Download (direct link):
I also explain how to purchase Treasury securities without a broker. You can now purchase Treasury securities online or over the phone with Buy Direct, a U.S. Treasury Department-sponsored program. In addition, you can access your account online to see your online statement. Other online services include helpful information — for example, dates of government auctions, Treasury yields, auction results, and instructions about how to open your investor’s account at Treasury Direct (the master record of the securities you own that is maintained by the federal government). Finally, I offer a hot strategy that can protect you from interest rate risk.
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The Math of Bonds
The bond market is dominated by institutional investors (insurance companies, pension funds, and mutual funds) that account for 80 to 85 percent of all trading. Individual investors tend to purchase municipal and corporate bonds because of their lower denominations (around $1,000) and tax-exempt features. However, the impact of individual investors can also be felt through the purchases of mutual funds that specialize in bonds.
The following section shows the valuation process of bonds and the relationship of interest rate changes to the value of bonds. I provide several easy-to-use approaches that take the mystery out of determining your bond yield.
Calculating bond Values
A bond issued by a corporation is called a debt instrument. The bond states how the debt holder (investor) is repaid. Generally, these terms are normal debt arrangements. The borrower makes interest payments and then pays the principal at a predetermined date. Several issues make bonds complicated, such as provisions to convert the bonds to common stocks at a predetermined stock value, or terms that allow the bond issuer to retire the bond before maturity.
Treasury securities and government agency and municipal bonds are valued in the same way as corporate bonds. However, this valuation doesn’t show the entire picture. Treasury securities are subject to federal taxes but are exempt from state and local taxes. Government agency securities are generally taxable for federal, state, and local purposes, but some exceptions exist. Municipal bonds are generally tax-free (from federal, state, and local taxes). Therefore, when you value corporate bonds, the calculated rate of return is somewhat overstated because it doesn’t consider the impact of taxes.
The value of the bond is based on the investor’s assessment of the bond’s value. The receipt of future interest payments, the repayment of principal, and the credit rating or riskiness of the bond usually temper these assessments. You aren’t obligated to hold a bond until maturity, and bonds are traded freely in the marketplace.
Calculating the value of a bond involves determining the present value of the interest payments and the eventual recovery of the principal. Present value means discounting the future cash flow to calculate how much you’re willing to pay today for these future receipts.
At times, calculating the yield on bonds can seem more complicated than it really is. For example, if you purchase a one-year Treasury bill for $9,500, and
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redeem it in 12 months at full face value ($10,000), your gain is $500 (subject to federal income tax but exempt from state and local taxes). To determine your yield if your holding period is one year, use the following formula:
(Face Value - Price) + Price = Annual Return ($10,000 - $9,500) - $9,500 = 0.0526, or 5.26%
See the section “The easy way to value your bond returns,” later in this chapter, where I show you how to calculate the yield for a bond that has a maturity term greater than one year.
Creating yield curves
A yield curve is a diagram that illustrates the relationship of bond yields to maturities on a specific day. You can use yield curves to decide which type of bond is best for your financial objectives. Bond yields and maturities are posted daily at the Bloomberg.com Web site (www.bloomberg.com/ markets/rates/index.html), shown in Figure 13-1.
Bloomberg. com shows the current yield and previous yield curve of U.S. Treasuries.
246 Part II: Finding the Right Investments
Figure 13-1 indicates the current and previous yields for U.S. Treasury bills, notes and bonds. The horizontal axis plots the maturities of Treasury securities from left to right starting with the maturity of 3-months to 30 years. The yield of each security is plotted on the vertical axis. The dots are connects to make a current and a previous yield curve.
When analyzing the yield curve in Figure 13-1, keep in mind that short-term yields are controlled by the Federal Reserve. Long-term yields of Treasuries are controlled by the market. Figure 13-1 illustrates that there is very little difference between the current and previous yield curves. Look at the bar chart below the yield curve in Figure 13-1. This chart indicates that the yield on 6-month Treasury bills has decreased and the yield on 3-year Treasury notes slightly increased. See the curve descriptions in the following list to find out what yield curves can indicate: