than an IOU. In place of the piece of paper where the IOU is written, bonds carry an indenture, which is a legally binding document that lays out the terms and conditions of the loan. The principal is the amount of money that you lend to the issuer of the bond; most of the time, this principal is set at a relatively simple $1,000 so that institutions can more easily market an issue (it makes it easier for us individual investors, too!). Also included in the indenture is the coupon, which is the stated interest rate that the borrower promises to pay you. To make things easier, many bond investors think of coupons as the annual rate of interest expressed as a percentage of the face value of the bond. This rate is fixed when the bond is first issued (although there are some bonds with floating coupons); most issuers make semiannual payments based on this fixed rate. 5

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The level of coupon represents the cost of money, which is the interest rate level that a debt issuer must offer investors to borrow their money. Perhaps the most impactful lesson here is that the cost of money changes depending on what is happening in the real world. When money is tight (or “expensive”), interest rates are high and issuers are forced to pay this unattractive rate. However, on the other hand, if there is a lot of money circulating within the system and banks are flush with cash that they are willing to lend out, then interest rates are low and issuers can borrow money “cheaply” at this favorable rate. The indenture also lays out how long the loan will last. The length of time before the bond expires is called the maturity. When the bond expires, whether it’s after 10, 15, or 20 years, the borrower must pay back the principal. If you bought a bond with a face value of $1,000, then you would expect to receive $1,000 when the bond expires. Maturities of fixed-income securities can be anywhere from under a year to 100 years. Longer-term bonds are generally most attractive to pension funds and state lotteries, which often acquire such bonds for their relative stability.

Yield The yield of a bond is the rate of return that you will receive from investing in the bond. The simplest measurement of yield is the coupon yield, which is just the same level as the coupon. For example, if you bought a bond with a coupon of 5.80 percent, then the coupon yield would be 5.80 percent. This gets more complicated because after a bond is issued it is usually traded in the secondary market, where a buyer and seller 6

Bond Basics

agree to a transaction based on the principal of the bond. If a bond trades at a premium, then it is being sold at a price higher than at its original issue; if a bond trades at a discount, then it is being sold at a lower price. It is important to point out that most individual investors do not trade bonds on the secondary market as do institutions— the general strategy is to buy and hold to maturity. However, some knowledge of how bonds are traded in the general marketplace can give a clearer understanding of fixed-income products in general.

Risks Bond prices fluctuate in the secondary market due to two types of risk: interest rate risk, and credit risk. Either of these risks will positively or negatively impact the price of a bond in the secondary market. The simplest way to remember the relationship between bond prices and interest rate risk is that the two behave in opposite ways: When interest rates go down, bond prices move up; when interest rates go up, bond prices move down. To repeat, since so many investors are completely unaware of this most basic bond relationship: When interest rates go down, bond prices move up; when interest rates go up, bond prices move down. Perhaps this makes no economic sense, but here is an example that will make things clearer. Suppose you buy a bond with a $1,000 face value, with a 10-year maturity, and it pays you interest of 5 percent per year. In three years’ time, interest rates have risen, and the same bond issuer (or another issuer with the same creditworthiness) is now issuing bonds with an 8 percent 7

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coupon. If you wanted to sell your bond, you would quickly realize that the 5 percent interest you’ve been receiving isn’t as attractive to a buyer as that of the bond issued with 8 percent. So you would have to sell your bond position for less than $1,000, at a price that would mathematically work out to the same yield. Therefore, when the interest rate rose, the price of the bond sank. Again, most individual investors don’t worry about wild gyrations in interest rates because they generally buy bonds and hold them to maturity. By buying shorter-term bonds, individuals can have the opportunity to move in and out of securities with interest rates they feel are favorable. Many individual investors have adopted this strategy to protect them from interest rate risk. The state of the economy affects interest rates. In basic terms, if the economy is strong and headed toward an inflationary environment (higher prices), the Federal Reserve will raise interest rates to cool the economy down. When the economy is sluggish, the Federal Reserve will lower interest rates in order to encourage borrowing and spending. The Federal Reserve is key to the bond market because it sets targets for interest rates. The longer the maturity of the bond, the more interest it will pay. This is because the issuer is holding your money for a longer period of time, and so they must compensate you for your willingness to assume more risk. The risks you are facing by buying a longer-term bond include interest rate fluctuations (you might get a more favorable rate with another security with a short-term maturity during the time you are holding the longer-term bond) as well as credit risk (when something bad happens to the issuer, such as bankruptcy, legal proceedings, business interruptions, or the like). Credit risk is better defined

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as the risk that you won’t receive the bond’s coupon payments and principal in full and on time. To assess credit risk, individual investors are made aware of the issuer’s creditworthiness by agencies such as Standard & Poor’s, Moody’s, Fitch, and other bond-rating firms. Often, to make an issue more attractive, an issuer—usually a company or a municipality—will seek the stellar reputation of an underwriter (Salomon Smith Barney, Merrill Lynch, etc.) and now, as additional strength, will include a layer of insurance in the deal—all to reassure investors that credit risk is minimal. Some issuers are more creditworthy than others. When a bond issue’s price is high and the yield is low, it usually means that the company or municipality has no risk of default. U.S. Treasury securities are priced very high and have a low yield precisely because of the reputation of their issuer: the U.S. government. The total return of a bond investment includes the coupon coupled with the gains or losses in the bond’s price; a more accurate measure of determining the yield on a bond investment is the yield-to-maturity.

Yield-to-Maturity The simplest yield measurement is the coupon yield, which is set when the bond is first issued. However, this assumes that the price of the bond remains at the original price you bought it, and does not take into account fluctuations in the price of the bond in the secondary market. Because the price of a bond will change depending on the level of interest rates, you must take into ac-

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count whether a bond is trading above par (at a premium) or at less than par (at a discount). The current yield takes into account the coupon and bond’s price and is calculated by taking the coupon and dividing that by the market price of the bond. Though widely quoted in newspapers and by brokers, it is relatively useless since it ignores the interest you receive on your coupon payments. Also, how do you calculate the return when you reinvest your semiannual coupon payments? The yield measurement that factors in all the possible income and losses from a bond during its lifetime is called the yield to maturity (YTM). The YTM measures the total amount of money you will earn from a bond investment assuming you hold it to maturity. It includes: • The interest payments • The interest gained by reinvesting the coupon payments in an investment with a similar rate of return • The amount of money earned or lost by the change in the price of the bond from your purchase price Not to worry; most bond calculators available on the Web (and mentioned here in this book) will give you the all-important YTM to use when evaluating different bond investments.

U.S. Treasuries Because U.S. Treasury securities are considered the safest bonds to own and are free from credit risk, all other bonds, whether issued by government agencies, municipalities, or companies, are 10

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priced relative to Treasury securities. The U.S. government is seen as least likely to default on its obligations. Treasury securities are very liquid: There are plenty of buyers and sellers at all times. The U.S. Treasury market is one of the most liquid markets of any security. Treasury securities also carry no call risk, or the possibility that the issuer may buy back the bond issue before maturity (the right to do this is a provision included in the indenture). Treasuries are also subject to taxes at the federal level, but are exempt from state and city taxes. This is another attractive feature of these securities. The safest of the Treasury securities is the T-bill, which carries the shortest maturity: 13, 26, and 52 weeks. Because the time span before redemption is so short, they do not pay interest in the form of a coupon but are sold at a discount to par. There is relatively no credit risk or interest rate risk. Some investors choose an investing strategy whereby they continue replacing Tbills in their portfolio as older ones reach their maturity date. Again, this is one of the safest of all investment strategies. Treasury notes have maturities of between 2 and 10 years. Because of their longer maturities, these notes have more interest rate risk associated with them and so their prices fluctuate more than T-bill prices. The U.S. government used to issue Treasury bonds, which carried maturities of 15, 20, and 30 years. The 30-year Treasury bond was just retired in November 2001. Another Treasury security is a “strip” or zero-coupon Treasury security created by separating the income streams of coupon payments and principal, wherein the holder receives no coupon payments, buys the bond at a discount, and is returned the principal at par. There is a high degree of volatility associated with strips. 11

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Federal Agency Bonds Bonds issued by federal agencies such as Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) are usually thought of as having little or no credit risk and pay only a marginal level of interest above Treasury securities. Fannie Mae and Freddie Mac, contrary to popular belief, are not divisions of the federal government; they operate under federal charter but are not backed by the full faith and credit of the U.S. government. Federal agency bonds enjoy this designation, although investors should be aware that default can occur. Most federal agency paper (as it is called) is callable, meaning that there is call risk to consider in risk calculations. The agencies can and will buy back the debt they have issued and reissue securities under more favorable terms for them.

Municipal Bonds Municipal bonds are bonds issued by states, counties, cities, and other divisions to finance the building and servicing of public facilities, such as airports, hospitals, roads, bridges, tunnels, power plants, and water systems. The bond’s interest is federal and sometimes state tax–free to encourage investment in projects that are felt to be for the greater good. This constant demand for tax-exempt instruments means prices for municipal bonds tend to remain steadier; municipal bonds tend to have more subdued highs and lows than other fixed-income securities. In order to compare a municipal bond’s return with that of other types of fixed-income securities, it is 12

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important to calculate the muni’s taxable equivalent yield— converting the yield of a tax-free bond into the equivalent yield it would have if it were a taxable bond.

Corporate Bonds Corporate bonds, as the name indicates, are issued by corporations. Corporate bond values often track the health of the company that issued them even more than they are affected by movements in interest rates. Investors in corporate bonds often evaluate balance sheets, products, management, competitive environment, and even the company’s stock performance. There are four different corporate market sectors: industrials (cyclicals), airlines/transportation, public utilities, and banking/finance. Maturities fall into four categories: short term (up to 4 years), intermediate term (5–12 years), long term (13–40 years), and “absurd term” (41–100 years). Corporate bonds fall into two broad credit classifications: investment-grade and high-yield (or “junk”) bonds. The largest holders of corporate bonds are institutions; the complexity as well as the fact that corporate bonds are fully taxable at all levels (federal, state, and local) usually makes individual investors shy away.

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3 The E-Bond Industry Bond Distribution to Individuals

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urely you are familiar with the online brokerage industry. During the height of the Internet expansion years of 1996–2000, plenty of investment banks and brokerage firms joined the race. The titans of Wall Street, including the likes of Merrill Lynch and Morgan Stanley, struggled to keep pace with plucky upstarts like E*Trade and Ameritrade. Let’s face it, it was their advertising that caught our attention and tickled our fancy. Suddenly, the characters in the TV commercials weren’t gray-haired advisors or smiling parents with pink-cheeked kids. The people who were using the online brokers were portrayed as truck drivers who could strike it rich and retire on a tropical island, or Generation X–type hipsters— pierced, tattooed, and shaggy-haired—who were now dispensing advice to their parents and bosses. Hand-in-hand with advertising, these online brokers offered incredible deals to ensnare you to get you to start trading. Banner advertisements and pop-up screens begged you to open an 15

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account and offered to pick up the tab for your first trade, or offered other promotions like receiving a $10 coupon at Amazon.com. Some brokers, like HarrisDirect, then known as DLJdirect, even allowed you to open an account with zero money down. The goal, in Internet-speak, was “customer acquisition,” or an attempt to grab market share at the beginning of the game. As part of the larger Internet industry picture, this marketing strategy soon helped bring on the disappearance of a number of firms in the brokerage industry. And let’s not forget the Day Trader. Dozens of books sprouted up in attempts to catch the newest wave and embrace the most promising phenomenon—telling thousands of people to quit their day jobs and do for themselves what they had paid a broker to do for them: Trade stocks all day and make money without having to pay commissions. All you had to do was buy a cable modem or DSL, subscribe to some sophisticated charting and analytical services, perhaps even buy into one of the high-end “proven trading systems,” and voilà—you, too, could become a millionaire overnight. But it wasn’t just the murder of coworkers by disgruntled trader Mark Barton in the Atlanta office of day trading outfit All-Tech Investment Group in July 1999 that began to erode the industry’s success. Day trading had been dying down long before that. Stock prices started to drop as shareholders demanded good old-fashioned profits—which the majority of technology and Internet-related startups clearly could not deliver. Even the bellwether technology and communications companies had trouble showing positive results, as they had overspent and witnessed a mass exodus of both corporate and individual customers. Trading activity—as high as 82.3 million trades in the first quarter of 2000, according to now-defunct Internet indus16

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try magazine The Industry Standard—continued to decline and investors dumped their positions in stocks, already with values below sea level. Well, this story only addresses one investment product— stocks. The stories of doom and gloom with respect to Internet brokerages point to only one culprit: the decline in stock trading. What about other financial products that these online brokers were selling? The online brokerages claimed to be “diversified financial services organizations,” but we all know that their first priority was executing stock trades. When commissions, and thus, revenue, started to vanish, they began to think about other products that they could start to offer the investing public. This, of course, has been the trend all over the Internet industry. Consolidations, layoffs, and bankruptcies all transmit the message that businesses need to change if they are to survive. But, enough about the past events of online brokerage; what can today’s investors hope for when buying bonds?

Size of the Fixed-Income Market As discussed earlier, retail investors play only a small part in the market for U.S. fixed-income securities. Individual investors represent only 6 percent of the $15 trillion debt market; the major customers are institutions, like mutual funds, asset managers, regional banks, pension funds, and other large investors. As such, large brokerage firms, while wanting to sell any product they can, do not view individuals as the big spenders—or the preferred customers. The reason for this is because the typical strategy of an 17

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Stocks are often purchased based on emotion, emergency, and timeliness, all fueled in large part by the financial media—the decision-making process for buying a bond is less-sensitive. —John Ladensack, senior vice president, Charles Schwab

individual investor is to buy a security and hold it until it matures. The strategy of an institution, on the other hand, is to constantly trade out positions in order to achieve a profit. As such, the number of buys and sales generated by individual investors isn’t very much at all compared to that of institutions, and so brokerage firms have never aggressively pursued the small guy. Their thinking was that a small number of trades equals a small number of commissions, which equals a small profit. John Ladensack, senior vice president and head of online fixed-income operations for Charles Schwab Inc., explains that individuals invest in bonds, they don’t trade bonds. “Stocks are often purchased based on emotion, emergency, and timeliness, all fueled in large part by the financial media—the decisionmaking process for buying a bond is less-sensitive,” Ladensack contends. Bonds, on the other hand, are purchased by investors who’ve done their homework, have researched the credit quality and yield, and anticipate a particular return for their investment. Figure 3.1 shows the proportion of fixed-income securities held by individuals. But the figures belie the concept that the individual investor category is not considered a potentially formidable segment in the bond market. For a long time, individuals have been extremely active in the municipal securities market, due to the 18

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Total fixed-income debt market = $15.1 trillion Individuals 6% = $879 billion Municipals = $535 B US Treasury = $138 B All other = $206 B

Institutional 94% = $14.2 trillion

Figure 3.1 Total fixed-income debt market. Source: TowerGroup, The Bond Market Association.

instruments’ tax-free advantages, serving to attract pools of highnet-worth individuals. According to financial services technology research firm TowerGroup, individual investors currently own an impressive 35 percent of outstanding municipal debt, representing a pool of assets totaling more than $535 billion.* U.S. Treasury securities are also widely held by individuals, as a result of their high name recognition, superior credit quality, and exemption from state and local taxes. Individuals hold almost $140 billion in U.S. Treasury securities—yet this accounts for just over 4 percent of the total supply. Still, most individuals continue to invest in bonds through fixed-income and money market mutual funds. As a result, they hold relatively few bonds directly in a managed portfolio. The ease of use and diversification capabilities of mutual funds easily *Nybo, Andy. “Retail Online Bond Trading: Bringing the Bond Market to the Mass Market.” Needham, MA: TowerGroup (November 2000), pp. 1–4. 19

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allow for passive investing when active trading—or aggressive returns—are not the desired goal.

Predictions TowerGroup, Forrester Research, and other financial services industry research firms are committed to the belief that thanks to advancements in technology and delivery/distribution systems, individuals will increasingly begin to purchase bonds directly online. Investing personality and demographic information aside, these analyst groups contend that people will be driven to bonds on the Internet due to reduced transaction costs, increased price transparency, ample supply, and ease of use. TowerGroup, for example, estimates that currently less than 1 percent of retail bond transactions are executed through online brokers, but this is expected to grow exponentially to 40 percent by 2005. (See Figure 3.2.)

Driven by Brokerage Firms As individual investors, specifically those considered Baby Boomers, enter their wealth management years, they are increasingly attracted to safer and more conservative investments in order to preserve capital—especially if they have large investment portfolios. Full-service brokerage firms are keeping a watchful eye on this group, and are constantly rolling out new “wealth management services” to cater to these individuals, as their investment needs are progressively more complex and sophisticated. Estate planning services, diversification strategies, and risk management all play a role in the management of these accounts. The online 20

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The E-Bond Industry 40% Online bond purchases as a percentage of total transactions

31% 19%

11% 6% 1%

2000

2001

2002

2003

2004

2005

Figure 3.2 Online bond purchase growth. Source: TowerGroup.

brokerages have expanded into this market, or have acquired other players who can provide them with clients in this bracket. The single-minded “online brokers” or “discount brokers” who were only interested in commission-based stock trades are either disappearing or are consolidating to become more diversified financial services companies. Despite its name, E*Trade considers itself to be one such company operating online, having swallowed up online bank pioneer Telebank (advertising slogan: “Cowabunga!”) and renamed it E*Trade Bank, and acquired online loan provider LoansDirect, naming it E*Trade Mortgage. According to spokesperson Deborah Newman, E*Trade Group’s strategy is constantly “to provide a diverse array of products and services for all of a customer’s financial needs.” And Charles Schwab acquired U.S. Trust, in hopes of retaining a high-net-worth clientele whose investment styles and goals differ from those of its existing clientele. 21

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The larger online brokerage firms and banks now have the capability to service all facets of a client’s demands, as well as to provide other goodies, such as education, news, quotes, and ongoing advice. Advice will always be considered the wild card: What is the investor willing to pay for advice?

How Bonds Get to Individual Investors Since there is no central U.S. Bond Exchange where brokers can go to obtain a bond on behalf of an individual investor, individual investors must buy smaller bond quantities (less than $1–5 million) from dealers. Dealers, often brokerage firms with large retail investor customer bases, purchase bonds in the wholesale or institutional marketplace in bulk. Once acquired, the large bond position must be subdivided and sold to numerous investors. If not all of the bonds can be sold immediately, the broker will hold the bonds in inventory until the position is completely liquidated. The dealer can inventory the bonds anywhere from a day to a few months, and this is the reason that retail bond spreads tend to be large. There is always the risk that the broker may have to hold the bonds in inventory for an extended period of time— hence, a large spread is typically “built” into the price. You are most likely already familiar with bond spreads. The spread is the markup, or the difference between what the dealer bought for the bond and what that firm is offering to the customer. This spread or markup is how the dealer makes money, as the differential is embedded in the price. The more seasoned bond investor understands spreads and is familiar with the markup process. 22

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How Bonds Get to Individual Investors Online Bonds weren’t always available to investors at online brokerages, but when they first were offered, they were available by calling a toll-free number listed on the web page and asking for what was available—exactly what offline investors would do by calling their broker. Things got better when lists of bonds appeared on the online brokers’ web sites, which were nothing more than a listing of that firm’s inventory, available for resale at what were considered to be extremely high markups for retail investors. The few online investors who pointed and clicked and discovered what bonds the online brokers were offering quickly logged off, noting not only the high cost, but also an abysmally low selection. For example, a major full-service broker/dealer offering online execution from its own inventory of municipals would list just two New York tax-exempt issues available for purchase online. This went against the preferences of the traditional bond investor, who is looking for diversification, as well as the preferences of the online investor, who seeks convenience, efficiency, and lower costs. One of the problems was that those online brokerages that already had a strong offline presence would save the “better” bonds for their regular retail customers, since they believed that few, if any, online customers would request bonds. The other, more significant problem facing all brokerages lay in the held inventory. Something needed to be done to reduce inventory, thereby creating the possibility of distributing bonds with lower spreads. After all, lower spreads would lead to better prices which would ultimately lead to building investor confidence. 23

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To reduce the risk of inventorying small bond quantities, bond brokers and dealers have been working together to create systems that aggregate or commingle the inventory of multiple broker/dealers and then present them broadly across the market. In this manner, individual brokers need to inventory fewer bonds but can broadcast the inventory they do own to a larger number of investors. The thinking here is that since this places less of their capital at risk, it allows the brokers to reduce their spreads—thereby displaying more attractive bond prices to the end users, in this case, individual investors.

Commingled Inventory Systems The case for commingling inventory is finally receiving more positive favor. Large bond dealers would traditionally conceal their holdings to brokers, for fear of revealing pricing information to competitors—the standard industry practice. But a commingled inventory system has the advantage of enabling dealers to manage their internal inventories more efficiently, since they can broadcast the availability of odd lots of bonds that are generated through daily retail activity. Not only do they reach a wider investor base, but they are, in the end, reducing the time the bonds are held in inventory. Moreover, the market intelligence gleaned from these systems is a valuable tool for retail brokers who need to be aware of the retail market for bonds they are buying from clients or selling to them. These inventory systems provide dealers and online brokers, whose online presence may be negligible or nonexistent, a ready-made, cost-effective system for offering bonds online. Full-service dealers can also deploy the commingled system 24

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and offer a wider selection of bonds to their clients. The systems solve the problem of limited bond inventory at online brokerage firms. All of the major online brokerage firms sell bonds through commingled inventory systems. The systems are provided with inventory from dozens of participating dealers, who have found that the number of different types of bonds that they can offer their customers has been enhanced and expanded. There are two types of commingled systems: databases of dealer offerings, and executable inventory systems. In the databases of dealer offerings, users can search by various selection criteria, and can then submit an indication of interest for a particular bond electronically to a trader through the system. The trader must then contact the offering dealer by phone or e-mail to check for availability and current pricing levels, since the offerings in the database are typically updated just once or twice a day. After confirming availability, the trader will then electronically notify the customer. In the executable inventory system, users can execute transactions directly at prices displayed on the screen without manual intervention. These systems provide real-time pricing information and dynamic inventory levels. As the system executes orders, it debits or credits inventory levels at the counterparty (see Figure 3.3). The executable inventory system is absolutely the trend in online retail brokerage. As technologies improve and online brokerages have been able to prove to dealers that individual investors are buying bonds online, more dealers are feeling increasingly comfortable commingling their inventories for display and sale to retail investors. The major commingled inventory systems used by the larger 25

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Figure 3.3 Commingled inventory systems. Source: TowerGroup.

online brokers are as follows (these three are all of the executable inventory type): BondDesk eSpeed ValuBond

http://www.bonddesk.com http://www.espeed.com http://www.valubond.com

(BondExpress, a database of dealer offerings and a major and visible player, and a supplier to Yahoo! Bond Center, was acquired by ValuBond in September 2001.) BondDesk is a consortium of 26 dealers, while eSpeed and 26

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ValuBond are owned by Cantor Fitzgerald and Charles Schwab, respectively, along with other private investors. Without going into the specific characteristics of each, all three allow participating broker/dealers to offer execution capabilities to traders, liaison traders, registered representatives, private clients, and correspondent broker networks. More important, all three allow participating dealers to privatelabel the system so that the individual investor gets a searchable database of bonds as well as real-time execution in a seamless environment. In other words, you have no idea where the selection of bonds comes from or how your trade gets executed—but it’s all done perfectly within the confines of your online broker’s web site. And you know you are getting the best selection at the best price. Figure 3.4 is the Bond Center screen for TD Waterhouse, which uses BondDesk’s system. BondDesk also provides inventory for HarrisDirect and E*Trade, among others.

The Room Got Crowded As with all participants in the Internet, only a few players remained standing after the market corrected itself in 2000 and 2001. The online bond market at one point was dotted with Internet companies claiming to revolutionize the way bonds are issued, distributed, sold, and cleared to institutions and individuals; each claim, of course, was more mighty than the previous one. A research report dated November 2000 conducted by technology consulting firm Scient counts 67 online bond providers. Most have closed up shop, merged with other firms, or “moved back home” (they were absorbed back by their parent companies that initially financed them). 27

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Figure 3.4 TD Waterhouse’s Bond Center.

Most of these companies were started by former bond salespeople and traders, flush with millions in cash; they hoped to start a company, take it public, and make even more millions in the New Economy. In the clubby world of institutional bond sales and trading, reputation is everything, and so the success of each company was thought to be based on the background and perceived skill set of the founders. The usability and functionality of the technology did not matter all that much. Most of the gee-whiz technology was already abundant on Wall Street—private trading networks and systems

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have existed on bond desks for years, way before the popularization of the Internet. But it is still important to realize that e-bonds were kept quiet to individual investors. Too much money was already being made between Wall Street and institutional clients (like mutual funds and asset managers) for companies to risk creating a platform or system simple enough for the individual investor to use. This, of course, has changed. Below is an excerpt from the first few pages of the Scient report that provides an interesting overview of the electronic transaction systems available at the time. The rest of the report gives in exhaustive detail each e-bond provider’s current and proposed offering, system type, availability, funding information, trading activity, revenue strategy, and customers. From this excerpt, however, note the number of e-bond companies in the industry just two years ago—most of whom you will not likely see in the future. Cross-Matching Systems Cross-matching systems generally bring both dealers and institutional investors together in electronic trading networks that provide real-time or periodic cross-matching sessions. Customers are able to enter anonymous buy and sell orders with multiple counterparties that are automatically executed when contra side orders are entered at the same price or when the posted prices are “hit” or “lifted.” In some cases, customers are able to initiate negotiation sessions to establish the terms of trades. These types of systems typically allow users to execute complex portfolio strategies that incorporate multiple orders in different securities.

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• • • • • • • • • • • • • • • • • • • • • • • •

Apogean Technologies, Inc. Automated Bond System Blackbird Bloomberg Secondary Market Auction System BondAgent BondBook Bond Connect BondDesk BondHub.com BondLink BondMart BondNet BuySideDirect Cantor Muni–Cantor Fitzgerald Creditex, Inc. eBondUSA.com IBX LIMITrader Securities, Inc. MBSAuction, LLC Muniversal Pedistal ValuBond Visible Markets Xbond

Interdealer Systems Interdealer systems allow dealers electronically to execute transactions with other dealers through the fully anonymous services of brokers’ brokers. A number of interdealer brokers have introduced or plan to introduce electronic transaction systems that will allow dealers anonymously to execute transactions in securities through proprietary net30

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works. All of the major interdealer brokers in the U.S. Treasury securities market currently offer or expect to offer their customers access to electronic brokering. In addition, several firms have announced their intention to offer electronic brokering services in this highly competitive market segment. Most of these systems are targeting the U.S. Treasury securities market but can be expected to expand the range of products available for execution to all markets in which interdealer brokers operate. • • • • • • • • • •

Broker Tec Global, LLC COREDEAL Limited eSpeed, Inc. EuroMTS Limited Garban–Intercapital plc GFInet Instinet Fixed Income LibertyDirect TheMuniCenter Xetra

Multi-Dealer Systems Multi-dealer systems provide customers with consolidated orders from two or more dealers and provide customers with the ability to execute from among multiple quotes. Often, multi-dealer systems display to customers the best bid or ask price for a given security among all the prices posted by participating dealers. Participating dealers generally act as principals in transactions. A variety of security types are offered through these systems, including U.S. Treasury, federal agency, mortgage-related and municipal securities, as well as certain money market instruments. 31

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• • • • •

Bloomberg Bond Transfer BondClick BondNews BondsOnline Dalcomp Variable Rate Trading System (Thomson Financial) • EuroMOT • MarketAxess • TradeWeb LLC Primary Market Auction Systems Auction systems enable issuers to conduct real-time electronic auctions of their primary offerings of securities. The mechanics of auction systems are similar to those of traditional competitive sales, the exception being that dealers and investors submit bids electronically during a set period of time, instead of using the traditional phone, fax, or hand-delivery methods. Auction systems may also allow bidders to improve bids during the auction period, as they are typically able to see competing bids from other auction participants. • • • • • • • • •

American Express Credit Corporation Bid Ohio Bloomberg Municipal System Bloomberg Direct Issuer Commercial Paper Auto-Ex cpmarket.com Ford Motor Credit Company FreddieMacAuction.com Intervest MuniAuction 32

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• PARITY • Treasury Direct Single-Dealer Systems Single-dealer systems allow investors to execute transactions directly with a specific dealer of choice, with the dealer acting as principal in each transaction. Dealers offer access through a combination of third-party providers, proprietary networks, and the Internet, although in recent years there has been a pronounced shift toward access through the Internet. Dealers can be expected to increase the range of products and services offered to clients through the Internet as they search for ways to attract new customers, as well as to sustain relationships with existing clients. • • • • • • • • • • • • • • • •

Autobahn Electronic Trading Deutsche Bank Bear, Stearns & Co. Inc. Credit Suisse First Boston eBondTrade Fixed Income Securities, Inc. Fuji Securities, Inc. Goldman, Sachs & Co. J.P. Morgan express Lehman Live LMS (Merrill Lynch Capital Markets) Morgan Stanley Dean Witter & Co. Odd-Lot Machine/GovRate Ragen MacKenzie Incorporated RetLots Caboto Spear, Leeds & Kellogg Tradebonds.com 33

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Terrorist Attacks Couldn’t Stop Them TradeWeb and eSpeed, two of the biggest institutional players in the e-bond industry, had their offices headquartered in the World Trade Center. On the morning of September 11, 2001, terrorist attacks leveled towers 1 and 2 of the Trade Center, forcing both companies to shut down for three weeks, as the two assessed the damage to their property, infrastructure, and human capital (TradeWeb suffered no employee deaths; eSpeed, a unit of Cantor Fitzgerald, was not so lucky). Using backup data centers and employees working remotely, TradeWeb restored service in its online markets on October 1, 2001; eSpeed on October 5. Both companies disputed reports of a material loss of market share and reaffirmed the strengths of their products and systems. Jim Toffey, president and CEO of TradeWeb, said in a press release at the time, “The recovery from the destruction of our U.S. operations has surpassed all our expectations. This tremendous achievement is a credit to the TradeWeb team, our dealer partners, and, of course, our devoted customers.” (PR Newswire, October 3, 2001) The terrorists sought to attack the symbol of U.S. dominance in the financial markets; however, these online bond powerhouses quickly and remarkably bounced back, as did other major financial services players.

