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How To Purchase A Bond – Important Guidelines To Follow

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Introduction

 

 

So at this point you’re probably beginning to think that maybe you would like to invest in bonds but are a little unsure of how to proceed since, investing for the first time can be a little daunting at first glance. In this lesson, I am going to show how to purchase a bond – primarily focusing on guidelines to follow and/or look for in order to be better equipped when trying to interpret bond data.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

Purchasing Bonds

 

When purchasing bonds you will want to abide by the following list as a
general rule of thumb :

  1. Bond Issuer
  2. Bond Rating
  3. Yield to Maturity
  4. Callable Bonds
  5. Bond Quote
  6. Bond Ladder

 

Since I have already discussed in great detail the first two components, let’s start with yield to maturity.

If you missed out on the information on the first two components or need a quick refresher be sure to look at my other post :

Types of Bond Issuers – Which Type Of Bond Is Right For You?

and

Bond Ratings Explained – Interpreting The Bond Rating System

Lets Begin.

Yield Maturity

 

 

There are some cases where the coupon rate and the bond yield are not the same.

The coupon rate is calculated by using the unchanging face value, whereas the yield is calculated using the constantly changing price.

For example, a bond can have a coupon rate of 4%, but because the price of the
bond has fallen in value, the actual yield may be 3%.

The bond price will need to change in order for its yield to be competitive with other bonds. If the current bond market has similar bond types, maturity lengths, and credit quality, the price of the bond will change so the yield
is competitive. This new competitive yield is known as the Yield to Maturity (YTM).

The Yield to Maturity (YTM) is calculated with the consideration of current yields, the coupon rate, and the face value at maturity.

 

 

 

Therefore, the YTM allows you to compare bonds with different coupon rates, maturities
and credit quality.

Callable Bonds

 

If your bond is being paid back early, it’s being “called away”.

Many bonds are callable, which means the issuer can redeem the bond before maturity and return the principal. Bonds may be issued with a call feature that allows the issuer to redeem the bonds at a specific price and date before maturity.

 

 

A bond issuer may call bonds if the current rates are low and the debt can be refunded at a lower interest rate

If you have locked in a high coupon rate on a 30-year bond, call risk is the chance that at some point in the future the bond can be taken away from you. You will receive the principal, but you may have to reinvest in a lower coupon rate.

Bond Quote

 

Before purchasing any investment, you need a quote that provides a detailed listing of the bonds features.

Your brokerage firm will be able to provide you with quotes allowing you to compare bonds side by side as shown in Figure 1.

 

 

The CUSIP is the symbol that your broker will use to buy and sell a bond.

The Sector is what type of company the corporation is.

QTY refers to the quantity of available bonds. In this example, the first bond has only 170 available bonds.

The Min is the minimum amount of bonds you must buy – in this example, the first bond requires that you buy 5 bonds in order to make the initial investment.

The Issue shows you the name of the company and whether the bond is callable.

The Coupon shows the rate of return at face value.

The Maturity shows the date when the bond expires.

Rating refers to the overall quality of the bond and it’s investment grade.

YTM (Yield to Maturity) is the rate of return considering the bonds current price.

YTW (Yield to Worst) shows the worst yield possible including the yield to call and the yield to maturity.

The Price is obviously the price of the bond.  The price can be classified as above or below par. If it is above par, then the bond is selling at premium. If it is below par it’s selling at a discount.

A quote of 125.858 multiplied by a par of $1000 , translates to a bond price of $1,258.58.

Bond Ladder

 

 

A bond ladder is when you divide your bond portfolio into relatively equal amounts and purchase several bonds with different maturity lengths and coupon payment schedules. This allows you to have bonds coming due at regular intervals for more consistent returns while reducing interest rate risk. Coupon payments can also be ‘laddered’ to ensure that interest income is available on a consistent basis.

Laddering Maturities

 

A bond ladder uses different maturities that come due at different intervals.

Let’s say for instance that you divided your bond portfolio into 3 portions : 1/3 of the bonds that you bought expire within a year, another third in two years and the last third, in three years. The longer maturities usually allow you to get a higher coupon payment while you still have some liquidity with the first group of bonds coming due in a year.

Ladder Reinvestment

 

At the end of the first year in the example that I described above, you could use the principal that was paid back or you can choose to reinvest those earnings into another 3 year bond

Because the second rung is now only a year away, you have the same liquidity you did when you first started the ladder.

As the years go by, the money can be continually reinvested potentially offering you a consistent income stream from the bonds that you have purchased.

Bond Cash Flow

 

 

Just as you have bonds that mature at regular intervals you can also receive interest or coupon payments at regular intervals.

This can be achieved by selecting several bonds that pay coupons in different months.

You can eventually adapt and evolve this into getting coupon payments every month, an extra hundred or even thousands of dollars that can alleviate your current living expenses. An extra two hundred dollars can be worth an entire week of groceries, gas money for the entire month, cover your utilities and so much more.

However, millions of bonds are traded on a daily basis, so there is no guarantee that you’ll be able to find replacement bonds of the same coupon, maturity, or payment schedule.

 

Quick Recap

 

In Review……

When purchasing bonds you will want to abide by the following list as a
general rule of thumb :

  1. Bond Issuer
  2. Bond Rating
  3. Yield to Maturity
  4. Callable Bonds
  5. Bond Quote
  6. Bond Ladder

 

  • There are some cases where the coupon rate and the bond yield are not the same
  • The Yield to Maturity (YTM) is calculated with the consideration of current yields, the coupon rate, and the face value at maturity
  • Therefore, the YTM allows you to compare bonds with different coupon rates, maturities
    and credit quality
  • Many bonds are callable, which means the issuer can redeem the bond before maturity and return the principal
  • A bond issuer may call bonds if the current rates are low and the debt can be refunded at a lower interest rate
  • Before purchasing any investment, you need a quote that provides a detailed listing of the bonds features. Your brokerage firm will be able to provide you with quotes allowing you to compare bonds side by side
  • A bond ladder is when you divide your bond portfolio into relatively equal amounts and purchase several bonds with different maturity lengths and coupon payment schedules. This allows you to have bonds coming due at regular intervals for more consistent returns while reducing interest rate risk. Coupon payments can also be ‘laddered’ to ensure that interest income is available on a consistent basis
  • Just as you have bonds that mature at regular intervals you can also receive interest or coupon payments at regular intervals. This can be achieved by selecting several bonds that pay coupons in different months. You can eventually adapt and evolve into getting coupon payments every month

 

And these are the aspects that are involved in purchasing your very first bond. I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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