Getting Spicy U.S. Treasuries and municipals still make up the majority of bonds that are purchased online directly through online brokerages. This is not only because of “what the market will bear,” but also due to suitability reasons. Have you ever noticed the fine 34

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print at the bottom of the web pages? It pretty much all sounds alike: Products offered by John Doe Securities, Incorporated, are not insured by the FDIC and are subject to investment risk, including possible loss of the principal invested. If you end up buying junk bonds online and lose your shirt, you can bet there will be more than just a complaint e-mail sent to the firm. There are serious liability issues here, and to protect themselves, online brokerages have refrained from offering all of their possible fixed-income inventory that can be provided by their trading desks and commingled inventory systems. However, if you are still interested in high-yield, mortgagebacked, sovereigns, and other types, they may not be available for screening and purchase online; you will probably have to contact the firm’s toll-free number and indicate interest in the class of bond not offered for sale on the firm’s web site. Again, the industry is still evolving, and as dealers recognize the individual investor’s growing appetite for—and willingness to buy— different flavors of bonds, they will begin to push inventory, albeit slowly.

Not for Everybody While the case for commingled inventory systems seems to serve every bond market participant’s best interests, not all of the major online brokerages offer these systems. Merrill Lynch Direct and Morgan Stanley, most notably, have shied away from offering a commingled system of bonds to their online retail brokerage customers and instead only offer bonds from their own in-house inventories—which are quite substantial. 35

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And the only major online brokerage that still offers bonds to retail investors not through an option on their web site but only by calling their toll-free number to get pricing information, is Ameritrade—an embarrassment considering how large the firm grew from individual stock trades during the good years and the industry’s general migration to diversification. Your best bet is to keep track of prices of the types of bonds that you are considering purchasing online. If a broker calls wanting to sell you municipal bonds, don’t hang up—take the opportunity to entertain yourself a bit. Take down his name and number, and promise that you’ll call back. Then, go online and check the prices for a few bonds you’ve been following. After jotting down the prices, call the broker back and tell him that if he can’t beat the prices of the bonds that you plan on reading off to him, then there won’t be a sale. I assure you that he and his firm cannot match the online brokerage’s prices. But considering the time it takes to actually speak with the broker the first and second times, and possibly have him hang up when he learns that he is competing with a web site, you could have easily already executed a sale and already own the bonds in your portfolio.

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P

ersonal finance books focusing exclusively on fixed-income investing could be considered extremely appealing given the tumultuous and uncertain equity market conditions at the present time. The wild party in stocks (most certainly technology stocks), is long over, with most investors feeling the effects of a hangover. The day trader is dead and investors are looking to diversify and for investments that will make the most of their money. A book that tracks traditional, “safe” investing for income can certainly find its audience these days. Yet this book combines two opposing disciplines: bonds and the Internet. Bonds are mostly thought to be the unglamorous, capital-raising instrument of the U.S. government and municipalities—the investment of choice for widows and orphans. The Internet, on the other hand, is the ever-evolving domain of the wild and adventurous maverick. Where’s the connection here? While the two seem mutually exclusive, oddly enough, they 37

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are appropriate partners. Both appeal to people interested in accessibility and efficiency. Here’s why: • The Internet affords access to the best information (often at the most attractive price—free), which can be searched, indexed, and scanned for information within minutes. • The costs of transacting online are dramatically reduced, in both time and actual dollars spent. One characteristic generally associated with bond buyers is that they are older, more conservative, and more sophisticated with respect to investing than the rest of the investing public. This is especially true regarding municipal bond investors, who are often retirees who may have as much as 90 percent of their portfolios allocated to these securities in order to take advantage of the tax strategies. These savvy investors also prefer access to substantial information before making a purchase. But are these folks really going to log on to the Internet to buy bonds? The answer is yes. According to the 2000 census (http://www.census.gov), there are more than 82.8 million people in the United States between the ages of 35 and 54—this is up 32 percent, or 20 million, from the 1990 census (and all but the 35-year-olds are considered by the U.S. Census Bureau to be Baby Boomers). Thus, the traditional “beginning investor” audience for Treasury and municipal bonds—those making the

The largest segment of the U.S. population is not only aging but also increasingly wired. —Ann Wrixon, CEO, SeniorNet

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financial preparations for retirement—has grown by one-third in 10 years. The bond market, therefore, will grow stronger as more individuals seek these securities for their portfolios as they get older. Interestingly enough, this population segment also: • Represents more than $2 trillion in income • Has 80 percent of the personal wealth in financial institutions • Owns over 70 percent of the financial assets in the United States • Controls nearly $9 trillion in net worth of U.S. households—70 percent of the total (Source: AARP) Yet despite the investment power of this group, online brokerages all but forgot them in the Internet boom years of 1997 to 1999. The entertaining, edgy ads on television and in print portrayed savvy Generation Xers smartly investing in technology stocks. News related to such stocks clogged the financial cable channels and web sites. Articles recounted innumerable get-richquick stories. What about bonds and other investments? They were hardly a blip on the Internet investing radar screen—and a joke to former day traders. It’s a good thing that the world is changing and has begun to finally take notice of bonds. And, thankfully, the Internet hasn’t disappeared altogether, and ordinary investors can take advantage of the efficiencies that are provided by investing online. But would ordinary investors—particularly those older investors who are the prime audience for fixed-income investments—take to the Internet? Yes; as it turns out, these Baby 39

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Boomers and “pluses” are quite wired, having shown a predilection for technology and all of its assumed conveniences. Firms that track the use of technology by senior citizens (ugh, that darned expression!), including San Francisco–based SeniorNet (http://www.seniornet.org), are aware that the Baby Boomers were forgotten in the splashy marketing campaigns brought on by the dot-coms. The online brokerages were quick to show young twentysomethings buying stocks, but neglected to sell to older people with computers—and much, much more money in the bank. “The largest segment of the U.S. population is not only aging but also increasingly wired. Purchasing and consumer confidence may ebb and flow, but the seniors of today and tomorrow will not so easily give up the conveniences of technology, including their PCs and Internet access,” explains Ann Wrixon, CEO of SeniorNet. The recent “Wired Seniors” report, published in August 2001 by the Pew Internet & American Life Project (http:// www.pewinternet.org), joins the chorus. According to their study, 69 percent of the more than 4 million wired seniors go online on a typical day, compared to 56 percent of all Internet users. The report tracked behavior across a broad spectrum of activities, including online banking and buying stocks. “Internet users aged 50–64 are likely to keep their Internet access even after they retire and this ‘silver tsunami’ may be the generation that takes advantage of all the Internet has to offer them as they get older,” states the report, which you can download for free on their web site. And so it is with hope and anticipation that investors, regardless of age, use the tools provided by the Internet for sensible investing. What follows is a short course on bonds.

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The Cheat Sheet Treasuries Bond issues play a major role in financing governments of all levels—city, state, and federal. The federal government has borrowed so much money from investors that 33 cents of every dollar you pay in taxes is currently used to pay investors the money owed them. That’s right, one-third of your tax dollars is used to pay debt. For some more mind-boggling statistics, visit the Public Debt web site, (http://publicdebt.ustreas. gov) for the amount of public debt outstanding and how much the federal government owes its investors. For kicks, you might wish to bookmark the page http://publicdebt.ustreas. gov/opd/opdpdodt.htm and visit it daily. (The Public Debt web site also allows you to buy Treasury securities directly from the government.) Due to an agreement between state and federal government made long ago, you don’t have to pay state income taxes on U.S. government bond interest. This mutual reciprocity rule has allowed the U.S. Treasury to raise substantial amounts of capital while at the same time winning investors’ and taxpayers’ confidence. The U.S. Treasury sells four types of fixed-income securities to individual investors: 1. 2. 3. 4.

U.S. savings bonds U.S. Treasury bills U.S. Treasury notes U.S. Treasury bonds

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U.S. Savings Bonds Series EE savings bonds have become extremely popular due to their simplicity. Savings bonds are actually discount bonds or zero-coupon bonds, since no interest is delivered during the time the bond is held. There is no reinvestment risk on the interest payments because the interest is reinvested internally at a constant yield, automatically compounding. These bonds are also known as accrual bonds because the interest is added to the redemption value rather than being paid out. The interest is all paid out at maturity. Savings bonds make great birthday and graduation gifts, because an amount of money is paid up front, and after 18 years when the bond matures the value seems to “double.” The purchase price is 50 percent of the face value. You can buy savings bonds at banks, credit unions, and savings and loan companies. Five of the Federal Reserve Banks also sell savings bonds. The minimum investment is $25 and the maximum is $5,000 per bond. Face amounts available are $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. An investor is allowed to invest only $15,000 per year in savings bonds— which makes them an unattractive investment option for wealthy, sophisticated investors. The other thing that is important to know about savings bonds is that you cannot sell them in a secondary market; they are considered to be an illiquid investment. If you redeem them early, you or the beneficiary will pay severe penalties, forfeiting a substantial amount of interest. U.S. Treasury Bills, Notes, and Bonds Whether a security is a Treasury bill, note, or bond is determined by how many months or years will pass between its conception 42

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and its maturity. Bills have maturities of 1 year or less; notes mature in 2, 3, 5, or 10 years; and bonds have maturities greater than 10 years but less than 30 (The 30-year T-bond was retired in November 2001). Treasury bills, or T-bills, are traded using their yield, not their price. The T-bill’s yield as calculated by the Treasury is the discount rate. This is the difference between the price you paid at issuance and the face value. U.S. Treasury notes and bonds are coupon bonds that pay interest semiannually. For example, if the bond’s coupon rate is 10 percent, a $1,000 investment will give the investor $100, paid out in two semiannual payments of $50. This represents a 10 percent return on investment. The U.S. government offers bills, notes, and bonds to the public through regularly scheduled auctions. The Treasury announces the size of the offering in a press release about a week before the auction, and the news usually appears in all of the financial publications and news broadcasts. If you use the Public Debt web site, you will be informed of the auctions at the time the news release goes out. The Public Debt web site is the most comprehensive, efficient Treasury security investment platform available to individual investors today. I cannot stress the value and facility that have been created by the government with the use of this web site. Any questions or inquiries concerning any of the issues can be sent electronically and someone will get back to you promptly (they did for me). You can manage your investments neatly online, and periodically review your portfolio. Even if you already have a live broker, or an account with any of the online brokerage firms, I strongly urge you to open an account with the Public Debt online. You’ll be glad you did. 43

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A Look at Corporate Bonds Many individual investors are aware that the biggest multinational companies issue bonds; yet, despite many of the companies’ blue-chip reputations, individuals, by and large, avoid investing in them. This is primarily because corporate bonds— issued from companies of any size or reputation—are still taxable and smart investors know that they can get a safer, tax-free alternative elsewhere. However, unlike other bonds that are dependent on interest rates, such as U.S. Treasury securities, corporate bond values often reflect the health of a company and are often buoyed by the company’s stock performance. Therefore, the price of a corporate bond may not fluctuate as wildly as interest rates, making it somewhat attractive to investors. More sophisticated corporate bond investors often look to identify and invest in lower-rated bonds of companies that they feel are on the path to future credit upgrades. These investors choose the bond instead of the stock because they are paid a substantial yield while they are waiting for the company to perform. This strategy is known in the industry as “being paid to wait.” The different corporate bond market sectors are: • Industrials: Manufacturing, energy, mining, retail, and service industries are affected by consumer demand and economic cycles. These industries are also referred to as cyclicals. • Airlines/transportation: Airlines, trucking, and railroads are affected by oil and energy prices, economic conditions, government regulations, and safety records. • Public utilities: Telecommunications, water, electric, and gas pipeline systems are affected by weather conditions, con44

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sumer demand, natural resource management, government regulations, and technology. • Banking/finance: Brokerage, insurance, mortgage, banking, and other financial services companies are affected by interest rate changes, government regulation, and economic conditions. Maturities fall into four categories: 1. 2. 3. 4.

Short-term: up to 4 years Intermediate-term: 5 to 12 years Long-term: 13 to 40 years “Absurd-term”: 41 to 100 years

To simplify, corporate bonds fall into two broad credit classifications: investment-grade and high-yield. Investment-grade bonds got their name because at one time banks were allowed to invest only in bonds ranked in the top four rating categories. High-yield bonds caught international attention in the 1980s when Michael Milken and other fixedincome barons used the financing instrument as an alternative for cash-strapped companies to raise capital quickly, when more traditional methods of borrowing became unavailable. The yield was high, but so was the likelihood of default, in which many of the companies often found themselves. When a company gets into serious financial trouble, defaults on the issue, and stops paying interest on its bonds, the bonds are said to be trading flat, or without interest. These bonds trade at fractions of their face value. The bondholder hopes that someday the company will do one or more of the following: begin to pay interest again, pay the past interest in arrears, or 45

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pay the principal at maturity. If they do, their value should move higher again. Corporate bonds are assumed to have a $1,000 face value unless otherwise stipulated. As a simple example, a 9 percent bond with a $1,000 face value would pay $90 per year, so each semiannual interest payment is $45. The bond’s indenture specifies all important facets of a bond’s issue, including coupon, maturity date, and seniority, or where the bond ranks in the overall debt hierarchy on the company’s balance sheet. This is very important because you want to know where you stand in the line of creditors looking for their piece of the company’s assets if the company ends up filing Chapter 11, or more politely, for protection under Chapter 11 of the U.S. Bankruptcy Code. Bankruptcies have taken center stage, with such well-known names as Enron, Kmart, Global Crossing, and Excite@Home all filing for protection. More and more individual investors have become frighteningly aware of bankruptcy and how it affects not only corporate bonds but also the rest of the capital markets as a whole. Here is the hierarchy of creditors in a company in the order in which they are paid in the event of bankruptcy: 1. 2. 3. 4. 5. 6.

Banks Bond investors or senior debt holders Subordinated investors Convertible bondholders Preferred stockholders Common stockholders

The bond’s indenture, or contract, tells you what, if anything, is backing the bond. Bonds that are not backed by any collateral 46

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and rely solely on the issuer’s name or goodwill to attract investors are called debenture bonds. Debentures are unsecured bonds and rely on the issuer’s ability to make money to pay investors. If the issuer fails, there is nothing to secure the bonds. Many companies cannot issue debenture bonds due to their sketchy credit histories, so they have to post some kind of collateral in order to attract investors. While corporate bonds are traded on the New York Stock Exchange, the vast majority are merely traded between dealers, in the manner described in earlier chapters. The ongoing development of electronic trading systems—again, primarily for institutional investors—has given corporate bonds of all credit qualities a new life of sorts, where pricing and other data can be delivered and exchanged quickly and efficiently. And again, do not be shocked that your online broker lists only a handful of investment-grade corporate bonds, or none at all. The risks are still high for a number of issues, and suitability for the individual investor is an ongoing concern. Bond Market Commentary, Live! When you can’t get enough from a morning news story, or an end-of-day report, there are a few websites that can provide you with continuous bond market commentary so that you can read about the economy, moves by the Federal Reserve Board, major corporate issues coming to market, or municipal news updated as frequently as every 15 minutes. For example, Briefing.com (http://www.briefing.com) is the only web site that provides continuous commentary and analysis on breaking news affecting the markets, providing insight on possible implications for trading. As the site claims, 47

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Briefing.com includes news, “but goes beyond news to what is important and why.” The site is primarily targeted toward the active investor—usually in stocks—who seeks live analysis; there are hundreds of updates throughout the trading day. But Briefing.com gives significant attention to bonds. The free version of the service offers their Bond Coverage three times per day—not bad. The professional version of Briefing.com, presently priced at $25 per month, offers their live Bond Coverage, live FX Coverage, live Bond Briefs, Bond Quotes every 15 minutes, as well as economic and Fed policy analysis. This is, of course, in addition to their other commentary offerings for stocks, and a free trial of the premium services is always available. (See Figure 4.1.) There are two analysts who provide all of the bond commentary content for Briefing.com. Tim Rogers, chief economist, is responsible for Briefing’s macroeconomic and Fed policy outlook. He joined Briefing.com after serving as chief U.S. economist at Thomson Financial Services, and writes regularly on the Bond Ticker and Bond Brief pages. Tim can be reached at trogers@briefing.com. The other analyst is Dan Antonellis, fixed-income strategist, who focuses on intraday movements and trading strategy for the Treasury and foreign exchange markets. Mr. Antonellis joined Briefing.com in early 1998 after previous experience as a mutual fund analyst for Scudder Kemper Investments. His commentary can be seen on the Bond Ticker, FX Ticker, and Bond Brief pages. Mr. Antonellis can be reached at dantonellis@briefing.com. I certainly encourage you to contact these individuals if you have a question on bonds, after reviewing their commentary on the Briefing.com site. Oddly enough, despite its name, CBS Marketwatch (http:// cbs.marketwatch.com) does not provide continuous bond 48

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Figure 4.1 Briefing.com. 49

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commentary throughout the day, as does Briefing.com. The Bond Report is published on the site near the end of the day, and covers mostly activity in Treasury securities. There is no report on new municipal issues or rumors of corporate issues about to come to market. In fact, under the “Personal Finance” tab for the site, bonds are not even listed in the Top 10 Features—you have to click on “More Features” in order to read about bonds (http://cbs.marketwatch.com/pf/started/getting started_bondintro.asp?siteid=mktw). CBS Marketwatch does have, however, substantial commentary on economics, which gives tips and clues for all types of bond investing. Bond Calculators One of the best functionalities for figuring out what types of bonds to buy and how they would fit in your investment portfolio—among other considerations—is to use any one of the free calculators available on the Web. Investment and personal finance calculators are nothing new on the Internet. Nearly all investing or financial news web sites offer these Java-based applications, capable of delivering “simple” numerical results after the user inputs a couple of numbers into blank fields (e.g., monthly savings) and/or makes a few selections from drop-down menus (e.g., how you would characterize your investing strategy—conservative, aggressive, etc.). Geek moment: You ask why these calculators seem to be everywhere? The answer: their “stickiness,” or the ability of the site to capture and retain the user’s attention for a sustainable period of time. If it is an online brokerage site, the goal—you guessed it—is to have the calculator deliver information that might move you into a transaction. If it is an online media site, 50

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such as a financial news portal, the goal is to keep you there long enough to show advertisers their page views, or length of time you are parked in front of that web site, so as to charge higher rates. But you probably knew this already. But these marketing directors only mean well. Dynamic, online calculators are certainly not available when you read a newspaper or magazine, or when you watch CNBC or CNN Money on cable television. They are always good to have on hand when you need to quickly verify the value or return of investments or savings when you are browsing securities offerings on the Internet. Again, caveat emptor: While these online calculators are good for simple arithmetic calculation of a security’s performance or determining the result of a savings plan, you should not rely on them solely when attempting to map out your complete investment strategy. The calculators do not predict particular market behaviors, nor do they accurately consider tax or estate planning laws, among other investment criteria. Charles Schwab has a great calculator (one of many) on their site. A relatively simple investment calculator is offered in the “Investment Basics” area of the Charles Schwab web site. This General Goal Planner tool allows users to calculate the amount of additional investment necessary to reach a specified goal, based on what they currently have and how they expect that to perform. But calculators specifically geared for bonds get a bit trickier. After all, one of the reasons that investors avoid investing in fixed-income securities altogether is the Great Fear of Math— that they would have to figure out return, yield-to-maturity, yield-to-call, and other calculations immediately before further considering investing in the bond. 51

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With the new bond calculators available on the Web now, all of your fears should be put to rest. Perhaps the most comprehensive selection of bond calculators appears on the Yahoo! Bond Center (http://bonds.yahoo.com/calculator.html). (See Figure 4.2.) That’s right, calculators, plural. The first thing you notice when you access the page are links to 12 commonly asked questions concerning bond returns. These questions spell out the simplest concerns for any investor, no matter how sophisticated he or she is with respect to bond investing. After clicking on a question, you are led through a series of additional investing questions with respect to particular bonds

Figure 4.2 Yahoo! Bond Center calculator. 52

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under consideration. What makes these calculators so complete is that they allow you to input data, view results, access a graph, and then receive an explanation—and all of these options appear conveniently as tabs at the top of each calculator. Let’s try one and find out. Click on the last question, “How will rate changes affect my bond’s current value?” Let’s not even change any of the data provided in the sample. The result is a screen of Inputs, Results, Graphs, and Explanation. The screen displays the underlined words, including “Price You Paid” and “Face Value,” which link to new windows displaying the word in a glossary. It doesn’t get much easier than this. Geek moment again: Yahoo! outsources almost all of its personal finance content, which means that most of the news you read and data or quotes you access on the Yahoo! Finance web sites come from other providers. Here, the calculators come from a company called FinanCenter (http://www.financenter.com), a provider of personal finance data solutions to web sites; you can click on their graphic on the upper-right-hand corner of the page displaying the Inputs, Results, Graphs, and Explanation, or anywhere else on the Calculators page displaying their name. You should always check out the web sites for Yahoo!’s data providers—sometimes that provider’s site may be more detailed, or arranged in a way that is more appealing to you. If Yahoo! didn’t want you to check out their vendors, they wouldn’t explicitly display them on their site. Go ahead, start clicking!

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5 Bond Psychology Why Investors Haven’t Taken to Bonds

Lack of Sex Appeal

A

dmittedly, bonds just aren’t as sexy as stocks. At the club, on the green, at the restaurant, on the plane, we all love to talk about what stocks we bought recently that made us a killing. Flaunting the winner is, well, basic human nature. (Note that people rarely talk about what stocks turned out to be losers.) Knowing the maturity date and yield of a security prior to purchase takes the fun out of investing, characterized by rebellious, maverick gunslingers in recent years. When you buy a stock, you have no idea what you’re getting into; with a bond (depending on credit quality), you pretty much can predict your future gains. The financial media are forever shouting out Corporate America’s biggest and most well-known brand names, tracking their stocks’ behavior, and narrating in painstaking detail every bit of advice or words of wisdom uttered from those companies’ CEOs. 55

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Bonds rarely get the same attention. When a company issues an IPO, there are the expected bell-ringing and associated festivities on Wall Street. When a company issues senior notes, it isn’t usually met with the same fanfare. This country’s public financial markets are forever promoting equity ownership in U.S. companies—but, by and large, the same cannot be said for ownership of bonds. The reason is that, of course, there is no U.S. Bond Exchange. Brokers and dealers cannot, on behalf of the individual investor, go to an open marketplace and acquire the securities for customers. Sorry, no gold jackets, no pits, no hand signals, no discarded tickets left on the exchange floor at the end of the day. Instead, bonds are bought by large dealers and institutions, and then subdivided and resold to numerous smaller investors. (See Chapter 3, “The E-Bond Industry,” for more information.) As such, there is less of a “public” persona—or a sense of an institutionalized distribution system—to bonds. Municipalities and the U.S. government, on the other hand, regularly court these smaller investors who are “left behind.” To clarify, the expression the bond market, is used to discuss the broader scope and number of participants in the industry, which include issuers, intermediaries, regulatory organizations, and investors, including both institutions and individuals. However, bonds make for much more of an interesting investment subject—there is so much to learn about and choose from for an investment portfolio. Since there is so much that is known about a bond when it is issued, the individual investor is actually empowered with information that can never be known for a stock. Some classes of bonds may be universally known as “investments for widows and orphans,” but some of the most sophisti56

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cated institutional investors and even entire investment banks are solely focused on the trading of fixed-income securities. There are plenty of individual investors—and not just retirees in Florida—that allocate their entire portfolios to bonds and money market instruments. There are a few trends already in place that will help bonds achieve a greater acceptance in the marketplace: 1. U.S. investors have been very badly burned by the stock market in recent years (Internet and technology-related stocks weren’t the only perpetrators); confidence in the equities markets was eroded, but—as with any rebuilding after a long bull run and then a steep decline—will be restored extremely slowly. 2. Layoffs continue, and by October 2001, according to the Bureau of Labor Statistics, reached approximately 400,000; as such, consumer spending has slowed to a trickle and people will behave much more conservatively with their money. 3. The U.S. population is aging, and Baby Boomers who contributed to the growth of the mid- to late-1990s are about to retire (and will most likely not be investing in growth stocks in years to come). 4. According to studies sponsored by AARP and the Social Security Administration, the majority of U.S. citizens are particularly concerned about retirement—regardless of age—as well as their ability to have enough to cover their most basic expenses. Individual investors are now searching for extremely conservative securities in which to place their money—whatever they 57

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have left over after being clobbered by the stock market and after having to pay for basic living expenses once unemployment benefits dried up.

I’m So Confused The other problem with bonds is that they are generally thought of as “complicated,” or at least that’s what brokers have told individual investors over the years. Investors claim, “I don’t have a ‘quant’ background—I can’t figure it out for myself.” The response is, “You don’t need to.” In the bad old days, when you had to rely on your broker, you probably had to. Thankfully, those days are over. The one good word to say about the rise of the Internet is that it has made plenty of information available to many more people at a price that’s universally agreeable: free. I implore you to log on, type in URLs, click around, and see what information is available out there so that you can make better decisions for yourself—and your portfolio. John Durrett, CEO of municipal bond broker MuniDirect. com, asserts that most investors still feel that bonds are more difficult to understand than stocks, which is not true. “Due to the clear-cut information that’s out there, making a bond purchase based on available information is much, much easier than that for stocks, with their charting, tracking, research, and other moving parts,” Durrett says. Admittedly, we all fear what we don’t know. And with most financial news and media explaining about what happens when you buy a stock, it only makes investing in other types of securities all the more foreign. Do not let the media and hype get to you. 58

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John Ladensack, senior vice president and head of online fixed-income operations at Charles Schwab, explains that his firm consistently conducts focus groups to further understand the thinking behind investing in bonds. By studying random groups of people who are brokerage clients, usually retired, he has learned that individuals are confused by the mathematical calculations behind bonds, and only end up in a purchase based on their character judgments of the broker selling them the bonds. “Hopefully, this will change,” Ladensack says. The online brokerages, however, are committed to investor education. Thanks to content-sharing arrangements, you can easily access web pages explaining investing basics, glossaries, calculators, or worksheets. Cynics cry that such information is nothing more than a slick e-brochure that moves the user into a sale. Call it what you will, but, considering the markup on bonds that traditional brokerages charge compared to that of bonds offered online, the online versions seem like one helluva bargain. Information on the Web, as stated above, is often offered at the most universally agreeable price, but sometimes you have to pay a tiny bit or be slightly inconvenienced.

Yes, Someone Decided to Test You Just how much does the average investor know about bonds and bond mutual funds? According to a “Bond IQ Quiz” conducted in fall 2001 by mutual funds giant American Century Investments ($85 billion under management), the investing public’s knowledge of basic fixed-income principles remains poor. This is surprising, given the dramatic increase in the number of investors who continue to seek refuge in bonds and bond mutual funds. 59

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In a national telephone survey of 750 investors who are primary or joint decision makers on investment issues, only four respondents—roughly 0.5 percent—were able to correctly answer all 10 questions on basic knowledge about bonds and bond mutual funds. American Century Investments first conducted the Bond IQ Quiz in 1998, and the results for 2001 show that little has changed; that year, only seven respondents were able to answer all 10 questions correctly. However, overall knowledge of bonds and bond mutual funds has dropped substantially over the past three years. Only 27 percent of those surveyed were able to answer at least half of the 10 questions correctly this year, compared to 35 percent in 1998. “Even in a year when U.S. bond mutual funds are expected to outsell domestic stock funds, there continues to be a high degree of confusion and mystery surrounding bonds,” said Colleen Denzler, vice president and senior portfolio manager of American Century Investments. “Although 63 percent of investors correctly described a bond as a debt security issued by a company, municipality or government agency, disturbingly few understand the relationship between the direction of interest rates and bond performance, credit quality and bond yields, and bond maturity and interest-rate sensitivity.’’ Here are some interesting findings: • Some 29 percent of those surveyed believe that bond prices rise when interest rates rise, while only 31 percent correctly answered that bond prices fall when interest rates rise. • Forty-one percent of respondents have the relationship between maturity and price sensitivity reversed, thinking that “the longer a bond’s maturity the less sensitive its price is to 60

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changing interest rates.” Only 13 percent correctly answered that the longer a bond’s maturity, the more sensitive its price is to changing interest rates. • Only 20 percent of surveyed investors understand that “the lower a bond’s credit rating, the higher the amount of interest it pays.” Fifteen percent believe that lower credit ratings are a function of longer maturities while 11 percent think that a lower credit rating indicates that it is a safer investment than a high-credit quality bond. According to the Bond Attitude portion of the study, confusion about bonds apparently prevents many from actually investing in bonds and bond funds. Almost 30 percent of investors indicated that they avoid bonds because they are difficult to understand, and 31 percent indicated that they would not invest in a bond mutual fund for the same reason. “Knowledge about bonds can add value to an investor’s portfolio, as classic allocation models suggest that nearly everyone needs at least some fixed-income exposure.” According to Denzler, “Investors can clearly better their financial positions by learning more about bonds, whether they access the abundance of resources offered by financial service companies via the Internet or by consulting a financial advisor.’’ “It’s definitely good news that a majority of investors readily acknowledge the important role bonds and bond funds play in diversifying an investment portfolio, even if those same investors truly may not understand bond basics,’’ Denzler added. Almost three out of five (57 percent) agreed that bonds help reduce risk by providing diversification, while 58 percent agreed that bonds are appropriate for a retirement savings portfolio. In fact, nearly two-thirds (62%) of investors indicate 61

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that diversification is a key reason why they would invest in fixed-income products. Preparing for retirement as one ages and a drop in stock prices of more than 20 percent are also likely to prompt some investors (46% and 36%, respectively) to increase bond or bond fund holdings. “As a group, respondents scored highest when asked about the basic advantages of bond funds versus bonds,” Denzler said. “Roughly two-thirds of investors answered that the combination of diversification, liquidity and low minimum investments made bond fund ownership generally more appealing than individual bonds.”

American Century Investments 2001 Bond IQ Quiz Following are results of the Bond IQ Quiz, which was given to 750 American investors. Percentages have been combined on questions where test participants indicated they “didn’t know’’ or refused to respond. Correct answers are in boldface. 1. Which of the following is the definition of a bond? • A debt security issued by a company, municipality, or government agency • A share of ownership in a corporation • A share in profits of a company • A mutual fund share • Didn’t know/refused

63% 6% 7% 9% 15%

2. Which of the following is not a type of bond? • Treasury notes • Government National Mortgage Association securities

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9% 12%

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American Century Investments 2001 Bond IQ Quiz (Continued ) • Zero coupon securities • Variable Annuities • Didn’t know/refused

10% 36% 33%

3. Over the last 50 years, which type of bond has offered the best total return? • • • • •

Long-term government bonds Treasury bills Long-term corporate bonds U.S. Treasury inflation-indexed securities Didn’t know/refused

16% 11% 27% 9% 37%

4. Generally speaking, when interest rates rise, bond prices . . . • • • • •

Rise Fall Stay the same Climb exactly 10 percent Didn’t know/refused

29% 31% 18% 2% 20%

5. To evaluate a bond’s performance, you should consider which of the following: • The interest it pays • Its price gains or losses • Both the interest it pays and its price gains or losses • The bond’s price-to-earnings ratio • Didn’t know/refused

11% 6% 44% 21% 18%

6. Please complete the following sentence. The lower a bond’s credit rating . . . • The higher the amount of interest it pays • The longer the maturity

20% 15% (Continued)

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American Century Investments 2001 Bond IQ Quiz (Continued ) • The safer the investment • The lower the tax-equivalent yield • Didn’t know/refused

11% 15% 39%

7. Generally speaking, the longer a bond’s maturity . . . • The less sensitive its price is to changing interest rates • The more sensitive its price is to changing interest rates • The more likely the issuer is to default • The more sensitive its price is to changes in the real estate market • Didn’t know/refused

41% 13% 3% 10% 33%

8. From the following list, please identify the advantages of owning bond mutual funds over individual bonds. Generally speaking, bond mutual funds . . . • Are more diversified, which can reduce overall risk • Are easier to buy and sell • Have a lower minimum investment requirement • All of these • Didn’t know/refused

20% 2% 3% 62% 13%

9. The primary benefit of a state-specific municipal bond mutual fund is . . . • Most of the portfolio is invested in lowerrated securities • The portfolio is invested in the state’s most successful companies

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5% 11%

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American Century Investments 2001 Bond IQ Quiz (Continued ) • The income is exempt from both federal and state taxes for residents of the state • The investment is insured by the various state agencies issuing the bonds • Didn’t know/refused

28% 24% 32%

10. A money market mutual fund . . . • Is guaranteed not to lose money • Usually maintains a constant share price of a dollar, although this is not guaranteed • Is insured by the U.S. government • Is made up primarily of long-term debt securities • Didn’t know/refused

10% 25% 18% 21% 26%

Source: American Century Investments, Mountain View, CA, company press release. Business Wire, November 13, 2001, “American Century Investments Releases Results of Bond IQ Test and Bond Attitudes Study; As Bonds Grow in Popularity, Knowledge of Fixed-Income Basics Slips.”

Understanding Interest Rates and Mutual Funds It is surprising that bond-fund buyers are not fully aware of the inverse relationship between interest rates and bond prices, considering that short-term interest rates are at their lowest levels in four decades. The interest rates on some types of bonds are likely to increase whenever the economy eventually rebounds from the current slump. And in a period of rising rates, as bond prices fall, some types of bond funds may actually post negative returns. “It can happen, 65

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and it has happened,” says Robert MacIntosh, chief economist and a bond-fund manager at Eaton Vance Management. The fact that investors are snapping up bond funds now, after sharp drops in interest rates, is evidence that “people don’t have a very good understanding of bonds and bond funds,” says Ian MacKinnon, a managing director in the bond-fund area at Vanguard Group, Malvern, Pennsylvania. Still, the fact that interest rates will eventually rebound doesn’t mean that investors should avoid bond holdings, many fundcompany executives and investment advisers argue. While bond values are generally “less compelling” than a year or two ago, Mr. MacKinnon says, “I don’t think bonds are a bad investment right now.” For one thing, investors whose portfolios are heavily tilted toward stocks can lower their overall risk over time by permanently including a bond component. Financial advisors say far too many investors blinded by the returns of stocks have ignored the usefulness of bonds as a risk-reducing component of their portfolios in recent years. The year 2001 was a good one to own bonds, with returns on fixed-income funds in the plus column as declining rates pushed prices of some bonds up. Through October 2001, the average taxable bond fund returned 5.59 percent and the average taxexempt municipal-bond fund returned 5.31 percent, according to Lipper; meanwhile, the average diversified U.S.-stock fund fell 19.38 percent. There is another reason not to write off new investments in bonds: Investors have some control over the pain they would suffer in a rising rate environment. To minimize losses, they can pick funds holding intermediate- or even short-maturity bonds, which fluctuate in price far less than the longest-maturity bonds. 66

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THE BOND-MARKET SEESAW When interest rates go up, bond prices go down. And those losses typically increase with bond maturity, as results for three Vanguard bond-index funds suggest. Below, the worst 12-month total return for each fund*

Vanguard Bond Index Funds

Short-Term 2%

Intermediate Term

Long-Term

1.50%

0 –2 –4 –6

–4.15%

–8 –7.95% *Since the three funds began in March 1994; lowest returns all occurred in periods ended January 2000.

Source Morningstar

Figure 5.1 The bond market seesaw. Source: Morningstar, Wall Street Journal.

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Unfortunately, that relationship between maturity and price volatility is another bond basic about which many investors aren’t well-informed, according to the American Century Bond IQ Quiz. Again, only 13 percent respondents in the Quiz correctly answered that in general terms, the longer a bond’s maturity, “the more sensitive its price is to changing interest rates.” Fully 41 percent of the survey participants mistakenly thought interest-rate sensitivity declines with the length of time until bonds mature. For fund investors new to the bond market, most advisors would suggest buying a fund dedicated to intermediate-term, investmentgrade bonds. They also should commit to hold that fund for at least a few years, if possible. The holding period is what is going to protect investors and provide decent returns over time. Theodore Giuliano, a managing director and fixed-income chief at Neuberger Berman, believes that novice bond-fund buyers should avoid long-term bonds and should concentrate on high-quality bonds—even though below-investment-grade, or “junk,” bonds currently offer very high yields compared with high-quality bonds. (See Figure 5.1.) “High-yield bonds behave more like equities than like highgrade bonds,” Giuliano explains, because their value is more closely related to the health of the issuing companies than to broad interest-rate trends. That means high-yield funds don’t provide as much diversification in a stock-heavy portfolio as do high-grade bonds.

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6

Learn about Bonds

T

hanks to the great advances in technology, you can learn about and research bonds for the very best price the Internet offers: free. In general terms, the Internet has revolutionized the way we invest, but more important, it has opened up investing to a group of people who previously solely relied on a broker or advice from a relative, colleague, or neighbor. With a few clicks, anyone can learn about securities. And once you find out what to buy, you can click the mouse a few more times and enter into a transaction—the seamless combination of information and commerce. But some feel that the best information should not be free, namely, the online brokerages. As such, these transaction providers have substantial content on their sites that seeks to educate investors, but beware: Their goal is to have you open an account (i.e., buy or sell). As any investment advisor would tell you, you should not buy or sell until you have read everything you possibly can about the security under consideration. 69

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Sensing this danger, the federal government and a number of nonprofit associations have created web sites to educate individual investors on buying and selling securities online, as well as to offer users glossaries of bond jargon and general information on investing. There are three categories to consider when searching the Web for bond information: (1) nonprofit organizations, (2) online media and news sites, and (3) online brokerages.

Nonprofit Organizations These are your best bet for uncompromised, independent investing information. Thanks to the increasing number of cases involving investing fraud, the federal government, securities industry, regulatory agencies, and industry trade organizations are fighting back. They have created web sites that provide substantial information for individuals seeking general industry data, as well as investing information aimed at beginning or intermediate investors. The Bond Market Association Perhaps the best no-nonsense sites for bond information, the Bond Market Association (http://www.bondmarkets.com, http://www.investinginbonds.com) operates the InvestinginBonds. com site, geared for individual investors who are considering making purchases of bonds. They have over a dozen “Investor’s Guide to . . .”-type online brochures, even for some classes of bonds not generally of interest to individual investors, including zero-coupon municipals, high-yield, and CMOs. You 70

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cannot engage in transactions on this site, but you can get updated pricing information on yesterday’s municipals and corporates, and prices on the most recently issued Treasuries. (See Figure 6.1.) Securities and Exchange Commission The “Investor Information” page (http://www.sec.gov) contains general, straightforward information on subjects relevant to the individual investor who is committed to investing online. The bond information is not as strong as that for stocks.

Figure 6.1 InvestinginBonds.com web site. 71

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Investment Company Institute This is the mutual fund industry’s watchdog, researcher, and disseminator of useful information (http://www.ici.org). Here, you can learn basics such as “What is a Mutual Fund?”, as well as find information on lesser-known products such as exchange-traded funds and unit investment trusts. For more information, see Chapter 10, “Bond Mutual Funds Online.” American Association of Individual Investors The AAII (http://www.aaii.org), headquartered in Chicago, doesn’t necessarily promote bonds, but it does advocate a rather conservative, cautious approach to investing. You may wish to become a subscriber to this organization. A plethora of useful information is available, including an unbelievable download library of software that would otherwise cost thousands of dollars.

The Fixed Income Primer If stocks are the building blocks of a portfolio, then so-called fixed income securities are the mortar that holds them together. While the words fixed income securities have a rather technical ring to them, conceptually, they are easy to understand. Simply put, fixed income securities simply refer to debts, or IOUs from businesses or governments. More commonly they are referred to as bonds where investors lend a certain sum, usually in $1,000 increments, in return for a quarterly or annual interest payment, and repayment of the $1,000 loan or principal at a stated future date. The name fixed income derives its origin from the fact that bonds, corporate or government, offer investors a rate of return which is usually stated and fixed.

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The Mechanics To understand why the rate of return is fixed even though bond prices tend to fluctuate, consider for a moment the mechanics of a typical corporate bond. Let’s say an investor has bonds from a large auto manufacturer. The face amount of the bonds, or the dollar value of each “loan,” is $1,000. The coupon rate is the amount of interest the bond will pay the investor each year, and is stated in terms of a percentage of the face amount. Therefore a $1,000 bond paying $100 per year in interest has a 10 percent coupon rate ($100/$1,000). The maturity date is the date in the future when the investor will get her original $1,000 back. Said another way, this is the date the company will pay the face amount of the bond to the owner. Now everything is nice and neat. But let’s assume two highly likely changes occur. First, that the investor holding the bonds has a need for cash and must sell them, and second, that the prevailing interest rates have gone up since the investor bought the bonds, so that similar corporate bonds are now paying a coupon rate of 12 percent. In order to sell the bond, it must be competitively priced. After all who would buy our investor’s bond with a 10 percent coupon rate, when there are other bonds out there paying 12 percent? To adjust, our investor will sell the bond at less than its face value of $1,000—and by doing so achieve a coupon rate and yield that is competitive with the then-prevailing market conditions. In this case, if the investor sells the bond for $830, the $100 that the new buyer of the bond would receive each year would result in a coupon rate with an annual yield of 12 percent ($100/$830). Conversely, if interest rates had generally gone down, the investor’s bond could command more than the face amount when (Continued)

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she went to sell. In this way, the price of a bond moves in the opposite direction of interest rates. However—and this is the key point about fixed income—even though the value of a bond may fluctuate with changes in interest rates, if the investor buys at the face amount, and never sells until maturity, the income from the investment will be known and fixed for the life of the investment—that is, the coupon yield plus return of principal. No Free Lunch In something that falls loosely under the concept of “There is no such thing as a free lunch,” all of this certainty associated with fixed-income securities has a price. That is, the historical return on government bonds since 1925 has been 5.02 percent as against the historical 12.36 percent return for small company stocks, according to Ibbotson Associates, Chicago. Not that everyone who bought stocks did better. Someone who bought stocks in the fourth quarter of 1987 when there was a crash, and didn’t stay in the market, probably did much, much worse. But, on average, investors pay for the certainty of fixed income with a lower return. As a result, the percentage of fixed-income investments that is appropriate for a portfolio differs from investor to investor. For retired people who are living off a nest-egg and who cannot afford to lose any of their savings, fixed-income securities are attractive. Even for young investors with growing incomes who may be saving for a home, retirement, or a new business, some fixed-income investment makes sense because it allows them to diversify their risk. And finally, for investors holding onto money between investments or business transactions, fixed-income securities such as certificates of deposit (CDs) or Treasury bills are an appropriate parking spot.

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Inevitable Risk Even though fixed-income securities are considered less risky than stocks, they still carry risk. The primary risks are interest rate risk and default risk. Interest rate risk comes three ways. First you will buy a bond bearing an 8 percent coupon rate, and interest rates will rise to 9 percent. This is an opportunity cost since investors who bought bonds yielding 8 percent are earning less than those who purchased bonds yielding 9 percent. Another, far greater, interest rate risk is that interest rates will rise, causing bond prices to fall, at a time when an investor needs cash. Under those circumstances, investors would lose principal just as if they purchased a stock whose price dropped. Of course, for investors who do not have to sell their bonds, this aspect of interest rate risk is eliminated. The third interest rate risk is a call feature. This feature, most often found on corporate bonds, allows the issuer of the bond to redeem them (i.e., pay back your principal) before the maturity date. This would most likely happen when interest rates fall, leaving the bond in question with a much higher coupon than prevailing rates. By calling the bonds, the issuer can avoid paying the higher interest rate by reissuing new bonds with a lower coupon rate. The risk here is that now you’ve gotten your money back and it’s going to be difficult to find a similar investment with as high an interest rate. It’s another case of opportunity cost. Finally, there is default risk, which is the risk that the financial condition of the issuer of the bonds (i.e., the borrower) deteriorates, and they are unable to make interest and/or principal payments. While there is little you can do to protect yourself against interest rate risk, investors can, to a large extent, insulate themselves from default risk by buying highly rated bonds. (Continued)

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The Rating Game Many corporate and some government bonds are rated by independent agencies. The agencies rate the ability of the borrower to make interest and principal payments. Two of the most wellknown rating agencies are Moody’s and Standard & Poor’s. They use different letters to rate bonds, but it’s fairly easy to translate between the two systems. For example, the highest rating Moody’s offers, which goes to bonds that present the smallest default risk, is “Aaa.” Standard & Poor’s highest rating is “AAA.” The great divide in bond ratings is investment grade versus noninvestment grade. Investment-grade bonds generally refer to any bonds rated Baa or higher by Moody’s, or BBB by Standard & Poor’s. Fiduciaries such as pension and mutual funds, are often prevented in their charter from purchasing noninvestment-grade bonds. Still, some institutions and individuals are attracted to noninvestment-grade fixed-income securities because they pay higher interest rates and because they do not believe the risk of default is unreasonable. Many of these investors turn out to be right, and though not common, it’s not completely unheard of for investment-grade bonds to default, either. Incidentally, fixed-income securities issued by the federal government such as Treasury bills, notes, and bonds are not rated. Since these bonds are backed by the full faith and credit of the U.S. government, they are considered to be relatively free of default risk. Municipal bonds, however, such as those issued by a city or a state or other local authority, many times are rated, since the finances of local governments can and do change. Tax Angle An important aspect to municipal bonds is that interest from those bonds is in most cases free of federal income taxes. While they generally pay a lower interest rate because of this

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feature, the so-called taxable equivalent may make them very attractive. For instance, if an investor is in a 28 percent tax bracket, a municipal bond paying 6 percent provides the same return as a corporate bond paying 8.33 percent (0.06/[1 – 0.28]). In fact, when taking into account the effects of taxes, some municipal bonds actually offer a premium over corporate fixed income securities. And, given equivalent returns between corporate and municipal bonds, some investors choose the municipals because they know that state and local governments have the option of taxing to meet interest obligations, whereas corporations do not. While fixed-income securities sometimes seem less glamorous and exciting than stocks, investors need to understand the merits of both. When you know what each has to offer, you can build a better portfolio. Source: “Fixed Income Primer,” National Investment Banking Association’s Investment Guide (http://www.nibanet.org).

Online Media and News Sites The fourth estate is the mass media—the guardians of democracy and the defenders of the public interest. They only wish to present the most relevant and compelling information to readers and investors, right? The Internet has toyed with this interpretation a bit, but with the plethora of sites out there, it is definitely worth your time to click around and see what they have to say about bonds. If your favorite portal or the web site 77

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for your favorite personal finance magazine is not among those listed below, it is most likely because it does not offer bond investing primers, interactive tools, glossaries, and the like. (It is no surprise that even TheStreet.com and CBS Marketwatch have pitiful bond information pages.) Be sure to check out all of the following sites, and then bookmark your favorites for continued usage.

Bondsonline Rated as a Top Investment Website by the American Association of Individual Investors, this Seattle-based company (http://www.bondsonline.com) has a dizzying array of information on bonds, with plenty of news, commentary, quotes, and more. Execution capabilities are handled by smaller online bond broker Bondpage, a service of Cambridge Group Investments, Ltd. (See Figure 6.2.)

Yahoo! Bond Center Providing the absolute best in bond calculators, this site (http:// bonds.yahoo.com) offers a clean, straightforward arrangement of pertinent information. The bond screener isn’t as comprehensive as those found on online brokerage sites, but the site absolutely should be bookmarked. (The bond screener was provided by BondExpress, an offering list provider, but since it was acquired by ValuBond, a commingled executable inventory system, in September 2001, the content of the Yahoo! Bond Center might change considerably.) 78

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Figure 6.2 Bondsonline.com web site.

Wall Street Journal Interactive Available only to subscribers, the online version (http://www.wsj. com) offers the same daily credit market information as the print Journal, only with the added ease of clickability. The Markets Data Center offers information on bond indexes, bond yields, Dow Jones Bond Averages, Federal Reserve Data, money rates, and other information. For Wall Street Journal print subscribers, online access is available for a very reasonable $39.

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Other Sites to Consider Barron’s Online (sister to the Wall Street Journal) SmartMoney.com (a content provider for Yahoo! Bond Center) Kiplinger

http://www.barrons.com

http://www.smartmoney.com

http://www.kiplinger.com

Ten Things Your Broker Won’t Tell You about Bonds 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

My commissions are top secret. I get paid to dump my inventory into your account. Your long-term investment may be short-lived. You don’t need this government bond fund I’m selling you. Warning: This ‘’low risk’’ bond fund can be hazardous to your wealth. Your tax-free municipal bonds may be taxable. . . . . . . and, um, so may be your tax-free muni funds. Your high-yield fund is full of foreign junk. You’re buying the wrong Treasury bond. The rating agencies need to brush up on their ABCs.

Source: “Ten Things Your Broker Won’t Tell You about Bonds,” from SmartMoney.com (http://www.smartmoney.com).

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My commissions are top secret. Thanks to a still-unsettled economic climate, more and more people are attracted to bonds. People have taken it on themselves to learn more about fixed income and how it can help them and their portfolios. However, they still must often deal with brokers—who may or may not reveal their commissions. Bond brokers don’t have to reveal their “markups,” or the commission-like profits they charge you. Typically, a broker buys a bond at one price and sells it to you at a higher one, pocketing the difference. Because most bonds do not trade on a formal exchange, investors must often shop around for the best prices. According to Berwyn, Pennsylvania–based InterVest, institutional investors paid $41 billion more than they should have on corporate bond markups between 1995 and 1997. And individuals are even more vulnerable, as any bond purchase under $1 million is considered an “odd lot” and subject to a higher markup. The National Association of Securities Dealers requires only that markups be “fair.” That leaves many brokers the opportunity to push the envelope. Most don’t, but plenty do. The Securities and Exchange Commission and the National Association of Securities Dealers have been passing reform proposals back and forth for years. Investors’ best bet is to avoid markups and bypass brokers altogether. You can buy Treasury notes and bonds online through the TreasuryDirect program (www.publicdebt.treas.gov on the Internet). You can also buy bonds through a so-called agency trade, in which your broker connects you with a seller and charges you a set commission, typically $50.

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I get paid to dump my inventory into your account. Commissions are one thing that investors must be aware of when dealing with a broker, but there are other sales incentives that give brokers the idea that they should sell you bonds with or without your best interests in mind. When brokerages buy bonds in huge blocks from the government, companies, and municipalities, the firms hold them as “inventory,” later trading them on the market (called the “secondary market”) or selling them to clients. Sometimes, brokers will push a bond from their inventory because they can make more on the markups in this manner. “You have to ask if the bond is being recommended on its own merits or because the brokerage house owns it,” advises Richard Lehmann, president of the Bond Investors Association, a financial advisor and newsletter publisher in Miami Lakes, Florida. Ask your broker if there are any incentives tied to his recommendations. “If they lie, it’s fraud,” says Steve Wallman, a senior fellow at the Brookings Institute and a former SEC commissioner. Your long-term investment may be short-lived. This refers to call risk, or the risk that the bonds will be called or bought back by the issuer long before the maturity date. Issuers usually call bonds and then, after interest rates have plunged (which they did last year), turn around, refinance their debt, and issue another offering at a rate more favorable to them. Thus, bondholders can quickly learn that their safe haven has disappeared. When a bond is called, you’re repaid at the issue 82

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price—”par”—or par plus a small premium. You face a loss if you bought the bond above its face price (a “premium” bond), or a loss of any gains if the bond rose after you bought it. Also, since interest rates have fallen, you would be reinvested at a lower yield. Be especially wary of high-yield, or “junk,” bonds since companies try to pay down their high-interest debt as soon as they can. You don’t need this government bond fund I’m selling you. Bond mutual fund assets continue to climb into the billions. Many small investors prefer to invest in them because, like other mutual funds, they just seem easier to deal with. However, when it comes to Treasuries and certain other government bonds, you’d be better off buying the bonds directly. Since government bonds carry no credit risk, the mutual fund manager—who is paid a very high management fee—has a very easy job. And don’t forget that many funds carry a load and other expenses, including the 12b-1 marketing fees. If you still want to invest in a government bond fund, do some shopping around. Warning: This “low risk“ bond fund can be hazardous to your wealth. With fund managers under pressure to beat their competitors and the overall market, some may pursue riskier investments— even in bond funds. Government bond funds, for example, might be invested in riskier mortgage-backed bonds such as Ginnie Maes to get better returns. While these bonds are backed by the government, they add volatility and sensitivity 83

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to changes in interest rates. That means investors need to do their homework and scour prospectuses. The SEC requires only that funds invest at least 65 percent of their assets in their objective. Surprised? Your tax-free municipal bonds may be taxable . . . Yes, it’s true. Municipal-bond holders used to expect virtual immunity from the IRS, but now that has been significantly challenged. The agency can now revoke the bonds’ tax-exempt status and tax muni investors when it finds that the bonds don’t comply with tax laws and it can’t reach a settlement with the issuer. The IRS can do this when it learns that the proceeds of a municipal bond offering have been misappropriated. Also, when a local government fails or refuses to pay certain taxes, the IRS will go no only after the municipality, but also the bondholders. Bondholders can be held liable for the actions of the issuer or underwriter long after the bonds are sold. More and more muni holders may find their investment backfiring as the IRS steps up its investigation into the effects on tax compliance of “yield burning”—the controversial practice of inflating muni offering prices by driving down bonds’ yields. As a result, investors now need to pay closer attention to the reputation and financial background of issuers and underwriters. . . . and, um, so may your tax-free muni funds. When investors buy so-called private-activity bonds, which are often used to help fund the building of airports and stadi-

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ums, they may not be aware that these bonds pay income that is subject to the alternative minimum tax (AMT), which was designed to prevent taxpayers from taking advantage of deductions and other breaks to pay little or no federal income tax. Investors must be aware that the interest payments from municipal bond mutual funds that own private-activity bonds can push the investor’s income to a level where he or she at least has to file an AMT form and possibly has to pay the tax itself. Congress estimates that as many as 8.5 million people will have to pay the AMT by 2007, up from just 605,000 in 1996. Your high-yield fund is full of foreign junk. High-yield bonds have made a slight comeback, shedding their “junk” reputation of the 1980s Milken era by providing attractive returns and a declining default rate. Default rates worldwide ran under 2 percent during the past few years, far below their 3.4 percent average since 1970, according to Moody’s. Today, a record $109.4 billion is invested in junk-bond funds, more than triple the Milken-era peak in June 1989. However, in order to seek the higher yield—and higher risk— fund managers have looked overseas for high-yield debt. As much as 15 percent of the assets of a high-yield bond fund may be invested in foreign issues, according to Mark Wright, a senior analyst at Morningstar. And if the issue is from a company in an emerging market, the debt is all the more risky because of currency fluctuations.

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You’re buying the wrong Treasury bond. You should always try to buy Treasuries through TreasuryDirect (see #1), but you may not always be able to. One problem: With infrequent auctions of longer-term issues, the program may not always have what you want when you want it. If you can’t wait for the Treasury’s next auction, the “secondary market” is where you’ll have to go. Yes, this means you will have to deal with a broker. Brokers like to push the latest-issued bond, since it is the most liquid and presumably easiest to sell. One problem, however, is that these current bonds usually carry a premium for their liquidity—and the market in older Treasuries is large and liquid enough to guard small investors from being ripped off should they have to sell suddenly. Your best bet is to keep abreast of the Treasury market and be aware of changes or shifts in the market. The rating agencies need to brush up on their ABCs. Moody’s, Standard and Poor’s, Fitch IBCA, and other agencies are supposed to be the first and best line of defense against changes in credit conditions. However, with several corporate defaults, both domestic and abroad, these agencies have been caught red-handed. What happened to their flawless commentary, predictions, and ratings? Investors have usually been the ones scratching their heads. The best way to ascertain the creditworthiness of an issuer is to do a little homework and study the past history of the issuer and whether there have been signs of trouble. It might mean a little more work, but it’s worth it in the long run. The ratings agencies are far from perfect.

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Top Ten Things to Know from CNN Ten more things to be aware of: 1. Stocks do not always outperform bonds. Stock and bond returns were roughly equal from about 1870 to 1940. It is only since World War II that stocks have widely outpaced bonds in terms of total return. With bankruptcies rising and weak corporate earnings, stocks may not enjoy their double-digit returns for awhile. 2. You can lose money in bonds. Far from being “investments for widows and orphans,” bonds, even with their certain lifespan and known interest payments, are subject to a number of risks. 3. Bond prices move in the opposite direction of interest rates. This is the first rule of thumb with respect to bond investing. When interest rates fall, bond prices rise, and vice versa. However, if you hold a bond to maturity, price fluctuations don’t matter since you will be paid back your principal and interest at maturity. 4. A bond and a bond mutual fund are totally different animals. Bond funds’ values fluctuate because the funds are portfolios of different securities that you have not individually scrutinized. There are also a number of management and marketing fees associated with bond funds. When you buy a bond individually, you can analyze risk factors and credit quality by yourself to make a decision. 5. When buying individual bonds, stick with new issues when possible. New issues are the best bet. Older bonds are more dicey, include a dealer’s markup. These markups are often excessive and you will never know what spread you are paying unless you ask—and if your broker is willing to tell you. (Continued)

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Top Ten Things to Know from CNN (Continued ) 6. Don’t invest all your retirement money in bonds. Rule of thumb: Inflation erodes the value of bonds’ fixed-interest payments. Stock returns, by contrast, tend to keep pace with inflation. While younger investors tend to be attracted to stocks, even retirees should own some stocks, given that people are living longer than they used to. 7. Consider tax-free bonds. When comparing taxable bonds with tax-free bonds, you should determine the taxable equivalent yield, or what the yield on a taxable bond needs to be if you decide to invest in that in place of a tax-free bond. However, even if the taxable equivalent yield is identical to the yield on a tax-free bond, go with the tax-free bond. Taxable bonds usually carry additional risks (especially if issued by corporations). 8. Pay attention to total return, not just yield. Total return takes into account the bond’s price as well as its coupon. Most investors, following the advice of their broker, simply look at the coupon, or the yield. 9. If you want capital gains, go long. Those who want to bet on the direction of interest rates should buy long-term bonds or bond funds, especially “zeros.” The reason is that when rates fall, longer-term bonds gain more in price than shorter-term bonds. So you win big—scoring a large potential capital gain in addition to whatever interest the bond may be paying. On the other hand, if rates rise, you lose big, too. 10. If you want steady income, stick with short to medium. Investors looking for income should invest in a laddered portfolio of short- and intermediate-term bonds. By reinvesting the prin-

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Top Ten Things to Know from CNN (Continued ) cipal in matured bonds in new issues, you are managing your portfolio more actively and will become more aware of bond behavior over the longer term. Source: CNN Money’s “Top Ten Things to Know” (http://money. cnn.com).

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7 Selecting an Online Broker

Y

ou see a billboard or an advertisement in a magazine for a brokerage, but how do you know which one to select? The decision is ultimately up to you. Perhaps you are already quite satisfied with your brokerage, and they already offer bonds and other products of interest to you. I will not tell you which brokerage is “better” than any other. (And again, I am not a registered representative of a NASD-member firm, so it is not in my interest to push you into opening an account at a particular firm.)

Gomez Advisors The Web (you guessed it) is the best place to turn for information on sizing up the brokerages. The first place you should start is the site for Gomez Advisors (http://www.gomez.com). 91

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One of the biggest research firms to track the online brokerage sector early in its development is Waltham, Massachusetts–based Gomez Advisors. Julio Gomez launched the company in 1996, and one of his strongest offerings was—and still is—the Online Broker Scorecard (Figure 7.1), which tracks both discount and full-service firms. “Discount,” of course, doesn’t mean that these firms offer

Figure 7.1 The Gomez Online Broker Scorecard. 92

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price reductions, or worse, cheap, low-quality products, which is often the case with traditional brick-and-mortar retailers known as discount stores. The term discount broker has come to refer to those online brokerages that started out as only offering one product—usually inexpensive stock trades—but that have expanded their offerings and now offer multiple financial services online. Just because these online brokerages are referred to as discount, that does not mean that “full-service” is unavailable through their web sites. Likewise, the firms rated on the Gomez Full-Service Scorecard usually refer to the online versions of traditional brokerage firms, such as UBS Paine Webber or Morgan Stanley. The Gomez Online Broker Scorecard was formerly published quarterly, but due to consolidation and other operational considerations it is now updated only twice a year. This is perfectly acceptable: With most new technologies already built and deployed by online brokerages, and no flashy advertising campaigns to lure trade-happy investors in the works, by and large, the online brokerage industry will not change as dramatically in the next few years as it did in the past two. The Scorecard is the result of Gomez’s analysts’ painstaking observations of the online brokerages. They open accounts with real money, and utilize the firms’ web sites as if they were actual investors with different goals. In a way, the Gomez analysts are “secret shoppers,” who use the brokerage firms’ offerings without the companies’ prior knowledge. In this way, you know that the information isn’t compromised. The results are arranged according to investing preference— Hyper-Active Trader, Serious Investor, Life Goal Planner, and One-Stop Shopper. 93

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Other Analysts Other online financial services “industry analysts,” or “e-finance analysts” as they have come to be called, include departments or groups within the following firms: TowerGroup International Data Corporation Forrester Research Gartner Jupiter Media Metrix Celent Datamonitor

http://www.towergroup.com http://www.idc.com http://www.forrester.com http://www.gartner.com http://www.jmm.com http://www.celent.com http://www.datamonitor.com

I’m sure you’ve read or heard about the analyst firms listed above. During the all-night party of Internet stocks, when online brokerages would consistently experience ever-higher trading volumes and issue ambitious press releases, the above-mentioned research firms would produce a stream of reports on the state of the online financial services industry. The reports would make wild predictions for daily trades, market size, new products, demographic profiles, and technology adoption. The principal buyers of the research are large corporations, technology providers, investment banks, and venture capital firms. The pricing would generally be in the $20,000 to $30,000 range for a year of reports in addition to access to the analyst. In the past few years, venture capitalists very much relied on this research, as their lean-staffed firms had to turn to external providers for approval on particular investments. But most likely, you are not a venture capitalist; you are an 94

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individual investor who is eager to learn of additional sources for guidance and knowledge. As such, the merits (and methodologies) of the research from such analyst firms are probably of little use for you—after all, who really cares about the size of the online insurance industry in 2012?—but it might be worth an occasional glance at the research to learn about trends and new markets in the online financial services industry. And you don’t have to pay $30,000 for the research: You can always read press releases on these firms’ web sites or sign up to receive free e-mail alerts. And with the markets turned south, plenty of venture capitalists were embarrassed making investments based on these firms’ untethered assumptions. Proceed with caution.

Equity Research Analysts Online brokerages also received attention during the Internet boom because some were publicly traded companies. As they issued press releases and conference calls declaring new partnerships, technologies, hires, trading volume, and account acquisitions, the resulting news often clogged the financial press, including the Yahoo! Finance and CBS Marketwatch web sites, or newspapers like the Wall Street Journal or Investor’s Business Daily, which also tracked their stock performance. The investment banks that underwrote the IPOs of the online brokerages, or those that held large positions in them, most likely had an analyst from the equity research side track and follow their corporate activity. Some investment banks, because they tracked so many companies involved in the online financial services industry, retained special e-finance analysts and groups. 95

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These groups became oft-quoted figureheads and notable mouthpieces on the direction of online brokerage. While the noise has quieted down somewhat, some continue to be respected voices in the industry: Hambrecht & Quist (owned by J.P. Morgan Chase) Robertson Stephens Piper Jaffray Putnam Lovell Keefe, Bruyette & Woods

http://www.jpmhq.com

http://www.rsco.com http://www.pjc.com or http://www.gotoanalysts.com http://www.putnamlovell.com http://www.kbw.com

If you read the research (full access will cost you, but you can sign up for free e-mail news alerts), you will be afforded an insider’s view of deals early on. You may also learn about which brokerages are about to expand, contract, merge, or go out of business, especially if that brokerage doesn’t issue a press release and doesn’t appear in the news. For example, you may read about a marketing partnership arranged between your online broker and a large mortgage originator. One month later, you get an email alert from your brokerage asking if you want to refinance your mortgage. Déjà vu: You read about it from the e-finance analysts first. While the research from e-finance analysts may somewhat be outside the scope of the individual investor’s interest, you may want to check it out from time to time, just to keep abreast of developments in the industry. (See Figure 7.2.)

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Figure 7.2 Putnam Lovell’s eFinance research group.

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8

Municipal Bond Overview

M

unicipal bonds, affectionately known as “munis,” are one of the best instruments ever created for investors. They are the be-all, end-all, civic-minded type of investment: Your hard-earned dollars go to building government and public structures and services, like highways, bridges, sewage treatment plants, airports, and hospitals. And besides doing your public-service part, the bond’s interest is federal and sometimes state tax–free to encourage investment in the bonds financing these projects. What more could you ask for? The federal and state governments don’t tax each other’s bonds, so you don’t have to pay federal taxes on the interest you earn on municipal bonds. And, in many states, the income is also exempt from state taxes. As long as the Internal Revenue Service exists, investors will be clamoring for an instrument that is tax-exempt. This constant demand means prices tend to remain steadier; municipal bonds tend to have more subdued highs and lows than other 99

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fixed-income securities. This does not mean that municipals cannot experience dramatic changes in their value in reaction to surprising economic news, or big swings in the new supply of or demand for muni bonds. Also, keep in mind that because of municipal bonds’ tax-exempt quality, local governments issue bonds with lower yields, knowing that they can still attract interested investors. You generally don’t shop in the municipal market based solely on yield; you look for credit quality, maturity, and other factors.

The Taxable Equivalent Yield Savvy investors use simple calculations to decide if they should buy a higher-yielding taxable bond, or go for the lower-yielding but tax-free offering. These calculations are presented here to help you understand yield calculations, but it is still important to understand that, generally speaking, the credit quality of lower-yielding tax-free bonds (munis, but also U.S. government or Treasury securities) is usually higher than any taxable offering, thereby making such bonds the right choice even if a similar taxable equivalent is available for purchase. As an illustration, here is how you calculate the taxable equivalent yield (TEY) for municipal bonds. Let’s assume a federal tax rate of 25 percent and a tax-exempt yield of 5.45 percent. First find the reciprocal of your tax rate: 1 – your tax rate 1 – 25% = 1 – .25 = .75 or 75% 100

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Then divide this tax rate reciprocal into the tax-free yield to calculate the TEY: TEY = Tax-free yield ÷ .75 = .0545 ÷ .75 = .07266 = 7.27% This means that you would have to buy a taxable bond yielding at least 7.27 percent in order to match the tax-free yield of 5.45 percent. If the taxable bond you are considering buying (most likely, a corporate bond) yields less than 7.27 percent, you would want to go ahead with the municipal bond. There is also the likelihood that the taxable bond you are considering is yielding something higher, which might seem a better alternative, but you must realize that the income you earn on the bond might push you into a higher tax bracket (speak to your accountant about this). Again, credit qualities of the taxable and tax-free varieties are most likely very different, so you must be willing to figure this into the calculation. The above example is the generally accepted method of calculating the TEY, and it’s the simplest. If you want a more accurate method, you need to adjust for the fact that state taxes are deducted from your federal tax bill. To calculate your federal tax rate adjusted for the state tax deduction, first multiply your federal and state tax rates together, then subtract this amount from the federal rate. Of course, the easiest and most accurate method is to simply take a look at last year’s federal tax form. Another factor to consider is whether you live in a state where municipal bonds are free from both federal and state taxes—this 101

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is called being “double tax-free.” Again, consult with an accountant when reviewing the tax consequences of the bonds.

Taxes of Munis versus Treasuries When you are comparing a municipal with a U.S. Treasury alternative, you need to calculate the TEY for the Treasury also, since Treasuries are exempt from state taxation. To do so, use the formula below: TEY = yield-to-maturity for the Treasury ÷ (1 – state tax rate) To summarize, U.S. Treasuries are free from state taxation. Municipals are free from federal taxation, and in most states, free from state taxation (generally, their own issues). So you need to calculate the appropriate TEY for each in order to equitably compare them.

Two Types of Municipal Bonds: GOs and Revs The taxing authority of the issuer backs general obligation bonds (GOs). The local government is pledging to pay back both the principal and the interest with money it receives either from taxpayers or from future bond issues. No specific project—tunnel, highway, bridge—is pegged to raise funds to pay GO investors. The issues are to be paid off with money from the general coffers of the government. GO ratings reflect how fiscally responsible the issuing governmental agency is. As with any bond, the better the government’s 102

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credit standing, the better its rating is and the lower the interest rate at which it can borrow. If it is less of a risk, it can offer lower rates and still attract investors. Similarly, if the governmental agency is more of a risk (yes, there are some out there), then its credit quality is lower and therefore it must borrow funds at higher rates. Remember that a higher rate isn’t necessarily a more attractive feature with GOs. Most investors prefer GOs over other types of munis because they feel that the government is less likely to go out of business than a project such as a tunnel. However, wary investors do not allow themselves to blindly put their money into any government or municipality. Remember Orange County, California, declaring Chapter 11 in 1994? Use your common sense with GOs; read research reports, pay attention to the bond’s rating, and consult with investment professionals. The various bond websites have much to say about GOs, and which municipalities are favored over others. The other class of municipal bond is revenue bonds, affectionately known as “revs.” Revs are backed by the revenues generated by a specific project’s user fees. The proceeds from the bond sale are used to build or maintain a project. User fees include tolls taken on a turnpike, bridge, or tunnel, override fees paid by attendees at civic or convention centers (you’ve no doubt had to pay these at any new convention center), or airport landing fees. The bond’s rating reflects the financial prospects for the project: how much it will be used, how much consumers can be charged, whether constructing the project is likely to stay within budget, how much it will cost to maintain, and so on. Revenue bonds are commonly felt to have a little more risk than GO bonds since it is believed that there is more that could go wrong 103

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on a project and that you can’t raise user fees as much as you can raise taxes. Also, what happens when motorists avoid using the new, expensive bridge or tunnel, or no one shows up at the new civic center? Or, a hurricane, tornado, or other natural disaster destroys the project? Whether or not this is the scenario, it is this risk with a revenue bond that gives it a yield slightly higher than that of a GO with a similar rating. GOs and revs are the two main muni issuers. They issue a number of different types of munis that include anticipation notes, alternative minimum tax (AMT) bonds, insured bonds, zero-coupon or capital appreciation bonds, and callable and prerefunded bonds. The web site or broker from which you are buying the bonds can describe each in more detail.

A Word about Insurance Insured municipal bonds have become more and more common. With an insured muni, an insurance company guarantees that the bond’s interest or principal payments will continue even if the issuer becomes insolvent and cannot pay. Some investors like the added peace of mind that comes with buying insured municipal bonds. For this added peace of mind, they are also willing to forgo some yield. As with any type of insurance, you should know the financial health of the insurance company that is insuring the bond you are buying. Insurance companies are evaluated by the rating agencies; the most well-known and accepted insurance companies enjoy an AAA rating. These private companies insure most of the bonds in the insured municipal market. These industry leaders include: 104

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MBIA FGIC AMBAC FSA

Municipal Bond Insurance Association Financial Guaranty Insurance Company American Municipal Bond Assurance Corporation Financial Security Assurance Holdings Ltd.

Bonds can be insured a number of different ways. The bond can be issued as an insured bond, or insurance can be bought after the bond is in the secondary market (individual investors usually do not participate in the latter—insurance is available only for extremely large bond quantities). Due to strong economic times and healthy competition among insurers, as many as half of all new municipal bond issues are insured. This is a good thing for individual investors.

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his chapter overviews the leading online brokerages available to investors: most notably MuniDirect and Public Debt Online. One sells municipal bonds, and the other, U.S. Treasuries (and even savings bonds). Since these categories are the two that individual investors concentrate on most when contemplating purchasing bonds directly for their portfolios, I feel that they would be of extreme value for you to consider.

MuniDirect With over 400 different dealers providing inventory of about 10,000 bonds available for purchase, three-year-old Atlantabased municipal bond brokerage MuniDirect (http://www.

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MuniDirect.com) is one of the best sites for direct municipal bond investing. MuniDirect does not hold inventory of the bonds it sells, and charges a fully disclosed commission—.250, .375, or .500 percent of the principal, depending on maturity—to its customers. “We have allowed the retail investor to take a huge step forward with respect to buying municipal bonds,” says John Durrett, CEO of MuniDirect. MuniDirect advocates that five basic pieces of knowledge are needed when making a municipal bond investment decision: 1. 2. 3. 4. 5.

Maturity Credit rating Yield to maturity Callable/not callable Number of bonds you want to buy

The site also offers a MuniWizard (Figure 9.1), on which, after answering a series of questions through five web pages, you can view the available bonds, based on the criteria you entered. And the “Learn About Municipal Bonds” web page has information from the Bond Market Association (http:// www.bondmarkets.com, or http://www.investinginbonds.com), perhaps the best site for free, uncompromised information from the industry. (See the sidebar by John Durrett.) “Brokers do not add value for individual investors,” continues Durrett. “It’s all very simple. If you can learn a small amount of information, any retail investor is completely able to make his or her own decision.” For even more information on municipal bonds, I suggest sub-

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Figure 9.1 MuniDirect’s MuniWizard.

scribing to the online version of financial newsletter The Bond Buyer (http://www.bondbuyer.com), allowing you access to breaking news, statistics, results of sales, and other institutionallevel information concerning the municipal bond industry. You might wish to also consider a subscription to Thomson Municipal Market Monitor (http://www.tm3.com). However, Thomson offers a free municipal bond glossary, available at https://www.tm3.com/refer/glossary/glossary.htm. MuniDirect’s glossary is available at http://www.MuniDirect/ glossary.html, provided by the California Municipal Bond Advisor newsletter.

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Lebenthal on the Web One of the most respected underwriters and dealers of municipal bonds is Lebenthal & Co., which in summer 2001 agreed to be acquired by brokerage firm Advest, a division of insurance company MONY. From the looks of their web site (http://www.lebenthal.com), it seems that Lebenthal is also committed to educating the individual investor on all aspects of municipal bonds. The self-proclaimed “Workhorse of Investments,” Lebenthal admits with a smile, “If you’re going into Municipal Bonds, we want you going in with your eyes wide open—not glazed over.” The leftmost tab of the homepage is “Municipal Research,” where you can access case studies of how actual municipal underwritings took place. One of particular interest is “Ports: A Resilient Issuer,” a financing for the Port Authority of New York and New Jersey after September 11, 2001. This case study provided on Lebenthal’s web site first walks the investor through the background and financial soundness of the issuer, and then proceeds to explain the Port Authority’s revenues, operating expenses, and reserves. It also gives a short historical background of the Authority, its varied operations and facilities, and how it is managed. But most important is the explanation of how the Authority’s revenues can be expected to change in consideration of the aftermath of September 11—reduced air travel and corresponding passenger activity and traffic, and reduced traffic at tunnels and bridges. In addition, the rates of insurance coverage for Authority properties can be expected to be adversely affected. Because of these uncertainties, the three ratings agencies— Moody’s, Standard & Poor’s, and Fitch—while all giving relatively high marks to the issuer are all divided on the issuer’s outlook.

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Lebenthal on the Web (Continued) This straightforward assessment of the risks involved with an investment in the Port Authority after September 11 should give investors the clues to decide whether getting involved with the Authority is the right decision for them—or for any given municipal underwriting. In other case studies, Lebenthal enlightens the online investor with relatively concise, to-the-point illustrations of the benefits as well as risks of considering an investment in the bonds issued by a particular municipality. Without endless pages of financial jargon, the municipal bond investor can learn more about the industry and how its financial system works—online and for free.

Public Debt Online Public Debt Online is at http://www.publicdebt.treas.gov. That’s right, this is a .gov site—perhaps the only one that is mentioned in this book that offers transactions. On this site, you can buy, direct from Uncle Sam, U.S. savings bonds (remember them?) as well as U.S. Treasury bills, notes, and bonds. (See Figure 9.2.) TreasuryDirect, a book-entry securities system operated by the Bureau of the Public Debt program, is designed for investors who purchase Treasury bills, notes, and bonds and intend to hold them until maturity. Under TreasuryDirect, individual investors maintain accounts directly with the Treasury. (See Figure 9.3.) I encourage you, even if you are not in the market right now for Treasuries, to click around this site and learn the inner workings of the U.S. Treasury and how they auction and distribute them. 111

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Figure 9.2 Public Debt Online site for placing orders for savings bonds.

Cheat Sheet (just in case you are lost) Treasury bills are short-term obligations issued with a term of one year or less. Treasury bills are sold at a discount from face value (par) and do not pay interest before maturity. The difference between the purchase price of the bill and the amount that is paid at maturity (par), or when the bill is sold prior to maturity, is the interest earned on the bill. Treasury notes and bonds bear a stated interest rate, and the owner receives semiannual interest payments. Treasury notes have a term of more than one year, but not more than 10 years. Treasury bonds are long-term obligations issued with a term of more than 10 years.

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Figure 9.3 TreasuryDirect.

Debt to the Penny A curiosity of the site mentioned earlier, publicdebt.gov, is their “The Debt to the Penny.” Just click on http://www.public debt.treas.gov/opd/opdpdodt.htm, and you can access the total national debt—including debt held by the public as well as that of intragovernmental holdings. As of this writing it stands at just over $57 trillion. Other factoids are available at http://www. publicdebt.treas.gov/opd/opd.htm. The site is, if anything, an experiment for the U.S. Treasury in selling securities to investors. Before the arrival of this site, the little guy went to the bank for those Series EE savings bonds, or 113

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had to rely on the large investment banks that, as major dealers of Treasury securities, were authorized to resell the securities to the public—often at questionable markups. This issue turned into scandal in 1991 when Salomon Brothers (now Salomon Smith Barney) was accused of improperly marking up prices of Treasuries for retail investors, forcing a multimillion-dollar fine and the resignation of the firm’s chairman, John Gutfreund. The site is also an experiment in the government’s utilizing e-commerce methods to enable ordinary citizens to invest.

MuniDirect and Municipal Bond Investing By MuniDirect CEO John Durrett Company: MuniDirect Headquarters: Atlanta, GA Professional Memberships: National Association of Securities Dealers (NASD), Municipal Securities Rulemaking Board (MSRB), and registered with the Securities and Exchange Commission (SEC) Product Offering: Offers thousands of municipal bonds and new issues Web address: www.munidirect.com Toll-free phone: 888-432-MUNI (6864) MuniDirect was founded in March 1999 with a fairly simple idea: create the first discount brokerage firm for the municipal bond market. Since that time, we have been both an online pioneer and a staunch consumer advocate for the individual investor. The municipal bond market is fraught with conflicts of interest and a lack of disclosure. MuniDirect has taken the conflict of interest out of

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MuniDirect and Municipal Bond Investing (Continued) this area and has empowered individual investors to make their own investment decisions involving tax-free bonds. If you have bought a municipal bond before, perhaps you know how it works. Your broker calls you and says, “I have a bond here for you paying 5.30% tax free,” and you say, “I’ll take it.” Well, you probably didn’t know that this bond he sold you was out of his inventory, a pure conflict of interest. Also, when your confirmation comes, the “Commission” box says zero, implying the broker makes nothing on this transaction. Little do most investors know that brokers embed fat markups into their prices, which can be up to 3% of your investment, and they don’t even tell you about it! (If you don’t believe me, the day after you buy a bond from a big firm, ask them to “bid” you for it; don’t be surprised if they bid you at least 3% lower than what you paid the day prior!). And lastly, how do you know that 5.30% is good or bad for a given security? Where is there a way to compare this yield to what other munis yield? Well, the truth is that your broker doesn’t want you to shop around, because chances are his yields will be lower because he has to build in his big commission, which raises the price and lowers the yield. Basically, the less you know the better from your broker’s point of view. MuniDirect is the only firm that does business in the complete opposite way. First, we do not hold any inventory internally and we trade “As Agent” for our customers while employing no commissioned salespeople, so we have no conflict of interest. Second, we have contacts with over 400 bond dealers, producing a much wider selection than the big firms and giving you a much better, unbiased view of the marketplace. Third, we are the first and only firm to fully disclose our commissions in writing on every single trade, so you know, to the penny, what your trade costs (Continued) 115

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MuniDirect and Municipal Bond Investing (Continued) you. Lastly, munis are all we do here at MuniDirect, whereas most brokers sell everything from annuities to stocks to home mortgages. Can they be that good at all of them? Most investors are timid to look at municipal bonds on their own and buy muni funds instead. When you think about it, chances are that buying funds is an expensive mistake. Here’s why: most funds have an annual expense ratio over 1% per year. When you have a fund that invests in bonds yielding around 5%, you are giving away 20% of your return to your mutual fund company every single year! Add the fact that you are not in complete control of your taxable events in a fund, and they start to look less and less attractive. So, how do you get started buying individual bonds? Simple. You can run an online search at www.munidirect.com and type in your state, maturity range, and credit quality, and a list of bonds will be presented for you to choose from. Even if you do not wish to do business with MuniDirect, we encourage you to use our site to keep your broker honest. The next time he/she calls with a bond offering, please use our site to look at comparables in the marketplace. It’s free of charge and can only make you a more informed and confident investor. Our hope is that over time, more and more investors will become more confident in buying bonds without a broker and save time and money using our services to their ultimate benefit. Best wishes to all muni investors!

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Bond Mutual Funds Online

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s any investment advisor might tell you, mutual funds offer considerable benefits for the individual, self-directed investor. For one thing, they seem to be much more convenient to invest in than if one were to purchase individual securities. Bond funds offer monthly income, portfolio diversification, and professional money management. A bond fund is usually made up of individual bonds similar in maturity, quality, and type of issuer; as such, buying into a bond fund is a good way for the small investor to tap into a specific sector or objective without committing a large exposure. Clearly, investors that seek to invest in bonds that sell in high denominations, such as certain mortgage-backed and agency bonds, or bonds that are too “complex” for individual investors, including convertibles, sovereigns, junk, and derivative securities, would be better off investing in these securities through mutual funds.

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And, of course, the most attractive feature of investing in bond funds is “daily liquidity”—bond funds have no set maturity date—the investor typically has the option to sell on any business day at the next available net asset value (usually the end of the day). Plus, many bond funds offer a check-writing option on the balance in addition to allowing the investor to automatically reinvest income dividends and to make additional investments at any time. Investing in bond funds rather than individual bonds might also carry less risk and help to diversify a portfolio. Individual bond investors stand to lose all of their money if the issuer defaults. In contrast, a bond fund holds hundreds of different bonds from different issuers, reducing the effect if one issuer fails to pay interest or principal. In 2000, according to the Investment Company Institute, net assets of all mutual funds amounted to $6.969 trillion. Of this total, roughly 57 percent, or $3.963 trillion, was held in equity mutual funds. Bond funds, on the other hand, witnessed $811 billion invested, or 12 percent of the total. However, with investor demand for bond funds remaining flat for a number of years, a number of fund companies have merged or liquidated a small number of bond funds. The total number of bond funds in 2000 fell to 2,222 from 2,261 the previous year. (See Figure 10.1.) Considering the percentage of IRAs, 401(k) plans, and other retirement programs that are invested in and allocated to mutual funds—$2.5 trillion, or about 35 percent of the industry’s assets—it seems that at one point or another, every investor, regardless of age, goals, and liquidity, would consider buying into mutual funds. Why not turn to the Internet to learn about, search for, and invest in bond mutual funds? 118

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Figure 10.1 The Investment Company Institute.

Turning to the Internet for Bond Mutual Fund Information Throw out the newspaper and cancel your subscription to that magazine: Everything you need to find out about bond mutual funds is available online—often free of charge and within seconds of a click of a mouse. Not all sites offering bond mutual fund information will allow you to actually engage in a transaction. (In Internet jargon, this category of site is an infomediary, since it provides information so that the user can later engage in a transaction using a different method, as opposed to a site involved in e-commerce, which allows for the full transaction to occur securely online.) 119

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Even if you do decide to purchase mutual fund shares offline (calling the fund management company’s toll-free number, or calling your broker), it is much more efficient—not to mention convenient—to utilize the Internet for information, ahead of engaging in a transaction. Again, as mentioned previously in this book, the Internet is continuing its rapid-fire consolidation, and it is quite possible that the web sites listed below will not offer the following features by the time this book appears for sale on Amazon or BarnesandNoble.com. I ask you to continually stay abreast of what financial sites are offering what, and to keep revisiting those sites based on your own information preferences and also the “look and feel” you are comfortable with. The Investment Company Institute Founded in 1940, the Investment Company Institute (http:// www.ici.org) is the national association of the U.S. investment company industry. Its membership includes 8,638 mutual funds, 498 closed-end funds, and seven sponsors of unit investment trusts. If you own shares of a mutual fund, that fund is most likely a member of ICI. You might never have realized that such an organization existed, but hopefully, it will become a terrific resource for you and anyone else who wishes to retrieve information on mutual funds in an unbiased, uncompromised format. The Institute provides statistics, research, and regulatory and legislative information to all members and their shareholders, and seeks to enhance public understanding of the investment company industry; most important, the Institute promotes the interests of fund shareholders. 120

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As such, their web site contains some very useful information for individual investors. The Institute calls its web site for the investing public the “ICI Mutual Fund Connection,” and you can view or access a number of documents for free on such topics as federal/state legislation and regulation, taxation, retirement, and other pertinent issues. Most of the documents available for access are in Adobe Acrobat Reader format, so you must have Reader properly installed in your computer in order to download and access these free documents. One of the more interesting documents is “Facts about Mutual Funds,” part of the ICI Investor Awareness Series. You can access the document at http://www.ici.org/pdf/factsaboutfunds.pdf. Written in a fact/explanation style, you can read about how mutual fund investors remain calm in volatile markets, how shareholder costs are decreasing, and how mutual funds clearly disclose all fees. Morningstar Based in Chicago, Morningstar (http://www.morningstar.com) is a provider of investment information, research, and analytical tools. Morningstar’s line of Internet, software, and print services offers news, data, and analysis on stocks, mutual funds, closedend funds, and variable annuities, and its web site appears almost as a portal for mutual fund investing—all aimed at the individual investor. An independent company, Morningstar does not own, operate, or hold any interest in mutual funds, stocks, or insurance products. Morningstar sells its data to financial institutions, fund companies, and media organizations. You may often see in a mutual fund data table in a newspaper, “Source: Morningstar.” 121

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You cannot purchase shares of mutual funds on the Morningstar site. You will be directed to the management company’s web site, where you may purchase directly there. But the Morningstar site offers countless benefits, such as its ability to quickly and easily search for information on thousands of funds. For example, from the homepage, click “Funds,” and then on the righthand side of the screen, click “Fund Selector.” On the drop-down menu for “Fund Group,” you’ll notice for bond funds, both “Taxable Bond” and “Municipal Bond.” For the purpose of this example, click “Taxable Bond.” If you proceed to “Morningstar Category,” just below it you will observe the different subcategories available for “Taxable Bond.” Again, for purposes of this example, click “Int’l Bond.” You can continue to add more criteria to your search, but let’s keep this search at “Taxable Bond” as the Fund group and “Int’l Bond” as the Morningstar category. Figure 10.2 shows the Fund Selector Screen for a Morningstar.com search. The search criteria and results create enormous amounts of information. You can search for specific funds, or even compare your present holdings to those of the broader market followed by Morningstar. Another terrific tool is the Morningstar Screen. The Morningstar analysts have already created special screens to help the investor sort through the often-confusing amounts of data. From the “Fund Selector” page, click on the light-blue-colored “Morningstar Screens” icon. Another window will appear. Click on “Conservative Bond Funds,” which appears as a selection on the left, then “Show Screen Results.” You now will get a much smaller list of funds of various categories. My best advice is to click around these results, and learn as much as you can about the different returns, expense ratios, and other information. 122

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Figure 10.2 Morningstar.com search.

It’s even easier than this: Morningstar has a special bond section (http://www.morningstar.com/centers/bonds.html?hsection =bondsc), offering their “Quicktake” reports on the top 15 bond funds (available via a drop-down menu), as well as links to articles and message boards (the “Bond Squad”) on bond mutual fund–related issues. You may already be familiar with Morningstar, as countless mutual fund advertisements joyfully proclaim their rating by Morningstar (“The fund received four stars from Morningstar . . .”). The ratings, from one to four stars, are based on a proprietary mathematical formula that makes an adjustment for risk, 123

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and the star ratings are only awarded to funds that are in existence for at least three years. As you continue to use Morningstar, you might wish to register with the web site, in order to receive periodic updates on information you might find relevant to your investing goals. Morningstar also has a premium service for $11.95 per month (as of this writing) that will provide you with more in-depth information to meet your investing needs. Lipper Lipper (http://www.lipperweb.com) is also a research firm that tracks the mutual fund industry. Sold to U.K.-based media conglomerate Reuters in 1998, Lipper, like Morningstar, sells its data to financial institutions, fund companies, and media organizations—you, as the individual investor cannot purchase Lipper data directly. You can, however, be afforded the benefits of their insightful research through countless financial media—newspapers, magazines, newsletters—and web sites are no exception. You may notice that Lipper is sourced in lists, articles, tables, and charts on about 25 web sites targeting retail investors. The web sites that use Lipper exclusively for their mutual fund data include: CBS Marketwatch Wall Street Journal Interactive USA Today Interactive

http://cbs.marketwatch.com http://interactive.wsj.com (subscription required) http://www.usatoday.com/ money/lipper/pgmain.htm

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TheStreet.com Quote.com (Lycos)

http://www.thestreet.com http://finance.lycos.com/home/ funds/market_overview.asp

Lipper has roughly 100 different objectives in its classification system for bond funds, compared with 40 for equity funds. History of assets for funds tracked by Lipper goes back 40 years. But Lipper doesn’t promote a star rating system as does Morningstar, and so advertisements from fund companies hardly announce a piece of research from Lipper in order to sell shares of their funds. However, like the Investment Company Institute, Lipper serves as a critical resource to asset managers, fund companies, and financial intermediaries, providing a onestop shop of information, analytical tools, and research. This eventually trickles down to the individual investor through content-sharing relationships with financial media, especially web sites.

Execution: Purchasing Shares of Bond Mutual Funds on the Internet The absolute best place to buy shares of mutual funds is directly from the fund company—on the fund company’s web site. Perhaps this piece of advice goes against the existing trend in fund sales: Use of an intermediary or third party is on the rise. An estimated 82 percent of new sales of long-term funds were made through a third party or intermediary in 1999, up from 77 percent in 1990, according to the Investment Company Institute. During the same period, sales to investors directly from

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fund companies fell to 18 percent from 23 percent. Third parties include banks, insurance companies, stockbrokers, financial planners, and retirement plans. The only explanation is that as demand for mutual funds continues to increase, the fund companies have become aggressive in creating marketing partnerships and building sales channels. Also, with the heavy merger activity witnessed in the financial services industry, as banks, brokerage firms, and insurance companies have transformed themselves into financial supermarket juggernauts—offering everything but a toaster—with a significant online presence, individual investors are bombarded with the ways and means to buy mutual funds. Buy from the Fund Families Let’s say that after reviewing information on Morningstar for the Vanguard High-Yield Corporate Bond Fund, you wanted to make a purchase. Located to the right of the title is a blue Vanguard icon—all you have to do is click and you are brought directly to Vanguard’s page for that fund; shown in Figure 10.3. Then, once on the Vanguard site, you are afforded all of the conveniences of reviewing the fund’s investment information online. You can then click “Open an Account,” located on the lower left-hand side of the screen, as seen in Figure 10.4. One thing that you will notice when you are ready to buy shares of the fund is choice. You can request a prospectus and application via U.S. mail, or you can download them in Adobe Acrobat Reader format, print them out, and mail them in with a check. Or, you can make an investment completely and seamlessly online, using their secure e-signature feature. While the 126

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Figure 10.3 Morningstar snapshot for Vanguard High-Yield Corporate Bond Fund.

preferred method of payment is a check, you can also authorize your bank to do a transfer.

Your Retirement Program If you are in a 401(k) or pension plan with your employer, and you are allowed to make periodic adjustments to your portfolio, the most efficient way to do this is online. If at all possible, access your account through your company’s intranet, and do your account review online. Most large companies either have their own benefits intranets or are more than willing to direct you to 127

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Figure 10.4 Vanguard High-Yield Corporate Bond Fund. Source: The Vanguard Group, Inc. Reprinted with permission.

their administrator’s web site, so that you may access your retirement account information electronically. This is always the best method, as information is refreshed quite frequently, and you can click through the different funds or annuities without having to thumb through massive books—which are probably outdated by the time they are mailed to you. Online or Discount Brokerages If you use an online broker that does not manage any of the funds it sells, there most likely will be additional transaction fees 128

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involved. At HarrisDirect, for example, load funds carry no fee, but no-load and low-load funds carry a $35 fee. The web page outlining fees for HarrisDirect even states that “Fund shares can be purchased or redeemed directly from the fund without paying transaction fees.” This should tell you that the online brokers are more interested in processing transactions rather than mutual funds, and want you to buy mutual funds elsewhere.

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11

Scripophily

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hen you buy bonds, either online or from a traditional brokerage, the bonds are issued to you in “book-entry” form. There isn’t any physical certificate; instead, you receive nothing more than a confirmation of sale; that you and your identity are stored along with other numbers in the trustee’s or brokerage’s computer systems. This wasn’t always the case. In the early 1980s, bonds began to be issued with the name of the owner imprinted on the actual certificate. These are called “registered” bonds, and interest payments are sent automatically to the owner of record. Before 1980, buyers of bonds used to receive ornate certificates, sometimes with coupons attached—to collect interest, you had to physically clip the coupons and send them to the trustee in return for your interest payment. This is the origin of the term “coupon.” These bonds were known as “bearer” bonds. As these older bonds mature, bonds in bearer form are becoming harder to come by. And even if you purchase a bond today, 131

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you cannot get it in bearer form. The only bonds available today that are still in bearer form are U.S. savings bonds, although these, too, can be purchased directly from the U.S. government via the Internet on the Public Debt web site, http://www. publicdebt.treas.gov. (For more information, see Chapter 9, “Buy Munis and Treasuries Online.”) But what about a healthy dose of nostalgia? Some believe that these older bond certificates make valuable collector’s items. The collecting of canceled stock, bonds, and other securities is known as scripophily (scrip-AHF-illy), and Bob Kerstein, founder and CEO of Scripophily.com (http://www.scripophily.com), can attest to the growing fascination with the hobby, as his group of web sites receive more than 6.5 million hits per year. Founded two years ago, Scripophily.com sells about 30 percent bond certificates in relation to stocks. Other sites offering the chance to buy bond memorabilia include: eBay Yahoo! Auctions Amazon Auctions StockandBondAuction.com

http://www.ebay.com http://auctions.yahoo.com http://www.amazon.com/ auctions http://www.stockandbond auction.com.

Some offer only stock certificates, such as: Frameastock.com Oneshare.com

http://www.frameastock.com http://www.oneshare.com

But more than being just a collectible, “Each certificate is a piece of history, and the history of a corporation or even of the U.S. gov132

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ernment is better given through an examination of old securities certificates,” adds Kerstein. He says that he receives inquiries all the time from investors interested to know more about a company’s history, often as part of research prior to making an investment in that company. Scripophily.com has a database of corporate information for over 3,200 companies. “The corporate story is better told and in much better detail through old certificates—modern histories don’t tell the full story,” continues Kerstein. In fact, Scripophily.com has a separate research service, OldCompanyResearch.com (http://www.researcholdstocks.com), that can provide you with a brief profile of companies whose original identities have been lost due to a change in name, merger, acquisition, dissolution, reorganization, bankruptcy, or charter cancellation. If they do not find any information regarding the company being researched, you are not even charged for the service or time. If you have old bearer or registered bonds, and the name of the company isn’t recognizable and/or you have lost contact with the original broker, a service like this is invaluable. Sometimes the old bond certificate is worth more dead than alive. For example, the Altoona and Beech Creek Terminal Railroad Company issued the bond shown in Figure 11.1 in 1901. This railroad company was incorporated in 1897, the bonds were issued in 1901, and the company went bankrupt in 1904. The certificate was hand signed by the company’s owners; there are over 50 unused coupons attached to this certificate. It is for sale at Scripophily.com for $149.95, obviously more than what was originally paid for the bond. I encourage you to click around the scripophily sites and learn more about the bond certificates that were issued years ago. It might become an interesting hobby. 133

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Figure 11.1 Altoona and Beech Creek Terminal Railroad Company bond, 1901. 134

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Scripophily is a collectible hobby, nothing more. Please do not buy as a security that’s redeemable. —Bob Kerstein, founder and CEO, Scripophily.com

Other Valuable Websites Located in New York City, the Museum of Financial History (http://www.financialhistory.org) is an affiliate of the Smithsonian and owns more than 10,000 financial documents, including stock and bond certificates, claiming to be the largest in the world. Some museums have e-commerce offerings or online stores on their web sites, where you can buy prints, replicas, or models of artwork or artifacts; the Museum of Financial History does not yet have this function available on their site. Learn more about joining the International Bond and Share Society (http://www.scripophily.org), a worldwide organization dedicated to scripophily. While not as deep or informative as Scripophily.com, you can still read sufficient information about the hobby.

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Final Thoughts

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hile I haven’t explained fixed-income investing in detail, or made any extreme or forward investing suggestions, I hope you finish this book with the sense that all the information you need to successfully invest in bonds online is available, mostly for free, on the World Wide Web. The information may be hidden from view, or might be a tad difficult to locate, but it’s there. You should not be afraid to click around, read, print out an interesting page, post a message on a message board, or the like. Your education—and finding out as much as you can about a security in advance of an investment—is extremely critical. While the traditional brokerages didn’t originally predict the droves of individual investors taking to the Internet, they can’t stop them now. The Day Trader may have led the pack, but as with the introduction of any new technology, there can always be expected to be an early shakeout, followed by a period of growth in completely new directions. 137

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The fact that bonds will continue their upward movement in the online investing hierarchy points to the fact that people don’t wish to abandon their original, long-term goals or intentions when it comes to money (safety, security), but will consider a new way of attaining them if the method is proven to be reliable and efficient (technology). Don’t think that because you haven’t seen leading news stories for bonds in the newspaper or on TV that they aren’t available for individual purchase. Don’t think that brokerage firms, both online and offline, aren’t willing to sell them to you. As described earlier in this book, there has been a prevailing psychology on Wall Street that bonds are “too complicated” for individual purchase— this is clearly not the case. Business journalists that cover bonds often play second fiddle to the day’s top story on stocks, but this should encourage you to do your own research for bonds. But I also ask you to have patience with the Web. Technology companies—as well as financial services conglomerates—will continue to rightsize and reconsider their operating structures. While the two have been paired for a long time, they are rethinking many of their proven ways of doing business. As such, your favorite financial information portal may disappear, or may suddenly start asking that you become a subscriber in order to continue receiving the content you’ve been enjoying for some time. Expect this. But don’t give up yet. Bonds are on their way to becoming the financial product in which individual investors will be the most widely invested via the Internet. Get in early—you will reap the rewards.

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Appendix A Bond Funds versus Individual Bonds

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hile the Internet has made the purchase of both bonds and bond mutual funds relatively easily and painless, there are major distinctions in ownership of the two. I feel it is important to cover these in this short Appendix. Carrying over the argument from Chapter 10, you would think that there would be no case against buying bond mutual funds: They offer professional management, diversification, and an ability to invest small amounts of money. However, a compelling argument arises for buying individual bonds over mutual funds—and the whole “ease of buying and selling” doesn’t figure into this—since the Internet is enabling people like yourself to make informed decisions regarding any securities transaction more quickly and efficiently. The first thing to consider is that rates of return on individual bonds are often greater than those earned from mutual funds. This is often the case because, even for no-load mutual funds, sales commissions, operating expenses, 12(b)-1 marketing fees, 139

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and other expenses pile up and effectively erode the returns of mutual funds. By investing in individual bonds, investors avoid these fees. The second argument for individual bonds is that if they are bought and held until maturity, interest rate risk is avoided. Changes in interest rates affect the price of both individual bonds and bond mutual funds. However, if investors do not need access to their funds for a certain amount of time, they can invest in individual bonds with maturities appropriate for their liquidity needs—without having to worry about interest rate fluctuation. This situation does not apply to bond mutual funds. If interest rates go up, a decline in the NAV of share prices of bond funds will occur. Table A.1 shows how total returns of bond funds generally behave contrary to those of interest rates. Another way of looking at bond mutual funds is that they never mature, which means that the possibility of loss of principal is always present. However, the biggest argument for buying bond mutual funds is that they provide an opportunity for investors who do not have enough money to diversify their investments, as well as a chance for investors to invest sums of money in uneven amounts. For example, an investment in U.S. Treasury notes requires minimum amounts of $1,000 and $5,000 for different issues. Investors with less than these amounts would be otherwise precluded from buying, or if they have more than the minimum but not in an exact, multiple amount, they can easily purchase shares of mutual funds where they can invest in smaller increments. Table A.1 summarizes the pros and cons of investing in individual bonds versus bond mutual funds. A well-known, safe, and common investment strategy for bonds involves a process called laddering, or buying bonds with 140

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Table A.1 Individual Bonds vs. Bond Mutual Funds Loss of Principal Diversification

Ease of Buying and Selling Fixed Amounts of Interest Professional Management Tax Planning Information

Individual Bonds

Bond Mutual Funds

Not if held to maturity Not unless a large number of bonds are purchased Yes

Yes, if share price declines Yes

Yes

Yes

No, amounts fluctuate

No

Yes

Yes

No

differing maturities so that as the bonds in your portfolio mature and come due, you replace those bonds with another issue that has a longer maturity (which will be at a higher or lower yield depending on the level of interest rates). As your investment strategy changes, or as your liquidity needs are reassessed, you can change the maturities, credit quality, and yields of the bonds in the ladder to suit your investment objectives. The savvy bond investor constructs multiple ladders for different investment objectives. By and large, the safest fixed-income strategy of all is a ladder of short-term Treasury securities. See Appendix B, “Your Investment Profile,” for more information on laddering. While laddering is a good strategy for individual bond investing, buying into mutual funds does not allow for you to construct your own ladder and buy bonds of differing maturities. Bond funds generally hold bonds of similar maturities and quality; by buying into funds, you are giving up your ability to 141

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review different bonds and add them to your portfolio to meet your objectives—in other words, you are giving up the flexibility afforded with buying individual bonds. With online brokerages allowing you to ladder, and with results appearing neatly on your screen, it makes sense to consider a laddering strategy in place of mutual funds.

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Appendix B Your Investment Profile

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hen formulating an investment plan, you must assess your

• Risks (What level am I comfortable with?) • Goals (What am I saving for?) • Situation (What am I currently invested in? What are my living expenses and what can I allocate to a savings and investment plan?) This isn’t just for an anticipated bond investment strategy—it applies to all asset classes, including stocks, insurance and annuities, real estate, venture capital, and others. And even within the asset class, the individual security invested in requires its own assessment of risks, goals, and situation. Many people are trained to think that bonds mean “secure, safe investments” or mean “income investments.” This is most likely the result of reading this year after year in brokerage firm 143

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brochures that oversimplify investing strategies so that people wind up thinking that the opposite goal of a stock is a bond (completely wrong!). Yes, bonds can be and are used to add safety to a portfolio as a whole, but even within bonds, as I’ve shown in this book, the investor can diversify and add or subtract levels of risk to the bond side of a portfolio. On the Web, there are plenty of tests you can take to assess your appetite for risk. One is available at Financial Psychology (http://www.financialpsychology.com), developed by university academics to help people understand their emotions when they invest, so that they don’t make any unwise decisions. Stocks usually trade on emotion, fueled by the media and the particular personality of the CEO or brand of the company’s products. This is not the way to invest—for any asset, for any portfolio. A good rule of thumb is that if you are a very risk-averse investor, you should plan to invest money that you won’t need. Then, invest this money in bonds that fit your risk and financial profile and hold the bonds until maturity. Generally speaking, bonds tend to be riskier if they have lower ratings, lower coupons, and longer maturities. The yield is most likely higher for these kinds of bonds, as the issuer must compensate the bondholder for assuming this risk. The riskaverse investor should avoid such bonds, and instead focus on bonds with the highest credit rating, the largest coupons, and the shortest maturities. Not only are they less risky, but they are also considered to be defensive investments. Another thing is that many investors feel overwhelmed by the sheer volume of securities available for investment. Given the 7,000+ mutual funds, as well as the hundreds of bonds viewable on the bond screeners available online through the Bond Market Association and most of the larger online brokers, most investors feel in144

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undated with information. You might feel overwhelmed or defeated—but do not give up. It takes time to learn anything, and the more you learn, the more comfortable you will be with investing. Inaction is also an option—simply not doing anything. Mutual funds appeal to “inactive” investors, but investors who do absolutely nothing, who make few investments, or who don’t take the time to review and research alternatives, will truly be left in the dark, missing potentially rewarding opportunities. Clearly, investors who favor risk have not been rewarded lately. Despite the dot-com fallout, tech wreck, or whatever you choose to call it, financial risk takers did nothing short of lick their wounds for 2000 and 2001. If you do enjoy the thrill of risk, at least be disciplined about it. Construct trigger points where you sell a portion of the investment when it reaches a particular low—in other words, decide beforehand how much you are willing to lose. Because you can monitor your portfolio quickly and easily online, creating and enabling this strategy shouldn’t be extraordinarily difficult. The long-term strategist is usually rewarded, not only in this investing climate, but in all investing climates. Even stockbrokers will tell you that the best-performing stocks are ones that have appreciated in value over the longer term. Here are some “life considerations” for which you may need to evaluate your allocation of assets: • • • • •

Retirement (usually, the biggest consideration) Education (for children, for your own career development) Home (primary, secondary, vacation, investment property) Unemployment, impending layoff, periods of not working Family payments (eldercare, other relatives requiring assistance) 145

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• • • • • •

Starting a business Charitable trust Travel Cars (one or two family cars, cars for grown children) Weddings, anniversaries, large parties or events Hobbies, pastimes, special projects

Once you determine your parameters, and have decided how much money you want to place in the intended securities, the next step is getting the best price. Again, as mentioned earlier, individual investors have the benefit of using online bond screeners to locate the bonds they wish to invest in and can be certain that these are the best prices available—certainly better than any prices that could be quoted over the phone by a broker. As more and more individual investors buy bonds online, the companies managing the inventory systems will introduce more and more product into the system, thereby increasing liquidity, efficiency, and optimal pricing.

Laddering This has become an extremely popular bond investing strategy. The bond web pages for the major online brokerages all have laddering capability, making it even easier for the individual investor to execute. BondDesk, one of the executable commingled inventory systems, has made laddering available to customers of E*Trade, HarrisDirect, and TD Waterhouse. Laddering refers to creating a structure of varied maturities. You construct your fixed-income portfolio by staggering the maturity dates, so the principal will return to you at different, albeit ex146

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pected, times. This helps to decrease reinvestment risk because you receive money back to reinvest during different interest rate environments. Because the strategy lowers reinvestment risk, it is very popular with investors who are living off the income their portfolio generates. To construct the ladder, every time a bond in your portfolio matures, you reinvest the principal in a security whose maturity is longer than the longest maturity you previously owned. The “rungs” of the ladder are equal, so that you will find yourself having money coming due and then reinvesting it every year, two years, five years, or whatever length of time you decide. For example, a laddered portfolio might include bonds with maturities of 2, 4, 6, and 8 years; to continue building the ladder you would reinvest the next lump-sum principal payment in a 10-year bond. While laddering may seem to be a very safe, sane, and structured approach to bond investing, there are inherent risks. What if the bonds are called (bought back) by the issuer? What if you purchase a bond with the desired longer maturity (to replace the bond coming due) and find out that you overpaid, or that there was another bond at the same price with better quality? What if one of the issuers defaults (this could happen in the longer-term issues)? What about interest rates? It is important to realize that while laddering is important because it gives investors a controlled approach, there are some dangers and considerations to be aware of. You can alter the ladder and decide to break it if you think interest rates are fluctuating, or if you want to “play” a little with your portfolio. Yield curves and interest rates are covered ad infinitum on the Internet. Use Briefing.com, CBS MarketWatch, or another site to keep abreast of rates and how they might affect a pending bond issue. After continued review of the relationship between rates and bonds, you will, no doubt, become an expert. 147

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Investor’s Checklist: Questions to Ask Yourself When Considering an Investment in Bonds An investment in bonds, like any other investment you make, should be tailored to your investment goals, tolerance for risk, and other individual circumstances. By answering some fundamental questions and arming yourself with some basic investment perspective, you will be better able to make decisions and work with investment representatives or advisors to find the appropriate mix of securities to achieve your investment objectives. But first, you should know what types of bonds are available. Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds. There are also many short-maturity options such as Treasury bills, bank certificates of deposit and commercial paper. Now answer these basic questions: What is my current investment status? A. Do I currently have any savings and investments? Yes No If no, go to B on the opposite page. If yes, what percentage of my investments are in: % Cash or cash equivalents (savings accounts, CDs, money market funds)?

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Investor’s Checklist (Continued) % Bonds or bond funds? % Stocks, stock funds, or stock in the company I work for? Is the total of my investment in cash, bonds, and bond funds less than 15% or 20% of my total investments? Yes No B. I have a lump sum to invest. Yes No I expect to invest on a regular basis. Yes No Perspective Most personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. For example, older or retired investors may typically have a higher proportion of bonds in their portfolio than younger investors. Whether you already have investments in stocks or bonds or are just beginning to invest, diversity can provide some protection for your portfolio, so if one sector or asset classis in the midst of a cyclical downturn, the rising value of another class of assets may help offset the negative impact. (Continued)

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Investor’s Checklist (Continued) What are my investment objectives? Current income? Saving for retirement? Saving for children’s college education? Capital accumulation? Preservation of capital? Other (such as a short-term goal):

Yes Yes Yes Yes Yes

No No No No No

Perspective Because bonds typically have a predictable stream of payments of interest and repayment of principal, many people invest in them to receive interest income or to preserve and to accumulate capital. If you are looking for current income, you will most likely be interested in bonds that pay an interest rate that stays fixed until maturity with interest that is paid semiannually. However, if you are saving for retirement or a child’s education or other capital accumulation goal, you may wish to consider investing in zero coupon bonds which do not have periodic interest payments. Instead, they are sold at a substantial discount from their face amount and the investor receives one payment— at maturity—that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the original interest rate.

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Investor’s Checklist (Continued) When do I need my money back? 1 year 5 years 10 years 20 years 30 years or more Other Perspective A bond’s maturity refers to the specific future date on which the investor’s principal is expected to be repaid. Bond maturities generally range from one day up to 30 years. Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment return you are seeking within your risk tolerance. Generally, the longer the maturity, the greater the return. How much risk am I willing to take? Very little risk. I want the safest investments possible. Modest risk. I’m willing to accept moderate risk of losing my investment if it means I will earn a higher return. Substantial risk. I want the highest possible yield and I’m willing to accept the chance that I may lose my investment. (Continued)

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Investor’s Checklist (Continued) Perspective Virtually all investments have some degree of risk that you might lose some or all of your investment. When investing in bonds, it’s important to remember that an investment’s return is linked to its credit as well as market changes. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns. Bond choices range from the highest credit quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government to bonds that are below investment grade and considered speculative. In assessing your tolerance for risk, ask yourself, “What will I do if my investment is not there when I need it?” You should also be aware that if you have to sell a bond before it matures, you will receive the prevailing market price, which may be more or less than its original price. The value of bonds fluctuates with the market, varying in the opposite direction of movement in interest rates. Bond funds’ values fluctuate in the same way. What will be the impact of taxes on my investment? What income tax bracket am I in? 15% (single return $0–$26,250; joint return $0–$43,850) 28% (single return $26,251–$63,550; joint return $43,851–$105,950) 31% (single return $63,55l–$132,600; joint return $105,95l–$161,450)

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Investor’s Checklist (Continued) 36% (single return $132,601–$288,350; joint return $161,451–$288,350) 39.6% (single return $288,351 & over; joint return $288,351 & over) Is my investment going to be made through a tax preferred investment vehicle? Traditional IRA Roth IRA 401(k) Pension plan Perspective Some bonds offer special tax advantages. There is no state or local income tax on the interest from U.S. Treasury bonds. There is no federal income tax on the interest from most municipal bonds, and in many cases no state or local income tax, either. Do you want income that is taxable or income that is tax-exempt? The answer depends on your income tax bracket—and the difference between what can be earned from taxable versus tax-exempt securities—not only presently, but also throughout the period until your bonds mature. The decision about whether to invest in a taxable bond or a tax-exempt bond can also depend on whether you will be holding the securities in an account that is already tax-preferred or tax-deferred, such as a pension account, (Continued)

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Investor’s Checklist (Continued) 401(k) or IRA: for example, a municipal bond will not bring you the tax benefits it otherwise might if you hold it in a tax-deferred account. In addition to the help you can get from your broker or financial or tax advisor to determine what is the best for you, many brokers and mutual fund companies offer calculators you can use yourself on the Internet. Should I invest in: Individual bonds? Bond funds? Unit investment trusts? Perspective There are several ways to invest in bonds. You can buy individual bonds, bond funds or unit investment trusts. Your choice will depend on the amount of money you have to invest in order to achieve diversification, the degree to which you want professional management of your portfolio and your willingness to pay for professional selection and portfolio management (bond funds). Generally, investing in individual bonds is best for preserving your capital assuming they closely match your other objectives (like maturity); while bond funds offer convenience and diversification even at minimum investment levels. The minimum investment for bond funds and UITs is typically between $1,000 and $2,500, and

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Investor’s Checklist (Continued) $500 for retirement accounts. Individual bonds are usually sold in $5,000 denominations and dealers sometimes require a minimum investment of $20,000. What are the key questions I should ask about an investment in bonds? What is the maturity of the bond? Does it have early redemption features such as a call date? What is the credit quality? What is the rating? Is it insured? What is the interest rate? What is the price? What is the yield to maturity? And what is the yield to call? What is the tax status? Perspective These are the key variables to look at when investing in bonds. Together these factors help determine the value of your bond investment and the degree to which it matches your financial objectives. Where can I find out more about investing in bonds? An investment representative at a brokerage firm or bank can provide more specific information about investing in bonds. There are numerous public sources of information available including major personal-finance magazines, the business page of your daily newspapers, and your local library. The (Continued)

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Investor’s Checklist (Continued) Bond Market Foundation’s Tomorrow’s Money site also offers some useful tools. There is a wealth of information specifically tailored to bond investing on this site. Here you will find booklets on investing in various types of bonds, information on pricing of bonds, tips on how to buy and sell bonds, links to other Internet sites where bond market information is available, and more. Consult your investment representative or tax advisor before making a specific investment. Source: Bond Market Association’s InvestinginBonds.com site (http://www.investinginbonds.com).

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Glossary

above par Having a price above face value. absolute priority rule The idea that creditors’ claims take precedence over shareholders’ claims in the event of a liquidation or reorganization. accreted value The theoretical price a bond would sell at if market interest rates were to remain at current levels. accrual bond Same as zero-coupon bond. accrual of discount The annual addition to book value contributed by bonds purchased below par. accrued interest Interest that is due on a bond or other fixed-income security since the last interest payment was made. This often occurs for bonds purchased on the secondary market, since bonds usually pay interest every six months, but the interest is accrued by the bondholders every month. When a This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 157

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Glossary bond is sold, the buyer pays the seller the market price plus the accrued interest, for which the buyer will be reimbursed at the end of the six-month period. Accrued interest is calculated on a 30-day month for corporate bonds and municipal bonds, and on actual calendar days for government bonds. Income bonds, bonds in default, and zero-coupon bonds trade without accrued interest. accrued market discount An increase in the market price of a discounted bond resulting from an approaching maturity date, rather than from declining interest rates. accumulation bond Same as discounted bond. acknowledge Certify the authenticity of a signature on a brokerage or bank document, such as for an account transfer. active management A money-management approach based on informed, independent investment judgment, as opposed to passive management (indexing), which seeks to match the performance of the overall market (or some part of it) by mirroring its composition or by being broadly diversified. The buying and selling of bonds, as opposed to holding them to maturity. advance refunding Issuing a longer-maturity bond in order to pay off an earlier bond (usually prior to its maturity), in order to take advantage of a drop in interest rates. Also called prerefunding. after-tax basis The comparison of investment returns after factoring in the tax consequences, such as when comparing the return on a taxable corporate bond with the return on a tax-exempt municipal bond. agency bond Bonds issued by U.S. government-related agencies, such as Government National Mortgage Association, Federal Home Loan Mortgage This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 158

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Glossary Corporation, and Federal National Mortgage Association. In most cases, they are exempt from state and local taxes. agency security A security, usually a bond, issued by a U.S. government agency. Agency securities are exempt from state and local taxes. Also called U.S. government agency security. American Municipal Bond Assurance Corporation (AMBAC) A corporation that offers insurance policies on new municipal bond offerings. American Stock Exchange (AMEX) The second-largest stock exchange in the United States, after the NYSE. Stocks and bonds traded on the AMEX tend to be those of smaller companies than on the NYSE. Some index options and interest rate options trading also occurs on the AMEX. Also called The Curb. AMEX American Stock Exchange. amortization of premium Charges made against the interest received on bonds in order to offset a premium paid for the bonds. amortized value The value of a security as determined by the process of amortization. anticipation note Short-term bond that will be paid off with the proceeds from a subsequent, larger bond issue. Also called bond anticipation note. arrearage An amount of an obligation that is past due. arrears The unpaid portion of a serial bond at maturity. ask The lowest price that any investor or dealer has declared that he/she will sell a given security or commodity for. For over-the-counter stocks, the ask is the best quoted price at which a market maker is willing to sell a stock. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 159

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Glossary For mutual funds, the ask is the net asset value plus any sales charges. Also called asked price, asking price, or offering price. asked price Same as ask. asking price Same as ask. assessment bond Same as special-purpose bond. asset coverage The extent to which a company’s net assets cover its debt obligations and/or preferred stock. Expressed in dollar terms or as a percentage. asset swap An exchange of two assets. A common example is the replacement of one debt obligation with another. A swap might convert a fixed rate asset to a floating rate asset in order to achieve a more favorable payment stream. asset-backed security A bond or note backed by loan paper or accounts receivable originated by banks, credit card companies, or other providers of credit—not mortgages. assumed bond Bond that is issued by one corporation but whose liability is taken on by another corporation. at par Refers to a bond or preferred stock that is selling at a price equal its face (or par) value. authority bond A corporate or government bond issued in order to run a revenue-generating public enterprise and payable from the resulting revenue. average effective maturity A measure of a bond’s maturity that takes into consideration the possibility that the issuer may call the bond before its matu-

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Glossary rity date. A weighted average of the maturities of the bonds in a portfolio, taking into account all mortgage prepayments, puts, and adjustable coupons. average nominal maturity A measure of a bond’s maturity which, unlike average effective maturity, does not take into account mortgage prepayments, puts, or adjustable coupons. average weighted maturity The length of time until the average security in a fund will mature or be redeemed by its issuer. It indicates a fixed-income fund’s sensitivity to interest rate changes: Longer average weighted maturity implies greater volatility in response to interest rate changes. baby bond A bond that has a par value less than $1,000. balanced fund A mutual fund that buys a combination of common stocks, preferred stocks, bonds, and short-term bonds, to provide both income and capital appreciation while avoiding excessive risk. balloon maturity A repayment schedule for an issue of bonds in which a large number of the bonds come due at the same time, typically the final maturity date. bank-eligible issues U.S. Treasury obligations eligible for immediate purchase by commercial banks, typically those which are due or callable in 10 years or less. basket A group of several securities created for the purpose of simultaneous buying and selling. Baskets often play a role in index arbitrage, program trading, and hedging. A collection of consumer goods and services that are tracked in the process of calculating a consumer price index. Also called market basket. bearer The holder of a negotiable instrument. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 161

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Glossary bearer bond Same as coupon bond. bearer instrument A negotiable instrument that is payable on demand to the holder, regardless of whom it was originally issued to. bellwether A stock or bond that is widely believed to be an indicator of the overall market’s condition. below par Having a price below face value. benchmark interest rate The minimum interest rate investors will accept for investing in a non-Treasury security. Also called base interest rate. best ask The lowest price any seller is willing to accept at a given time for a given security. best bid The highest price any buyer is willing to pay at a given time for a given security. bid The highest price any buyer is willing to pay for a given security at a given time—also called bid price. Opposite of ask. An offer of a specific amount of money in exchange for products and services, as in an auction. bid/ask spread See spread. bid-to-cover ratio In a Treasury auction, the number of bids received divided by the number of bids accepted. bill Same as Treasury bill. Paper currency. An invoice of charges for products and services. bill pass The purchase of Treasury bills from dealers by the Federal Reserve. blanket bond Broad insurance coverage against losses due to theft or employee dishonesty, carried by brokerages and other financial institutions. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 162

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Glossary blend fund A mutual fund whose assets are composed of a combination of stocks, bonds, and money market securities, rather than just one or two of these asset classes. This enables investors to diversify their holdings with a single fund. block A large amount of securities being held or traded, typically at least 10,000 shares of stock or $200,000 in bonds. block trade Same as block. Blue List A daily list of nearly all current municipal bonds. Its official name is the Blue List of Current Municipal Offerings. bond A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The federal government, states, cities, corporations, and many other types of institutions sell bonds. A bond is generally a promise to repay the principal along with interest on a specified date (maturity). bond anticipation note Same as anticipation note. Bond Buyer A daily publication containing key bond market statistics. bond circular A document describing a bond offering, put together by its underwriter. bond crowd The members of a stock exchange who transact bond orders on the floor. The term derives from the fact that the bond traders work in a separate area from the stock traders. bond discount Same as discount. bond equivalent yield A restating of the yield on a debt instrument in terms

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Glossary of semiannual interest, in order to facilitate direct comparison to an interestbearing coupon security. bond fund A mutual fund which invests in bonds, typically with the objective of providing stable income with minimal capital risk. Also called debtholder. bond indenture Same as indenture. bond market The market for all types of bonds, whether on an exchange or over-the-counter. bond ordinance resolution.

Ordinance authorizing a bond issue. Also called bond

bond quote The price at which a given bond is or was trading, expressed in terms of percentage of par, with minimum increments of 1/8 for corporate bonds and 1/32 for government bonds. bond rating A measure of the quality and safety of a bond, based on the issuer’s financial condition. More specifically, an evaluation from a rating service indicating the likelihood that a debt issuer will be able to meet scheduled interest and principal repayments. Typically, AAA is highest (best), and D is lowest (worst). bond ratio The percentage of a company’s capitalization that is represented by bonds, equal to the total amount of bonds due after one year divided by that amount plus equity. Traditionally, a ratio of 30 to 40 percent or more is considered highly leveraged. bond resolution Same as bond ordinance.

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Glossary bond swap The simultaneous sale of one bond issue and the purchase of another, to stretch out maturities or for tax reasons. bonded Guaranteed by a bond, thereby insuring that a payment is made or that specific rules are followed. Failure to meet the stipulations may result in forfeiture of the bond. bondholder The owner of a bond. In addition to receiving regular interest payments and the return of principal, bondholders are given precedence over stockholders in case of asset liquidation. book-entry security Security issued not as a certificate but simply as an entry in a bank account. Most Treasury securities are book-entry. Brady bond U.S. dollar-denominated bond issued by an emerging market, particularly those in Latin America, and collateralized by U.S. Treasury zerocoupon bonds. bullet bond Same as noncallable bond. bullet contract A GIC purchased with a single premium. Bureau of Public Debt The agency that presides over the sale of government securities such as Treasury securities and U.S. savings bonds. business risk Risk associated with the unique circumstances of a particular company, as they might affect the price of that company’s securities. busted convertible A convertible security for which the market price of the common stock is so low that the convertible feature is nearly worthless, and the security trades almost as if it were a fixed-income investment. Also called fixed-income equivalent.

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Glossary buy To obtain ownership of a security or other asset in exchange for money or value. An order with a broker to buy a security or commodity. Here, also called a buy order. A recommendation by an analyst or advisor that a given security should be bought. Opposite of sell. buyback The purchase of a long position to offset a short position. A corporation’s repurchase of stock or bonds it has issued. Reasons for doing so include putting unused cash to use, raising earnings per share, increasing internal control of the company, and obtaining stock for employee stock option plans or pension plans. Here, also called corporate repurchase. Same as repo. cabinet security A security, usually a bond but occasionally a stock, which is listed on a major exchange but which is not actively traded. call An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date). Also called call option. The act of exercising a call option. The right to redeem a callable bond before its scheduled maturity. In banking, a demand to repay a security loan immediately. call date Date, prior to maturity, on which a callable bond may be redeemed. call price The price, specified at issuance, at which a bond or preferred stock can be redeemed by the issuer. Also called redemption price. call protection A characteristic of some callable bonds in which the bonds may not be called for a specified initial period, usually two to three years.

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Glossary call provision A clause in a bond’s indenture granting the issuer the right to buy back all or part of an issue prior to the maturity date. call risk The cash flow risk resulting from the possibility that a callable bond will be redeemed before maturity. callable Able to be redeemed prior to maturity. callable bond A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. Also called redeemable bond. Opposite of irredeemable bond. called away Term describing a call option or a put option which is exercised, or a bond which is redeemed before maturity, or a delivery that is required on a short sale. called bond Callable bond that the debtor has declared to be due prior to maturity. cap The highest interest rate that can be paid on a floating-rate bond, or the highest rate that an adjustable rate mortgage can rise to in a specified period of time. Also, an abbreviation for capitalization, as in market cap. capital market A market where debt or equity securities are traded. capital structure The permanent long-term financing of a company, including long-term debt, common stock, preferred stock, and retained earnings. It differs from financial structure, which includes short-term debt and accounts payable. capitalization The sum of a corporation’s long-term debt, stock, and retained earnings. Also called invested capital. The market price of an entire

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Glossary company, calculated by multiplying the number of shares outstanding by the price per share. Here also called market cap or market capitalization. capitalization ratios The percentage of a company’s total capitalization that each capital component (debt, preferred stock, common stock, other equity) contributes. cash equivalents Highly liquid, very safe investments which can be easily converted into cash, such as Treasury bills and money market funds. cash reserves Cash deposits, short-term bank deposits, money market instruments, and Treasury bills. cat bond Same as catastrophe bond. catastrophe bond A high-yield, insurance-backed bond containing a provision causing interest and/or principal payments to be delayed or lost in the event of loss due to a specified catastrophe, such as an earthquake. CBO Collateralized bond obligation. certificate A formal declaration of a fact, such as a stock certificate, certificate of deposit (CD), certificate of incorporation, mortgage-backed security, or American depositary receipt. certificate of participation Financing in which an individual buys a share of the lease revenues of an agreement made by a municipal or governmental entity, rather than the bond being secured by those revenues. certificateless municipal bond A municipal bond that does not have a certificate of ownership for each bondholder. Instead, one certificate is valid for

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Glossary the whole issue, enabling investors to trade the bonds without having to transfer certificates. chart A graph of the price movements of a given security over a given time period, sometimes along with volume data. circular Same as prospectus. class Type, as of a security. For options, puts and calls of the same security are considered different classes. CLO Collateralized loan obligation. CMO Collateralized mortgage obligation. collar The lowest rate acceptable to a buyer of bonds, or the lowest price acceptable to the issuer of an underwriting, or the lowest rate possible for an adjustable rate. The index level at which a circuit breaker is triggered. A combination of put options and call options that can limit, but not eliminate, the risk that their value will decrease. collateral trust certificate A corporate bond backed by other securities, usually a parent corporation borrowing against securities of its subsidiaries. collateralized bond obligation (CBO) An investment-grade bond backed by a large, diversified pool of junk bonds. Usually broken down into tiers with varying degrees of risk and varying interest rates. collateralized loan obligation (CLO) A debt security backed by a pool of commercial loans.

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Glossary collateralized mortgage obligation (CMO) A mortgage-backed, investment-grade bond that separates mortgage pools into different maturity classes, called tranches. combination bond A bond which is backed both by revenue from the project for which the borrowing is being done as well as by the full faith and credit of the government issuing it. commercial paper An unsecured obligation issued by a corporation or bank to finance its short-term credit needs, such as accounts receivable and inventory. Maturities typically range from 2 to 270 days. Committee on Uniform Securities Identification Procedures (CUSIP) The committee that supplies a unique nine-character identification, called a CUSIP number, for each class of security approved for trading in the United States, to facilitate clearing and settlement. commodity-backed bond A bond that is tied to the price of a commodity, often used as a hedge against inflation. common stock equivalent A preferred stock or bond which is convertible into common stock, especially one that is trading like an equity issue because the optioned common stock share price is high. companion bonds A CMO tranche that protects another tranche from prepayment risk by assuming a greater share of that risk. consol A bond that never reaches maturity. consolidated bond A bond issued to replace two or more earlier bonds, to make things simpler or to take advantage of lower interest rates. consumer debenture A debenture sold by a financial institution directly to the public. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 170

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Glossary contagion When an economic crisis in one country’s bond or equity markets spreads to other countries, which then experience the same problems. The term comes from the more general definition of contagion, which refers to highly transmittable diseases. conversion The process of converting a convertible security, such as a bond or preferred stock, into common stock. conversion option A feature on some bonds and preferred stock issues allowing the holder to convert the shares into common stock. conversion parity price Same as market conversion price. conversion premium The dollar or percentage amount by which the price of the convertible security exceeds the current market value of the common stock into which it could be converted. conversion price The price, specified when issued, at which a given convertible security can be converted to common stock. conversion ratio The number of shares of common stock that could be obtained by converting each share of a convertible security. conversion value The value of a convertible security if it is converted immediately. convertible Security that can be exchanged for a specified amount of another, related security, at the option of the issuer and/or the holder. convertible bond A corporate bond, usually a junior debenture, that can be exchanged, at the option of the holder, for a specific number of shares of the company’s preferred stock or common stock. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 171

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Glossary convertible debenture Debenture which can be converted into stock at the option of the holder and/or the issuer. convertible Eurobond A Eurobond that can be converted into another asset, often through the exercise of attached warrants. convertible security Bond, preferred stock, or debenture that is exchangeable at the option of the holder for common stock of the issuing corporation. convex Bowed, as in the shape of a curve. Usually refers to the price/yield relationship for interest-bearing bonds. convexity A volatility measure for bonds used in conjunction with modified duration in order to measure how the bond’s price will change as interest rates change. It is equal to the negative of the second derivative of the bond’s price relative to its yield, divided by its price. For example, since a noncallable bond’s duration usually increases as interest rates decrease, its convexity is positive. corporate bond A bond issued by a corporation. Such bonds usually have a par value of $1,000, are taxable, have a term maturity, are paid for out of a sinking fund accumulated for that purpose, and are traded on major exchanges. corporate bond equivalent The semiannual rate of return that would provide the same overall return as a given bond whose interest payments are not made semiannually. corporate trust A trust created by a corporation, often to secure a bond issue.

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Glossary corpus The principal amount of a debt instrument, or the underlying assets in a trust. coupon The interest rate on a fixed income security, determined upon issuance, and expressed as a percentage of par. The term for each interest payment made to the bondholder. coupon bond An unregistered, negotiable bond on which interest and principal are payable to the holder, regardless of whom it was originally issued to. The coupons are attached to the bond, and each coupon represents a single interest payment. The holder submits a coupon, usually semiannually, to the issuer or paying agent to receive payment. Coupon bonds are being phased out in favor of registered bonds. Also called bearer bond. coupon pass The purchase of Treasury notes or bonds from dealers by the Federal Reserve. coupon rate The interest rate stated on a bond, note, or other fixed-income security, expressed as a percentage of the principal (face value). Also called coupon yield. coupon yield Same as coupon rate. credit analysis The process of evaluating an applicant’s loan request or a corporation’s debt issue in order to determine the likelihood that the borrower will live up to his/her obligations. credit analyst One who performs credit analysis. credit risk The possibility that a bond issuer will default, that is, fail to repay principal and interest in a timely manner. Also called default risk.

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Glossary current coupon bond A bond with a coupon within 0.5 percent above or below current market rates. current issue In Treasury securities, the issue that was auctioned off most recently. These tend to be the most actively traded issues. current market value The largest amount any buyer is currently willing to pay for a bond. This amount might be at a premium (above face value) or a discount (below face value). The present worth of a portfolio of securities. current maturity Amount of time between now and the maturity date of a given bond. current production rate The highest interest rate permitted on current GNMA mortgage-backed securities, usually half a point below the current mortgage rate. current yield Same as yield. cushion Same as call protection. CUSIP

Committee on Uniform Securities Identification Procedures.

CUSIP number A nine-character number that uniquely identifies a particular security. CUSIP is an acronym for the Committee on Uniform Securities Identification Procedures, the standards body that created and maintains the classification system. Foreign securities have a similar number, called the CINS number. date of issue Same as issue date. date of payment Same as payment date.

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Glossary dealer market A market in which transactions occur between principals acting as dealers buying and selling for their own accounts, rather than between brokers acting as agents for buyers and sellers. One example is the market for Treasuries. debenture Unsecured debt backed only by the integrity of the borrower, not by collateral, and documented by an agreement called an indenture. One example is an unsecured bond. debt A liability or obligation in the form of bonds, loan notes, or mortgages, owed to another person or persons and required to be paid by a specified date (maturity). debt capital Capital raised through the issuance of bonds. debt financing Financing by selling bonds, bills, or notes to individuals or institutions. debt instrument A written promise to repay a debt. Examples include bills, bonds, notes, CDs, GICs, commercial paper, and banker’s acceptances. debt limit The maximum amount of debt that a state, city, or local government is allowed to take on, beyond which voter approval is usually required. debt market The market for trading debt instruments. debt shelf A shelf registration for a bond offering. debt/equity ratio A measure of a company’s leverage, calculated by dividing long-term debt by common shareholders’ equity, usually using the data from the previous fiscal year.

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Glossary debt-equity swap A transaction in which a corporation exchanges newly issued stock (equity) for existing bonds (debt). debtholder Same as bondholder. debtor An individual or company that owes debt to another individual or company (the creditor), as a result of borrowing or issuing bonds. Also called obligor. deep-discount bond A bond that sells at a discount of 20 percent or more from face value. Deep-discount bond most often refers to a zero-coupon bond. deferred interest bond A bond which pays interest at a later date, such as a zero-coupon bond. delivery vs. payment The delivery of securities in exchange for an asset, usually money. One of two methods for the delivery of securities, the other being delivery vs. receipt. delivery vs. receipt The delivery of securities in exchange for a signed receipt for the securities. One of two methods for the delivery of securities, the other being delivery vs. payment. delivery vs. repayment Same as delivery vs. payment. denomination The face amount of a security or currency. Depository Trust Company A central repository through which members electronically transfer stock and bond certificates. derivative A financial instrument whose characteristics and value depend on the characteristics and value of an underlying instrument or asset, typically a commodity, bond, equity, or currency. Examples are futures and options. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 176

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Glossary digested security A security purchased by an investor likely to hold it for a long period of time. direct issuer Company that sells commercial paper directly to retail investors, rather than using brokers. direct paper Commercial paper that is distributed by the issuer rather than through an underwriter. discount The amount by which a bond’s par exceeds its market price. The amount by which the value of a closed-end fund’s holdings exceeds its market price. Anything selling below its normal price. Opposite of premium. discount bond Same as discounted bond. discounted The factoring in of expected upcoming news into a security’s value. discounted bond A bond that is sold at a price below its face value and returns its face value at maturity. Also called discount bond. distribution date Same as payment date. dollar bond A municipal bond quoted in terms of dollar price rather than yield. A bond denominated in U.S. dollars but issued outside the United States or by a foreign corporation in the United States. dollar price A bond whose price is expressed as a percentage of par, rather than in terms of yield to maturity. domestic bond A bond denominated in the currency of the country where it’s issued. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 177

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Glossary double exempt Free from both federal and state income tax liability, such as for a municipal bond. downgrade A negative change in ratings for a security. Two common examples are an analyst’s downgrading a stock (such as from “buy” to “sell”) and a credit bureau’s downgrading of a bond. Opposite of upgrade. drawn securities Securities called for redemption. droplock security A floating-rate security that becomes fixed income if the rate to which it is pegged reaches a specified level. dual currency bond Bond denominated in one currency, but paying interest in another currency at a fixed exchange rate. dual listing The situation that arises when a security is registered for trading on more than one exchange. Dual listings can lead to increased liquidity for the issue. Some securities listed on one exchange may not be listed on another exchange, preventing a dual listing. due date Date on which an obligation must be paid. Also called law day. duration The change in the value of a fixed-income security that will result from a 1 percent change in interest rates. Duration is stated in years. For example, a five-year duration means the bond will decrease in value by 5 percent if interest rates rise 1 percent and increase in value by 5 percent if interest rates fall 1 percent. More generally, an interval of time. duration gap A method of attempting to quantify interest rate risk involving a comparison of the potential changes in value to assets and liabilities that are affected by interest rate fluctuations over all relevant intervals. The duration of each asset or liability defines an interval that must be assessed.

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Glossary Dutch auction A type of auction in which the price on an item is lowered until it gets its first bid and is sold at that price. The Treasury auction is a Dutch auction. DVP Delivery vs. payment. DVR Delivery vs. receipt. dwarf Pool of mortgage-backed securities with a maturity of 15 years, issued by the Federal National Mortgage Association. effective duration The duration for a bond with an embedded option when the value is calculated to include the expected change in cash flow caused by changes in interest rates. This measures the responsiveness of a bond’s price to interest rate changes. effective rate The yield on a debt as calculated from the purchase price. A more accurate measure of the return on a bond investment than the simple coupon payment. Computed using both the capital gain from price appreciation and the bond’s yield. embedded option An option that is part of the structure of a bond. equity risk premium The extra return that the overall stock market or a particular stock must provide over the rate on Treasury bills to compensate for market risk. equity-linked note A debt instrument whose return on investment is tied to the equity markets. The return on equity-linked notes may be determined by a stock index, a basket of stocks, or a single stock. These securities are usually protected from negative performances in the base equity by guaranteeing a minimum redemption value.

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Glossary equivalent taxable yield The yield needed on a taxable investment in order to match the tax-free return offered on a municipal bond. Calculated by dividing the tax-exempt yield by (1 minus the investor’s marginal tax rate). Also called yield equivalence. escrowed to maturity The holding of proceeds from a new bond issue in an escrow account, to be used to pay off an existing bond issue at its maturity. Eurobond A bond issued and traded outside the country whose currency it is denominated in, and outside the regulations of a single country. Usually a bond issued by a non-European company for sale in Europe. Also called global bond. Euroclear One of the leading clearing systems for Eurobonds. Eurodollar bond A Eurobond denominated in U.S. dollars. Euroequity issues Securities sold in several national markets simultaneously by an international syndicate. Euroyen bond Eurobond denominated in Japanese yen. event risk The likelihood that the rating of a bond will drop due to an event, such as the taking on of additional debt or a recapitalization by a company. exchange Any organization, association, or group that provides or maintains a marketplace where securities, options, futures, or commodities can be traded, or the marketplace itself. To provide goods or services and receive goods or services of approximately equal value in return. Here, also called barter. The currency markets.

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Glossary exchangeable security A security that grants the holder the right to exchange the security for the common stock of a company other than the issuer. exempt security A security which is not subject to certain SEC or Federal Reserve Board rules. ex-legal Municipal bond which, unlike most municipal bonds, does not have the legal opinion of a bond law firm printed on it. extendible note Note whose maturity can be lengthened at the option of the issuer. extension swap A swap in which an investor extends the maturity of his investment by selling one security and buying another one with a longer maturity. external financing Financing through the issuance of debt or equity. Also called outside financing. Opposite of internal financing. external funds Funds brought in from outside the company, such as through a bond or equity offering. external market The market for securities that are issued outside the jurisdiction of any single country and are offered to investors in multiple countries simultaneously. Sometimes also called the Euromarket. face value Same as par. face-amount certificate A debt security issued by a type of mutual fund called a face amount certificate company. The debt holder makes payments periodically to the issuer, and the issuer agrees to pay to the holder the face value at maturity (or a different amount if the security is called prior to maturity).

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Glossary fallen angel A bond that was investment-grade when issued but is now of significantly lower quality. Fannie Mae Federal National Mortgage Association. Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) Government-chartered corporation that buys qualified mortgage loans from the financial institutions that originate them, securitizes the loans, and distributes the securities through the dealer community. The securities are not backed by the U.S. government. The market value of these securities prior to maturity is not guaranteed and will fluctuate. Federal National Mortgage Association (FNMA or Fannie Mae) A congressionally chartered corporation that buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market. Monthly principal and interest payments are guaranteed by FNMA but not by the U.S. government. Also called Fannie Mae. Federal Reserve Note Note issued by Federal Reserve Banks to handle sudden increases in the demand for currency in a particular area. They are retired as soon as demand returns to a normal level. FHLMC Federal Home Loan Mortgage Corporation. fidelity bond A debt obligation serving to protect an employer from loss in the event that its employees cause damages through dishonest or negligent action. Insurance companies and securities firms are often required to possess a fidelity bond. finance The management of assets, especially money. To raise money through the issuance and sale of debt and/or equity.

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Glossary financial instrument An instrument having monetary value or recording a monetary transaction. financing flows Cash flows generated through debt and equity financing. fine paper Securities which are nearly risk-free. first call date The first date on which a callable bond may be redeemed, specified in its indenture. fiscal agent A bank or trust company which handles fiscal matters for a corporation, including disbursement of dividend payment funds, redeeming bonds and coupons at maturity, and handling taxes related to the issuance of bonds. fixed income A security that pays a specific interest rate, such as a bond, money market instrument, or preferred stock. fixed income equivalent Same as busted convertible. fixed-income arbitrage An investment strategy that involves exploiting the price differences in related short-term bonds. flat A price that is neither rising nor falling. Here, also called sideways. A bond which is trading without accrued interest, such as a bond in default, here also called selling flat. flat yield curve A yield curve showing the same yield for short-maturity and long-maturity bonds. Also called even yield curve. flight to quality Flow of funds from riskier to safer investments, such as bonds, in times of marketplace uncertainty or fear.

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Glossary flip-flop note A note that enables investors to switch between two different kinds of debt. floater A fixed-income instrument which has a coupon rate or interest rate that varies based on a short-term rate index. A floater is generally advantageous when interest rates are rising. Opposite of inverse floater. floating-rate bond Bond whose interest is pegged to a benchmark, such as the Treasury bill rate, and adjusted periodically. flow of funds For municipal bonds, a statement that specifies the priorities for which the revenue will be used. Usually, the flow of funds goes from maintenance and operation to bond debt service to facility expansion to savings for prepayment of debt. For mutual funds, the movement of money into and out of mutual funds. FNMA Federal National Mortgage Association. forced conversion An action resulting in the calling in of a convertible security against the will of the holder. Forced conversion is usually undertaken when the price of the underlying stock is well above the conversion price because the resulting transaction strengthens the company’s balance sheet. forward A contract obligating one party to buy and another other party to sell a financial instrument, equity, commodity, or currency at a specific future date. free bond A bond that is unpledged and can therefore be disposed of immediately. full Said of a bond trading with accrued interest.

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Glossary full coupon bond A bond with a coupon rate above, at, or just slightly below current market interest rates. full lot Same as round lot. full price The price of a bond including accrued interest. general obligation bond A municipal bond secured by the taxing and borrowing power of the municipality issuing it. GIC Guaranteed investment contract. Ginnie Mae Government National Mortgage Association. Ginnie Mae pass-through A fixed-income security that represents an undivided interest in a pool of federally insured mortgages put together by Ginnie Mae. global bond Same as Eurobond. GNMA Government National Mortgage Association. gnomes Slang for the Federal Home Loan Mortgage Corporation’s 15-year fixed-rate pass-through securities. gold bond A bond backed by gold, often issued by gold mining companies. good delivery Designation indicating that a certificate has the necessary endorsements and meets all requirements, so that the title can be transferred by delivery on the settlement date to the buyer. government bond A bond sold by the U.S. government. Government National Mortgage Association (GNMA or Ginnie Mae) A government-owned agency that buys mortgages from lending institu-

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Glossary tions, securitizes them, and then sells them to investors. Guaranteed by the full faith and credit of the U.S. government. government paper Any debt security, such as a Treasury bill or a Ginnie Mae, either guaranteed by the issuer or backed by the U.S. government. Government Securities Clearing Corporation (GSCC) An affiliate of the National Securities Clearing Corporation created to handle Treasury securities, including both new issues and resales. governments Any securities issued by the U.S. federal government or its agencies. grade A quality rating, such as for a commodity. graduated security Security that has moved from one exchange to another, often from AMEX or Nasdaq to NYSE. GSCC Government Securities Clearing Corporation. guaranteed bond Corporate bond whose principal and/or interest payments are guaranteed by a corporation other than the issuer. guaranteed investment contract (GIC) Debt instrument issued by an insurance company, usually in a large denomination, and often bought for retirement plans. The interest rate paid is guaranteed, but the principal is not. Also called guaranteed interest contract. high-grade bond ratings.

A bond with a rating of AAA or AA, the two highest

housing bond A bond that is issued to finance a municipal construction project such as housing development. Such bonds are generally free from federal income taxes and often from state and local taxes as well. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 186

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Glossary income bond A bond that promises to pay interest only when earned by the issuer; failure to pay interest does not result in default. indenture A written agreement between the issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility, and other terms. A written note evidencing proof of indebtedness. index bond A bond whose cash flow is inflation-adjusted, by being linked to the purchasing power of a particular currency. index-linked bond A bond that pays a coupon that varies according to some underlying index, usually the Consumer Price Index. industrial revenue bond Bond used to finance the construction of manufacturing or commercial facilities for a private user. inflation-indexed security A security that promises a higher return than the rate of inflation if the security is held to maturity. installment bond Same as serial bond. insured bond A municipal bond insured against default by an insurance company. interchangeable bond Bond that can be converted from registered to coupon form, or vice versa, upon demand by the bearer, possibly for a fee. interest rate collar A security that combines the purchase of a cap and the sale of a floor to specify a range in which an interest rate will fluctuate. The security insulates the buyer against the risk of a significant rise in a floating rate, but limits the benefits of a drop in that floating rate. interest rate risk The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 187

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Glossary interest rate swap An exchange of two debt obligations which have different payment streams. interest-bearing Paying interest. intermediate-term Two to 10 years, usually used in reference to bonds. When used in technical analysis, usually a few weeks to a few months. Also called medium-term. International Securities Identification Number (ISIN) A unique international code which identifies a securities issue. Each country has a national numbering agency that assigns ISIN numbers for securities in that country. intrinsic value The perceived actual value of a security, as opposed to its market price or book value. The amount by which an option is in the money, calculated by taking the difference between the strike price and the market price of the underlier. inverse floater A fixed income instrument which has a coupon rate or interest rate that varies with a short-term interest rate index in such a way that the yield is inversely related to the market rate of interest. Opposite of floater. inverted scale A serial bond offering in which later maturities have lower yields than earlier ones. inverted yield curve An uncommon situation in which long-term interest rates have lower yields than short-term interest rates. Also called negative yield curve. invested capital See capitalization. investment bill A bill of exchange purchased as an investment, with the intention of holding until maturity.

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Glossary investment letter A letter establishing that the buyer of new securities in a private placement does not intend to resell them for some specified period of time, but instead plans to hold them as an investment. investment memorandum A letter that commits an individual to acquire a company’s securities and describes the terms of the deal. investment security A security purchased for investment purposes, rather than for resale to customers. investment value The estimated price a convertible security would sell for on the open market if it lacked convertibility. Also called straight value. investment-grade bond A bond which is relatively safe, having a high bond rating such as BBB or above. irredeemable bond Bond without a call feature or a redemption privilege. Opposite of callable bond. ISIN International Securities Identification Number. issue date The date on which a bond, insurance policy, or stock offering is issued. Also called date of issue. issuer A company or municipality offering (or having already offered) securities for sale to investors. Examples include corporations, investment trusts, and government entities. junior Subordinate to other claims, rights, or interests. Opposite of senior. junior refunding An exchange by holders of intermediate-term bonds (maturing in less than five years) for long-term bonds (maturing in more than five years). Opposite of senior refunding.

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Glossary junk bond A high-risk, non-investment-grade bond with a low credit rating, usually BB or lower; as a consequence, it usually has a high yield. Opposite of investment-grade bond. kicker A right, warrant, or other feature added to a debt obligation to make it more desirable to potential investors, such as equity participation. law day Same as due date. law of one price An economic rule which states that in an efficient market, a security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrage opportunity would exist. letter security A security sold directly by the issuer to an investor, without SEC registration. Can be done only if the buyer signs and sends a letter of intent to the SEC, indicating that the purchase is for investment rather than resale. limited risk An investment whose loss cannot exceed a specific amount, usually the amount invested. Examples include options, buying stocks, and buying bonds. Opposite of unlimited risk. listed Traded on a major exchange, such as NYSE or AMEX. Opposite of over-the-counter. listing The acceptance of a security for trading on a registered exchange. A written agreement between a real estate owner and an agent authorizing the agent to search for a buyer for the property. Little Board American Stock Exchange. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 190

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Glossary long The state of actually owning a security, contract, or commodity. Also called long position. Opposite of short. long bond The 30-year bond, the longest-maturity bond issued by the U.S. Treasury, the most widely traded bond, and the benchmark against which all other bonds are measured. More generally, any bond with a term of 10 years or more. long position Same as long. long-term A long period of time, as for a bond (e.g., 10 or more years) or for a buy-and-hold investment strategy. low grade A bond rating of B or lower, indicating some uncertainty as to the issuer’s ability to meet the bond’s obligations. Macaulay duration The weighted-average term to maturity of a bond’s cash flows. The weighting is based on the present value of each cash flow divided by the price. This is one of two ways to calculate duration, the other being modified duration. maintenance bond Bond guaranteeing against defects for a specified time period following the completion of a contract. market basket See basket. market capitalization See capitalization. market conversion price The price that an investor effectively pays for common stock by purchasing a convertible security and then exercising the conversion option. Also called conversion parity price. marketability A measure of the ability of a security to be bought and sold. If there is an active marketplace for a security, it has good marketability. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 191

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Glossary Marketability is similar to liquidity, except that liquidity implies that the value of the security is preserved, whereas marketability simply indicates that the security can be bought and sold easily. marketable security Security that probably could be converted into cash quickly and easily. master notes Commercial paper issued by large, creditworthy companies to banks. matrix trading Bond swap strategy designed to profit from yield curve differentials between bonds of different ratings or classes. matured Paid up, due for payment, or completed. maturity The date on which a debt becomes due for payment. Also called maturity date. maturity basis A bond’s interest divided by its maturity value. maturity date Same as maturity. maturity gap A method of attempting to quantify interest rate risk by comparing the potential changes in value to assets and liabilities that are affected by interest rate fluctuations over all relevant intervals. The maturity of each asset or liability defines an interval that must be assessed. maturity value The amount that will be received at the time a security is redeemed at its maturity. For most securities, maturity value equals par value. MBIA Municipal Bond Insurance Association. MBS

Mortgage-backed security.

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Glossary medium-term Same as intermediate-term. medium-term bond Same as intermediate-term note. minimum yield

Yield to call or yield to maturity, whichever is lower.

minus yield Condition in which a convertible bond is selling at a premium higher than the interest yield on the bond. mob spread The yield spread between tax-free municipal bonds and Treasury bonds with the same maturity. “Mob” refers to “municipals over bonds.” modified duration A measure of the price sensitivity of a bond to interest rate movements. Equal to the Macaulay duration divided by [1+ (bond yield/k)] where k is the number of compounding periods per year. It is therefore inversely proportional to the approximate percentage change in price for a given change in yield. This is one of two ways to calculate duration, the other being Macaulay duration. money market Market for short-term debt securities, such as banker’s acceptances, commercial paper, repos, negotiable certificates of deposit, and Treasury bills with a maturity of one year or less and often 30 days or less. Typically safe, highly liquid investments. moral obligation bond A type of state-issued municipal bond which is backed by a moral, but not a legal, obligation. mortgage bond A bond secured by a mortgage on a property. mortgage pass-through security A security consisting of a pool of residential mortgage loans. All payments of principal and interest are passed through to investors each month. Issued by Ginnie Mae, Freddie Mac, and others. Also called pass-through. mortgage pool Same as pool. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 193

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Glossary mortgage-backed certificate Same as mortgage-backed security. mortgage-backed security (MBS) Security backed by a pool of mortgages, such as those issued by Ginnie Mae and Freddie Mac. Also called mortgagebacked certificate. muni Short for municipal bond. muni fund Same as municipal bond fund. municipal bond Bond issued by a state, city, or local government to finance operations or special projects; interest on it is often tax-free. Also called muni. municipal bond fund A mutual fund which invests in municipal bonds. Also called muni fund. municipal bond insurance Insurance policy underwritten by a private insurance company that guarantees a municipal bond in the event of default. Municipal Bond Insurance Association (MBIA) A group of insurance companies which insure payment of principal and interest on certain bonds. municipal investment trust A unit investment trust which invests in municipal bonds and passes the income, usually tax-free, to its shareholders. municipal note Short-term municipal bond with a maturity of one year or less. municipal revenue bond Same as revenue bond. National Market System The trading system for over-the-counter stocks under the sponsorship of NASD and Nasdaq. The trading system where

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Glossary prices for stocks and bonds on NYSE and the regional exchanges are listed simultaneously. near money Highly liquid assets which are not cash but can easily be converted into cash, such as bank deposits and Treasury bills. Similar to cash equivalents. negative pledge clause A covenant in a bond agreement whereby the borrower agrees not to pledge any assets if such pledging would result in less security for the agreement’s bondholders. Also called covenant of equal coverage. negative yield curve Same as inverted yield curve. negotiable security Security that can be transferred or delivered to another party. Examples include coupon bonds, bearer notes, bearer warrants, stock certificates, and coupons. Opposite of registered security. New York Stock Exchange (NYSE) The oldest and largest stock exchange in the United States, located on Wall Street in New York City. Responsible for setting policy, supervising member activities, listing securities, overseeing the transfer of member seats, and evaluating applicants. Also called Big Board. Nine-Bond Rule The NYSE rule requiring that orders for nine or fewer bonds be sent to the floor for one hour to seek a market. nominal Not adjusted for inflation. The par value of a bond. nominal rate

The stated interest rate on a bond, unadjusted for inflation.

nominal yield The amount of income earned from a fixed-income security divided by the security’s par value, expressed as a percentage.

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Glossary noncallable Not able to be redeemed prior to maturity. noncallable bond A bond that is not able to be redeemed prior to maturity. Also called bullet bond. noncompetitive bid A method of purchasing Treasury bills in which an investor agrees to buy a specified number of securities at the average price of the accepted competitive bids. non-interest-bearing note Same as zero-coupon bond. nonrefundable Condition in a bond indenture which prohibits or restricts the ability of the issuer to retire the bond through a subsequent issue (refunding). normal yield curve A situation in which long-term debt instruments have higher yields than short-term debt instruments. Also called positive yield curve. not rated Said of a security or company that has not been given a rating by Moody’s, Standard & Poor’s, or another rating service. note A short-term debt security, usually with a maturity of five years or less. A legal document that obligates a borrower to repay a mortgage loan at a specified interest rate during a specified period of time or on demand, here also called promissory note. notice of sale The notice which a lender is usually required to give before foreclosure sale of collateral. An advertisement placed by a municipal bond issuer inviting underwriters to submit bids for an upcoming offering. NYSE New York Stock Exchange.

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Glossary obligation Any debt, written promise, or duty. obligation bond Mortgage bond whose face value exceeds the value of the underlying property, and for which a personal obligation is created to compensate the lender for any costs that may exceed the value of the mortgage. obligor Same as debtor. offer Same as ask. To express a desire to enter into an arrangement or contract with another party. offering The making available of a new securities issue to the public through an underwriting. Also called public offering. offering circular Same as prospectus. offering price In general, same as ask. Or for an underwriting, the price at which the first investors (typically institutions) are able to purchase shares. offering scale Prices (or yields to maturity) at which different maturities of a serial bond issue are offered to the public. OID Original issue discount. original issue discount (OID) The discount from par value, if any, at the time a bond is issued. original maturity Amount of time between a bond’s issue date and its maturity date, as opposed to its current maturity. OTC Bulletin Board An electronic quotation system for unlisted, nonNasdaq, over-the-counter securities.

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Glossary OTCBB OTC Bulletin Board. out-of-favor Stock, industry, or investment that is currently unpopular. outside financing Same as external financing. outstanding Remaining, in existence. For debt, not yet paid. For securities, in the hands of investors. over-the-counter (OTC) A security that is not traded on an exchange, usually due to an inability to meet listing requirements. For such securities, broker/dealers negotiate directly with one another over computer networks and by phone, and their activities are monitored by the NASD. Also called unlisted. The computer and phone system through which over-the-counter (as well as listed) securities are traded. paper A short-term debt security. paper dealer Dealer who buys commercial paper and resells it at a lower interest rate, realizing a profit. par The nominal dollar amount assigned to a security by the issuer. For an equity security, par is usually a very small amount that bears no relationship to its market price, except for preferred stock, in which case par is used to calculate dividend payments. For a debt security, par is the amount repaid to the investor when the bond matures (usually, corporate bonds have a par value of $1,000, municipal bonds $5,000, and federal bonds $10,000), here also called face value or par value. par bond A bond selling at its face value. par value Same as par.

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Glossary participating GIC A GIC in which the policyholder is not guaranteed a specific return, but instead receives a return based on the performance of the portfolio. participation certificate Same as certificate of participation. pass-through A security representing pooled debt obligations, that passes income from debtors to its shareholders. The most common type is the mortgage-backed certificate. pass-through coupon rate The interest rate paid on a pass-through security. paying agent An agent who makes dividend payments to stockholders or principal and interest payments to bondholders on behalf of the issuer of those stocks or bonds. payment date The date on which a dividend, mutual fund distribution, or bond interest payment is made or scheduled to be made. Also called distribution date. payment-in-kind security A bond that pays interest in the form of additional bonds, or preferred stock that pays dividends in the form of additional preferred stock. performance bond A bond issued by an insurance company to guarantee satisfactory completion of a project by a contractor. permanent financing Long-term debt or equity financing. phantom income Reportable or taxable income which does not generate cash flow. One example is taxable income from zero-coupon bonds.

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Glossary pickup The value gained in a bond swap for which the bond purchased has a higher yield than the bond sold. pickup bond A callable bond which has a high coupon rate and whose callable date is in the near future. A decrease in interest rates will usually trigger an early redemption, which means that the buyer of such a bond should expect a redemption premium. point For loans, 1 percent of the loan amount. For stocks, $1 per share. For bonds, 1 percent of the face value (usually $10, 1 percent of $1,000). pool Group of related financial instruments, such as mortgages, combined for resale to investors on a secondary market. Also called mortgage pool. positive yield curve Same as normal yield curve. preferred debt Debt that takes precedence over other debts. preliminary official statement The initial document published by an underwriter of a new municipal securities offering. premium The amount by which a bond or stock sells above its par value. The amount by which a closed-end fund’s market price exceeds the value of its holdings. An additional cost above the normal cost. The amount that the buyer of an option pays to the seller. A regular periodic payment for an insurance policy, here also called insurance premium. The amount by which the first trading of an IPO exceeds its offering price. Opposite of discount. premium bond Bond whose selling price exceeds its par. Opposite of discounted bond.

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Glossary premium over bond value The positive difference between the market price of a convertible bond and the price that bond would sell at without the convertibility feature. premium over conversion value The positive difference between the market price of a convertible security and the price at which it is convertible. prepayment speed The average rate at which mortgage holders are expected to pay off their loans ahead of schedule. This is used in calculating the value of mortgage pass-though securities. prerefunding Same as advance refunding. price value of a basis point (PVBP) The change in the price of a given bond if the required yield changes by one basis point. primary distribution Same as primary offering. primary instrument A financial instrument whose value is not derived from that of another instrument, but instead is determined directly by the market. primary offering The original sale of a company’s securities, in which the proceeds from the sale are received directly by the company. Also called primary distribution. prime paper Commercial paper with a very high credit rating. prior lien bond A bond that has a higher claim than other bonds from the same issuer. private sector pass-through Mortgage-backed securities issued by a nongovernmental financial institution.

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Glossary privileged bond A convertible bond that has attached warrants. prospectus A legal document offering securities or mutual fund shares for sale, required by the Securities Act of 1933. It must explain the offer, including the terms, issuer, objectives (if mutual fund) or planned use of the money (if securities), historical financial statements, and other information that could help an individual decide whether the investment is appropriate for him/her. Also called offering circular or circular. provisional call feature A feature in a convertible issue enabling the issuer to call the issue if the price of the stock reaches a certain price. public bond Same as agency bond. public offering Same as offering. public purpose bond A type of municipal bond that is exempt from federal income taxes, provided the benefits to private individuals are very small. Often used for roads, libraries, government buildings, and similar projects. purchase Same as buy. put bond Relatively uncommon type of bond that allows the bondholder to redeem the bond at a specified price prior to maturity. put provision A relatively uncommon feature of a bond that allows the holder to redeem the bond at par value on specific dates prior to maturity. An investor might exercise a put provision if interest rates have increased since the bond was issued. PVBP Price value of a basis point. quality spread The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 202

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Glossary quotation Same as quote. quote The highest bid or lowest ask price available on a security at any given time. rate covenant A covenant in a municipal revenue bond that specifies how it will be determined what rates to charge to users of the facility the bond is financing. rating See bond rating, credit rating, stock rating. rating service A company that publishes ratings for securities such as preferred stock and debt issues based on the likelihood of consistent and timely payments. real estate mortgage investment conduit (REMIC) An investment-grade mortgage bond that separates mortgage pools into different maturity and risk classes. recapitalization A change in a company’s capital structure, such as an exchange of bonds for stock. redeem See redemption. redeemable Same as callable. redeemable bond Same as callable bond. redemption The return of an investor’s principal in a security, such as a bond, preferred stock, or mutual fund shares, at or prior to maturity. redemption date The date on which a bond matures or is redeemed. redemption price Same as call price. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 203

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Glossary refund The return of retail goods by a customer for his/her money back. Refinancing a bond. The government’s return of excess taxes paid when filing, here also called tax refund. refunding Issuing a bond to retire an existing bond. registered bond A bond issued with the name of the owner printed on the face of the certificate. It can be transferred to another individual only with the owner’s endorsement. registered coupon bond registered.

A bond whose principal, but not interest, is

registered security Security that cannot be transferred or delivered to another party. Opposite of negotiable security. A security for which a registration statement has been filed with the SEC. registrar The organization, usually a bank or a trust company, that maintains a registry of the share owners and number of shares held for a mutual fund, bond, or stock, and makes sure that more shares are not issued than are authorized. regular-way delivery Delivery of securities in a transaction on the third business day after the transaction occurs (or, for government bonds, the first business day after the transaction occurs). remaining maturity The amount of time left until a bond becomes due. REMIC Real estate mortgage investment conduit. rentier Individual living off of income from fixed investments.

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Glossary residual security Security that could potentially dilute earnings per common share, such as preferred stock, convertible stock, warrants, and rights. restricted security Securities that have limited transferability, usually issued in a private placement. retire To pay off a debt. To cancel redeemed or reacquired securities. To end the period of life during which one works. return The annual return on an investment, expressed as a percentage of the total amount invested. also called rate of return. The yield of a fixed-income security. revenue anticipation note Security issued in anticipation of future revenue that will be used for repayment. revenue bond Bond issued by a municipality to finance a specific public works project and supported by the revenues of that project. Also called municipal revenue bond. risk The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power risk, event risk. round lot The normal unit of trading of a security—100 shares of stock or 5 bonds. Also called normal trading unit, even lot, or full lot. Opposite of odd lot. savings bond A registered, noncallable, nontransferable bond issued by the

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Glossary U.S. government, and backed by its full faith and credit. Face values range from $50 to $10,000. Tax-deferred. Also called U.S. savings bond. SEC Securities and Exchange Commission. SEC filing A document, usually containing financial data, that a company delivers to the SEC and, thereby, to the public. secondary distribution Same as secondary offering. secondary market A market in which an investor purchases a security from another investor rather than the issuer, subsequent to the original issuance in the primary market. Also called aftermarket. secondary offering A registered offering of a large block of a security which has been previously issued to the public, by a current shareholder. The proceeds of the sale go to the holder, not the issuing company, and the number of shares outstanding does not change. Also called secondary distribution. secured bond Bond backed by collateral, such as a mortgage or lien, the title to which would be transferred to the bondholders in the event of default. Securities and Exchange Commission (SEC) The primary federal regulatory agency for the securities industry, whose responsibility is to promote full disclosure and to protect investors against fraudulent and manipulative practices in the securities markets. The SEC enforces, among other acts, the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act. The supervision of dealers is delegated to the self-regulatory bodies of the exchanges. security An investment instrument, other than an insurance policy or fixed annuity, issued by a corporation, government, or other organization This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 206

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Glossary which offers evidence of debt or equity. The official definition, from the Securities Exchange Act of 1934, is: “Any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ‘security’—or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing—but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.” Property that is pledged as collateral for a loan. self-supporting bond Bond sold to finance a project whose revenues will be used to pay off the obligation. sell To transfer ownership of a security or other asset in exchange for money or value. An order with a broker to sell a security or commodity, here also called sell order. A recommendation by an analyst or advisor that a given security should be sold. Opposite of buy. selling flat Same as flat. senior refunding Exchanging bonds for other bonds with longer maturities. Opposite of junior refunding. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 207

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Glossary sentiment A measurement of the mood of a given investor or the overall investing public, either bullish or bearish. serial bond A set of bonds issued at the same time but having different maturity dates. Also called installment bond. series bond

A single bond issue offered to the public on multiple dates.

Series EE bond A savings bond issued at a discount from par, sold in face amounts of $25 to $10,000. All interest is paid at maturity and is exempt from state and local taxes. Series HH bond A savings bond purchased only by trading in Series EE bonds at maturity. Sold in amounts from $500 to $10,000. It may be redeemed after only six months, and its interest is exempt from state and local taxes. shelf offering Same as shelf registration. shelf registration A registration of a new issue which can be prepared up to two years in advance, so that the issue can be offered quickly as soon as funds are needed or market conditions are favorable. short bond A bond with a maturity of less than one year (or sometimes two). short coupon A bond interest payment covering less than the usual sixmonth period, often the bond’s first coupon. short-term Usually one year or less, often used to refer to bonds or loans. Opposite of long-term. short-term reserves Investments in interest-bearing bank deposits, moneyThis Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 208

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Glossary market instruments, and Treasury bills or notes, with maturities of three years or less. sideways Same as flat. sinker Bond whose interest and principal payments are made from a sinking fund. sinking fund A fund into which a company sets aside money over time, in order to retire its preferred stock, bonds, or debentures. sovereign debt A debt instrument guaranteed by a government. special-purpose bond Municipal bond which is repaid from taxes collected from those who benefit from the project the bond’s proceeds were used to fund. Also called assessment bond. split coupon bond Same as zero-coupon bond. split offering A municipal bond which is part serial bond and part term maturity bond. split rating A security which is given different ratings by two or more major rating agencies. spot rate The theoretical yield on a zero-coupon Treasury. spread The difference between any two prices. staggered maturities Holding a portfolio of bonds which includes some short-term, some medium-term, and some long-term, to reduce interest rate risk. stamped security A security that has been stamped to show that some feature of it has changed since its issuance, such as the maturity date. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 209

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Glossary step-up bond A bond that pays one coupon rate for an initial period followed by a higher coupon rate. stock buyback See buyback. straight bond Bond which will pay back the principal on its maturity date, will pay a specified amount of interest on specific dates, and does not carry a conversion privilege or other special features. straight value Same as investment value. strip Bond, usually issued by the U.S. Treasury, whose two components, interest and repayment of principal, are separated and sold individually as zero-coupon bonds. “Strip” refers to “separate trading of registered interest and principal of securities.” structured note A derivative instrument whose value is based on that of an underlying index. A medium-term bond in which the issuer enters into a swap arrangement to change the required cash flows. Student Loan Marketing Association (Sallie Mae) A federally established, publicly traded corporation that buys student loans from colleges and other lenders, pools them, and sells them to investors. subordinated Junior in priority of claim. subscription warrant Same as warrant. super sinker bond

Bond with long-term coupons but short maturity.

surety A pledge, guarantee, or bond, usually to back the performance of an individual or company. surety bond A bond issued by an entity on behalf of a second party, guaranteeing that the second party will fulfill an obligation or series of obligations to This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 210

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Glossary a third party. In the event that the obligations are not met, the third party will recover its losses via the bond. sweetener A feature of a debt obligation or preferred stock which is added in order to make it more attractive to buyers. One example is a warrant. tax anticipation note A short-term debt obligation issued by a state or municipal government in anticipation of future tax collections. tax revenue anticipation note A short-term debt issued by a qualified entity for the purpose of improving cash flow. The note is secured with future revenue, such as tax revenue in the case of a municipality. tax-exempt bond A bond, issued by a municipal, county, or state government, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax. T-bill Treasury bill. term A period of time, such as for a policy, bond, or contract. term bond Bonds of the same issue all maturing at the same time. term to maturity The amount of time between now and when a bond matures. TIPS Treasury Inflation-Protected Security. ton

Informal term for $100 million in bonds.

trade A transaction of a security or commodity, same as barter. More generally, same as commerce. trading Buying and selling securities or commodities on a short-term basis, hoping to make quick profits. More generally, any buying and selling of securities or commodities. This Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 211

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Glossary tranche One of a set of classes or risk maturities which comprise a multipleclass security, such as a CMO or REMIC. Treasuries Negotiable U.S. government debt obligations, backed by its full faith and credit. They come in three types, which have varying maturities: Treasury bills, Treasury notes, and Treasury bonds. Exempt from state and local taxes. Treasury auction A Dutch auction at which Treasury bills are sold to the public. Treasury bill A negotiable debt obligation issued by the U.S. government and backed by its full faith and credit, having a maturity of one year or less. Exempt from state and local taxes. Also called bill, T-bill, or U.S. Treasury bill. Treasury bond A negotiable, coupon-bearing debt obligation issued by the U.S. government and backed by its full faith and credit, having a maturity of more than seven years. Interest is paid semiannually. Exempt from state and local taxes. Also called U.S. Treasury bond. Treasury Direct System operated through Federal Reserve Banks in which retail investors can buy Treasuries without paying a fee to a broker/dealer. Treasury Inflation-Protected Security (TIPS) A security that is identical to a Treasury bond except that principal and coupon payments are adjusted to eliminate the effects of inflation. Treasury note A negotiable debt obligation issued by the U.S. government and backed by its full faith and credit, having a maturity of between one and seven years. Also called U.S. Treasury note. triple exemption A bond or bond fund whose dividends and interest are exThis Glossary of bond terms is provided by InvestorWords.com and reprinted with permission. Copyright © 1997–2002 by WebFinance Inc. All Rights Reserved. Unauthorized duplication, in whole or in part, is strictly prohibited. The full InvestorWords glossary can be found at http://www.investorwords.com. 212

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Glossary empt from federal, state, and local income taxes for investors in the appropriate locations. trust-preferred security A security possessing characteristics of both equity and debt issues. A company creates trust-preferred securities by creating a trust and issuing debt to the new entity. Because the interest paid to the trust is taxdeductible, the company may realize significant tax benefits. U.S. government agency security Same as agency security. U.S. savings bond Same as savings bond. U.S. Treasury The department of the U.S. government that issues Treasury securities. U.S. Treasury bill Same as Treasury bill. U.S. Treasury bond Same as Treasury bond. U.S. Treasury note Same as Treasury note. U.S. Treasury securities Same as Treasuries. underlying debt For municipal bonds, the debt of a government entity within the jurisdiction of a larger government entity which has partial credit responsibility. unit A quantity generally accepted as a standard for exchange. A combination of multiple securities, such as common stock and warrants, sold together as a single product. unlimited risk An investment whose loss is potentially unlimited. Examples include short selling and futures trading. Opposite of limited risk. unlimited tax bond

A municipal bond backed by a full faith and credit

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Glossary commitment to tax at whatever rate and for whatever duration is necessary to fulfill the obligation. unlisted Same as over-the-counter. unseasoned issue An issue that has not been previously traded in the open markets. upgrade A positive change in ratings for a security. Two common examples are an analyst’s upgrading a stock (such as from “sell” to “buy”) and a credit bureau’s upgrading of a bond. Opposite of down payment. wallpaper A worthless security. The name derives from the fact that the security certificate might as well be used as wallpaper. warrant A certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a specific amount of securities at a specific price, usually above the current market price at the time of issuance, for an extended period, anywhere from a few years to forever. Also called subscription warrant. watch list List of securities being monitored particularly closely by a brokerage or exchange to spot irregularities which might be caused by rule violations. with interest Bond for which the buyer must pay the seller all accrued interest from the last interest payment date up to but not including the settlement date. X or XD A symbol used by newspapers to signify that a stock is trading ex-dividend, or that a bond is trading without interest, or that a mutual fund recently paid a capital gain or dividend.

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Glossary Yankee bond market Market for dollar-denominated bonds issued in the United States by foreign corporations, banks, and governments. Yellow Sheets A daily bulletin from the National Quotation Bureau which provides updated bid and ask prices for over-the-counter corporate bonds along with a list of brokerages that make a market in those bonds. yield The annual rate of return on an investment, expressed as a percentage. For bonds and notes, it is the coupon rate divided by the market price. For securities, it is the annual dividends divided by the purchase price. Also called dividend yield or current yield. yield advantage The yield on a corporation’s convertible securities minus the dividend yield on its common stock. yield burning An illegal practice in which an underwriter places excessive markups on bonds used to complete some types of municipal bond offerings. Marking up the price causes the yield to fall, which is known as “burning” the yield. yield curve A curve that shows the relationship between yields and maturity dates for a set of similar bonds, usually Treasuries, at a given point in time. yield elbow highest.

Point on the yield curve at which the interest rate is the

yield equivalence Same as equivalent taxable yield. yield spread The differences in yields on different types of debt securities, a function of supply and demand, credit rating, and anticipated interest rate changes.

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Glossary yield to call Yield that would be realized on a callable bond in the event that the bond was redeemed by the issuer on the next available call date. yield to maturity Yield that would be realized on a bond or other fixed income security if the bond was held until the maturity date. It is greater than the current yield if the bond is selling at a discount and less than the current yield if the bond is selling at a premium. yield to worst The lowest of all yield to calls or the yield to maturity. zero-coupon bond A bond which pays no coupons, is sold at a deep discount to its face value, and matures at its face value. Under U.S. tax law, the imputed interest is taxable as it accrues. Also called accrual bond. zero-coupon convertible A zero-coupon bond issued by a corporation which can be converted into that corporation’s common stock at a certain price, or a zero-coupon bond issued by a municipality which can be converted into an interest-bearing bond under certain circumstances. Also called split coupon bond.

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Bibliography

Cohen, Marilyn, with Nick Watson. The Bond Bible. Upper Saddle River, NJ: Prentice Hall, 2000. Fabozzi, Frank J. Bond Markets, Analysis and Strategies, 4th ed. Upper Saddle River, NJ: Prentice Hall, 2000. Faerber, Esmé. All about Bonds and Bond Mutual Funds: The Easy Way to Get Started, 2nd ed. New York: McGraw-Hill, 2000. Faerber, Esmé. Fundamentals of the Bond Market. New York: McGrawHill, 2000. Norton, Ralph G. Investing for Income: A Bond Mutual Fund Approach to High-Return, Low-Risk Profits. New York: McGraw-Hill, 1999. O’Higgins, Michael B. Beating the Dow with Bonds. New York: Harper, 1999. Reuters. An Introduction to Bond Markets. New York: John Wiley & Sons, 2000. Sheimo, Michael D. Bond Market Rules: 50 Investing Axioms to Master Bonds for Income or Trading. New York: McGraw-Hill, 2000. Thau, Annette. The Bond Book: Everything Investors Need to Know about Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, 217

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Bibliography

Money Market Funds, and More, 2nd ed. New York: McGrawHill, 2001. Wright, Sharon Saltzgiver. Getting Started in Bonds. New York: John Wiley & Sons, 1999. Zipf, Robert. How the Bond Market Works, 3rd ed. Upper Saddle River, NJ: Prentice Hall, 2002.

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Index

AAA rating, 76, 104 AARP, 57 Absurd-term maturity, corporate bonds, 13, 45 Advest, 110 Agency bonds, 117 Aging population, impact of, 2, 38–40, 57 Airlines/transportation sector, 13, 44 Allocation method, 3 Alternative minimum tax (AMT) bonds, 85, 104 Altoona and Beech Creek Terminal Railroad Company, 133–134 Amazon Auctions, 132 Amazon.com, 16 American Association of Individual Investors (AAII), 72, 78

American Century Investments, Bond IQ Quiz, 59–65, 68 American Express Credit Corporation, 32 American Municipal Bond Assurance Corporation (AMBAC), 105 Ameritrade, 15, 36 Analysts, as information resource: equity research, 95–96 overview of, 94–95 Antonellis, Dan, 48 Apogean Technologies, Inc., 30 Ask price, 31 Asset allocation: Investor’s Checklist, 148–150 life considerations, 145–146 Asset-backed securities, 148 Auction systems: primary market, 32–33 secondary market, 86 219

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Index Autobahn Electronic Trading Deutsche Bank, 33 Automated Bond System, 30 Baby Boomers: characteristics of, 20, 38 investment power of, 39, 57 Banking/finance sector, 13, 45 Bankruptcy, 46, 87, 133 Barron’s Online, 80 Barton, Mark, 16 BBB rating, 76 Bear, Stearns & Co., Inc., 33 Bearer bonds, 131–132 Beginning investor, 38–39 Beneficiary, savings bonds, 42 Bid, 31 Bid Ohio, 32 Blackbird, 30 Bloomberg Bond Transfer, 32 Bloomberg Direct Issuer Commercial Paper Auto-Ex, 32 Bloomberg Municipal System, 32 Bloomberg Secondary Market Auction System, 30 BondAgent, 30 Bond Attitude, 61 BondBook, 30 Bond Buyer, The, 109 Bond buyers, online, 38 Bond calculators, 50–53 Bond certificates, 131, 133 BondClick, 32 Bond Connect, 30 BondDesk, 26–27, 30, 146 BondExpress, 78

Bond funds: bonds vs., 62, 87, 139–142 characteristics of, generally, 83, 117–118 check-writing options, 118 daily liquidity of, 118 information resources, online, 119–125 retirement program, 127–128 risk, 118 trade execution, 125–126 BondHub.com, 30 Bond investments, see Bonds, basics of amount of investment, 2–3, 155 benefits of, 2 Investor’s Checklist, 148–156 Bond IQ Quiz, 59–65, 68 BondLink, 30 Bond market: defined, 56 growth in, 39, 145 seesaw, 67 Bond Market Association, 70–71, 144 Bond Market Foundation, Tomorrow’s Money site, 156 BondMart, 30 Bond mutual funds, see Bond funds BondNet, 30 BondNews, 32 Bond psychology, see Investment psychology Bond-rating firms, see Rating agencies

220

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Index Bonds, basics of: corporate bonds, 13, 44–47 federal agency bonds, 12 municipal bonds, 12–13 overview, 5–6 risks, 7–9 U.S. Treasuries, 10–11, 41–43 yield, 6–7 yield-to-maturity, 9–10 BondsOnline, 32, 78–79 Bond spreads, 22–23 Briefing.com, 47–50, 147 Brokerage firms, see Brokerages, online; Brokers/dealers as dealers, 22 full-service, 20–21, 93 Brokerages, online: acquisitions, 21–22 characteristics of, 16–17 commingled inventory systems, 24–27 current status, 27–33 growth of, 20–22 retail bond transactions, 20 retail investors, 36 Brokers/dealers: bond mutual funds, 83 bond ratings, 86 commingled inventory systems, 24–25 commissions, 81–82 discount, 21 full-service, 24–25 functions of, 22–23, 58 high-yield bonds, 85 inventory, 82

long-term investments, 82 risk and, 83–84 tax-free investments, 84–85 Treasury bonds, 86 Broker Tec Global, LLC, 31 Brookings Institute, 82 Bull market, 57 Bureau of Labor Statistics, 57 Buy-and-hold strategy, 18 BuySideDirect, 30 Callable, defined, 12 Callable bonds, 104 Call feature, 75 Call risk, 11–12, 82 Cambridge Group Investments, 78 Cantor Fitzgerald, 27, 34 Cantor Muni–Cantor Fitzgerald, 30 Capital appreciation bonds, 104 Capital gains, 88 CBS Marketwatch, 48, 50, 78, 95, 124, 147 Certificates of deposit (CDs), 74, 148 Chapter 11, 46 Charles Schwab, 18, 21–22, 27, 51, 59 CMOs, 70 CNN, as information resource, 87–89 Collateral, 46–47 Commercial paper, 148 Commingled inventory systems, 24–27, 35 221

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Index Commissions: day trading and, 16 disclosure of, 81 MuniDirect, 115–116 online brokerages, 17 Confirmation of sale, 131 Conservative investments, 20, 57 Convertibles, 117 COREDEAL Limited, 31 Corporate bonds: call feature, 75 characteristics of, 13, 44–47, 148 investment-grade, 47 Coupon: defined, 5 interest rate and, 7–8 Coupon rate: defined, 73 interest rate and, 75 cpmarket.com, 32 Creditex, Inc., 30 Creditors, hierarchy of, 46 Credit quality: bond yields and, 60 significance of, 101, 103, 152 Credit rating, 61, 144 Credit risk, 7–10, 12 Credit Suisse First Boston, 33 Creditworthiness, 9 Cross-matching systems, 29–30 Cyclicals, 13 Dalcomp Variable Rate Trading System, 32 Databases of dealer offerings, 25 Day Traders, 16, 137

Dealers, see Brokers/dealers Debenture bonds, 47 Debt, high-yield, 85 Debt market, 17 “Debt to the Penny, The,” 113–114 Default risk, 9–11, 75–76 Defaults: corporate bonds and, 45–46 high-yield bonds, 85 Demographics, 20 Denzler, Colleen, 60–62 Derivatives, 117 Discount: defined, 7 yield-to-maturity, 10 Discount brokers/brokerages, 21, 92–93, 128–129 Diversification, see Portfolio diversification DLJdirect, 16 Dot-coms, 40, 145 Durrett, John, 58, 108, 114 Eaton Vance Management, 66 eBay, 132 eBondTrade, 33 eBondUSA.com, 30 E-brochures, 59 E-commerce, 119 EE savings bonds, 42, 113 Electronic transaction systems: cross-matching systems, 29–30 development of, 47 interdealer systems, 30–31 multi-dealer systems, 31–32 222

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Index primary market auction systems, 32–33 single-dealer systems, 33 Enron, 46 Equities markets, 57 Equity ownership, 56 Equity research analysts, 95–96 eSpeed, Inc., 26–27, 31, 34 Estate planning, 20–21 E*Trade, 15, 21, 27, 146 E*Trade Mortgage, 21 EuroMOT, 32 EuroMTS Limited, 31 Excite@Home, 46 Executable inventory systems, 25 E-Z allocation method, 3 Face amount, defined, 73 Fannie Mae, 12 FDIC, 35 Federal agency bonds/securities, 12, 31, 148 Federal Home Loan Mortgage Corporation (FHLMC), 12 Federal National Mortgage Association (FNMA), 12 Federal Reserve Bank, 8, 42 Federal tax rate, calculation of, 101 Fiduciaries, 76 FinanCenter, 53 Financial advisor, role of, 154 Financial Guaranty Insurance Company (FGIC), 105 Financial Psychology, 144 Financial Security Assurance Holdings Ltd. (FSA), 105

Fitch IBCA, 9, 86, 110 Fixed-income securities, generally: benefits of, 1 bond calculators, 51 characteristics of, 72 information resources, 48 investor characteristics, 39–40 noninvestment-grade, 76 portfolio diversification and, 74 rate of return, 74–75 short-term Treasury securities, 141 size of, 17–20 taxation, 76–77 Fixed Income Securities, Inc., 33 Focus groups, 59 Ford Motor Credit Company, 32 Foreign government bonds, 148 Forrester Research, 20 401(k) plans, 118, 127, 154 Frameastock.com, 132 Freddie Mac, 12 FreddieMacAuction.com, 32 Fuji Securities, Inc., 33 Fund families, 126–127 Fund management, 120 Garban-Intercapital plc, 31 General obligation bonds (GOs), 102–103 Generation Xers, 39 GFInet, 31 Ginnie Mae, 83–84 Giuliano, Theodore, 68 Global Crossing, 46 Going long, 88 Goldman, Sachs & Co., 33 223

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Index Gomez, Julio, 92 Gomez Advisors, 91–92 Gomez Full-Service Scorecard, 93 Gomez Online Broker Scorecard, 92–93 Government bonds: benefits of, generally, 76–77, 148 long-term, 2 risk and, 9–11 Growth stocks, 57 Gutfreund, John, 114 Hambrecht & Quist, 96 HarrisDirect, 16, 27, 129, 146 High-yield bonds, 13, 68, 70, 83 Historical returns, 74 Holding period, 68 Ibbotson Associates, 74 IBX, 30 Inactive investors, 145 Indenture, 5, 46 Individual investors: conservative investments, 57–58 corporate bonds and, 47 fixed-income holdings, 18 insured municipal bonds and, 105 investment strategies, 7–8, 13, 17–18 laddering, 140–142 online purchases, 23–24 portfolio diversification, 57 purchasing process, 22 Industrial sector, 13, 44 Industry research firms, 20 Industry Standard, The, 17

Inflation, impact of, 88 Infomediary site, 119 Information resources: bond calculators, 50–53 Bondsonline, 32, 78–79 Briefing.com, 47–50, 147 CBS Marketwatch, 48, 50, 78, 95, 124, 147 CNN, 87–89 FinanCenter, 53 research analysts, 91–96 on scripophily, 132–135 TheStreet.com, 78 Wall Street Journal Interactive, 79, 124 Yahoo! Bond Center, 26, 78 Initial public offering (IPO), 56, 95 Instinet Fixed Income, 31 Institutional investors, 57, 81 Insured municipal bonds, 104–105 Interdealer systems, 30–31 Interest rate risk, 7, 75 Interest rates: bond performance and, 60, 152 bond prices, relationship with, 65–68, 87 impact of, generally, 7–9, 75, 83–84 short-term, 65 Intermediate-maturity bonds, 66 Intermediate-term bonds, 88 Intermediate-term maturity, corporate bonds, 13, 45 Internal Revenue Service (IRS), 84, 99 International Bond and Share Society, 135 224

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Index Internet, see specific web sites benefits of, 3–4 as information resource, 69, 91, 119–125 user profile, 39–40 Internet stocks, 16, 38 InterVest, 32, 81 Inventory: commingling, 24–27, 35 sales incentives and, 82–83 InvestinginBonds.com, 70–71 Investment banks, function of, 95–96 Investment Company Institute (ICI), 72, 118, 120–122, 125 Investment-grade bonds, 13, 47, 76 Investment objectives, 150 Investment profile: importance of, 143–146 Investor Checklist, 148–156 laddering, 146–147 Investment psychology: confusion, 58–59, 138 decision-making, influential factors, 59–62 sex appeal, lack of, 55–58 Investor Checklist, 148–156 Investor education: bond mechanics, 73–74 importance of, 59, 61 information resources, generally, 155–156 on Internet, 69–70 nonprofit organizations, 70–72 online media and news sites, 77–89 portfolio diversification, 74

ratings, 76 risk tolerance, 75 taxation, 76–77 Investor’s Business Daily, 95 IRAs, 118, 153–154 Issue price, 82–83 Jargon, 70, 119 J.P. Morgan Chase, 96 J.P. Morgan express, 33 Junk bonds, 13, 35, 83, 117 Keefe, Bruyette & Woods, 96 Kerstein, Bob, 132–133 Kiplinger, 80 Kmart, 46 Laddering, 140–142, 146–147 Ladensack, John, 18, 59 Lebenthal & Co., 110–111 Lehman Live, 33 Lehmann, Richard, 82 Liability considerations, 35 LibertyDirect, 31 LIMITrader Securities, Inc., 30 Lipper, 66, 124–125 Liquidity, 86 LMS (Merrill Lynch Capital Markets), 33 LoansDirect, 21 Long-term bonds, 8, 88 Long-term maturity bonds, 13, 45, 66 MacIntosh, Robert, 66 MacKinnon, Ian, 66

225

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Index Management fees, 83 MarketAxess, 32 Market corrections, impact of, 27 Market sectors, 13, 44–45 Markups, 22, 59, 81 Maturities, corporate bonds, 13, 45 Maturity: bond funds vs. bond investments, 141–142 defined, 151 interest rates and, 8, 60 Maturity date: call risk and, 82 defined, 73 staggering, 146 MBSAuction, LLC, 30 Media, influences of, 77–89, 144 Merrill Lynch, 9, 15 Merrill Lynch Direct, 35 Money market: instruments, 57 mutual funds, 19 Moody’s, 9, 76, 85–86, 110 Morgan Stanley, 15, 35, 93 Morgan Stanley Dean Witter & Co., 33 Morningstar, as information resource, 85, 121–124, 126–127 Mortgage-backed bonds/securities, 35, 83–84, 117, 148 Mortgage-related securities, 31 Multi-dealer systems, 31–32 MuniAuction, 32 Municipal Bond Insurance Association (MBIA), 105

Municipal bonds: characteristics of, 12–13, 99–100, 148 general obligation bonds (GOs), 102–103 individual investors, 18–19 insured, 104–105 investor characteristics, 38 multi-dealer systems, 31 online brokerages, 107–116 popularity of, 34 revenue bonds, 103–104 state taxation, 101–102 taxable equivalent yield (TEY), 100–102 taxation, 76–77, 84–85, 101–102 Treasury taxes compared with, 102 types of, 102–104 zero-coupon, 70 MuniDirect, 58, 107–109, 114–117 Muniversal, 30 MuniWizard, 108–109 Museum of Financial History, 135 Mutual funds: interest rates and, 68 no-load, 139 popularity of, 19–20, 60 trade execution, 129 National Association of Securities Dealers (NASD), 81 Net asset value (NAV), 118, 140 Neuberger Berman, 68 New Economy, 28 New issues, 87 226

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Index Newsletters, municipal bonds, 109 New York Stock Exchange, 47 No-load mutual funds, 139 Noninvestment-grade bonds, 76 Nonprofit organizations, as information resource: American Association of Individual Investors, 72 Bond Market Association, 70–71 Investment Company Institute, 72 Securities and Exchange Commission (SEC), 71 Odd lot, 81 Odd-Lot Machine/GovRate, 33 OldCompanyResearch.com, 133 Oneshare.com, 132 Online banking, 40 Online brokerages/brokers: bond funds, 128–129 characteristics of, 15–17, 20–22 selection factors, 91–96 Online Broker Scorecard, 92 Online trading: advertising campaigns, 39–40 benefits of, 4 Operating expenses, 139 Opportunity cost, 75 Par, 83 PARITY, 33 Pedistal, 30 Penalties, savings bond redemption, 42 Pension plans, 127

Pew Internet & American Life Project, 40 Piper Jaffray, 96 Portfolio diversification, 21, 23, 61–62, 66, 68, 74, 144 Portfolio management, 154 Predictions, 20 Premium: defined, 7 yield-to-maturity, 10 Premium bond, 83 Prerefunded bonds, 104 Primary market auction systems, 32–33 Principal, 5 Private-activity bonds, 84–85 Private trading systems, 27–29 Public Debt Online, 43, 111–112, 132 publicdebt.treas.gov, “The Debt to the Penny,” 113–114 Public utilities sector, 13, 44–45 Putnam Lovell, 96–97 Quote.com, 125 Ragen MacKenzie Incorporated, 33 Rating agencies, 9, 86, 110 Ratings, significance of, 9 Registered bonds, 131 Reinvestment risk, 147 Retail market, 24 Retirement planning, 57, 61–62, 88, 118 RetLots Caboto, 33 Return, calculation of, 10 Revenue bonds, 103–104 227

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Index Risk-averse investors, 144 Risk management, 21 Risk tolerance, 2–3, 151 Risks: calculation of, 12 types of, 7–9, 11–12 Robertson Stephens, 96 Rogers, Tim, 48 Salomon Brothers, 114 Salomon Smith Barney, 9, 114 Scient, 27, 29 Scripophily, defined, 132, 135 Scripophily.com, 132–135 Scudder Kemper Investments, 48 Secondary market, 42, 86 Securities and Exchange Commission (SEC): as information resource, 71 as regulatory agency, 81, 84 Selling process, 73–74 Selling strategy, 145 SeniorNet, 40 Short-maturity bonds, 66 Short-term bonds, 8, 88–89 Short-term interest rates, 65 Short-term maturity, 13, 45, 144 Single-dealer systems, 33 SmartMoney.com, 80 Social Security Administration, 57 Sovereigns, 117 Spear, Leeds & Kellogg, 33 Staggering maturity dates, 146 Standard & Poor’s, 9, 76, 86, 110 State taxation, 101–102 Stock certificates, 132

Stock investments: portfolio diversification, 66, 68 rate of return, 87 StockandBondAuction.com, 132 Strips, 11 Taxable equivalent yield (TEY), 100–102 Tax advisor, role of, 154 Taxation: corporate bonds, 13 government bonds and, 76–77 Investor’s Checklist, 152–153 state, 101–102 Tax-deferred accounts, 153 Tax-exempt bonds, 153–154 Tax-exempt investments, 99 Tax-free bonds, 12–13, 19, 88 Tax-preferred accounts, 153 T-bills (Treasury bills), 11, 42–43, 74, 76, 111–112, 148 TD Waterhouse, 146 TD Waterhouse Bond Center, 27–28 Technology stocks, 16, 37, 57 Telebank, 21 TheMuniCenter, 31 TheStreet.com, 78, 124 Third-party providers, 33, 125–126 Thomson Financial Services, 32, 48 Thomson Municipal Market Monitor, 109 Time horizon, 2 Toffey, Jim, 34 Total return, 88, 140 TowerGroup, 19–20 Tradebonds.com, 33 TradeWeb LLC, 32, 34 228

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Index Transaction costs, 38 Transaction fees, 128–129 Treasury bonds, 2, 11, 76, 81, 111–112 Treasury Direct, 33, 81, 86, 111, 113 Treasury notes, 11, 43, 76, 81, 111–112, 140 12b-1 marketing fees, 83, 139 UBS Paine Webber, 93 Underwriters, 84, 110 Unemployment rates, implications of, 57 Unit investment trusts (UITs), 154 U.S. Bankruptcy Code, 46 U.S. savings bonds, 42, 111–112, 132 U.S. Treasury securities: characteristics of, 10–11, 41 credit quality, 152 individual investor holdings, 19 interdealer systems, 31 multi-dealer systems, 31 online brokerages, 107–117 popularity of, 34 short-term, 141 U.S. Trust, 21 Unsecured bonds, see Debenture bonds USA Today Interactive, 124 User fees, 103 ValuBond, 26, 30, 78 Vanguard Group, 66

Vanguard High-Yield Corporate Bond Fund, 126–128 Visible Markets, 30 Volatility, impact of, 11, 83–84 Wall Street Journal, 95 Wall Street Journal Interactive, 79, 124 Wallman, Steve, 82 Wealth management, 20 Widow and orphan investments, 3, 56 World Trade Center, terrorist attack on, 34 World Wide Web, 4, 137 Wright, Mark, 85 Wrixon, Ann, 40 Xbond, 30 Xetra, 31 Yahoo! Auctions, 132 Yahoo! Bond Center: bond calculators, 52–53 services provided, 26, 78 Yahoo! Finance, 95 Yield: burning, 84 characteristics of, 6–7 credit quality and, 60 interest rates, impact on, 8 Yield-to-maturity (YTM), 9–10 Zero-coupon bonds, 104, 150 Zero-coupon municipals, 70 Zero-coupon Treasury bonds, 11 229