Bonds or CDs?

[OldAgePensioner]

I'd like to understand the attraction of bonds a little bit better.

As I understand them:
1. You buy, say, a $1000 bond but it may be discounted? Why is this?
2. Bonds value is face value at maturity or market value if sold before then.
3. Market value fluctuates according to interest rates.
4. Read on Morningstar that 1% uptick on interest rate devalues a 5 yr bond by 5%,approx.
5. A conservative bond would yield about 4%-5% currently?

My big question is why buy a 5% yielding, non-protected bond when you could by a FDIC protected 5 year CD that pays the same 5%.

Seems the only way for the bond to increase in value is the unlikely event that interest rates go down.

Anyone help with my novice understanding of bonds?

 

[cute fuzzy bunny]

You've asked a good question, and now you know another reason why I've sold almost all of my bonds.

Bonds have a face value and an interest payment. A 'yield' is calculated as a function of the interest and value. For example, a $100 bond that pays a 5% interest/dividend yearly has a 5% yield.

Bonds also have a maturity, which is usually expressed in months or years. When that maturity is reached, you can have the issuer pay you back the face value.

Fluctuation happens when the credit worthiness of the bond issuer changes, or new issues pay higher or lower dividend rates.

Lets say you own a 20 year TIPS (government treasury bond) that you bought several years ago, and it pays a 4% dividend. Pretty good considering the CPI is added to that, having a safe 7.5% total payout. Current TIPS pay 2%. Lets say you want to sell that TIPS bond and have cash instead of the bond. You might expect that people would pay you more than the face value of that bond in order to secure the higher interest payment. And they will.

Similarly, if you own general motors bonds and saw their recent credit rating drop, you would find that some people might be only willing to pay you less than the face value to take them off your hands. They're riskier, and newer GM bonds will have to pay higher interest rates before people will buy them.

Held to maturity, bonds pay their interest rate, period, end of story. Bought and sold on the secondary market, or in bond funds, you can sell appreciated bonds while keeping depreciated bonds through their maturity date. Most amateurs get killed trying their luck on the secondary market...its really for experts.

Faced with a 3.5% muni bond that may suffer value fluctuation (especially if held in a fund), a 3% short term bond, and a 4% intermediate term bond, or 5% in cash that wont fluctuate, in a period of rising interest rates (which hurts bonds, the 'longer' the bond, the worst it hurts)...its not that hard of a decision...

 

[OldAgePensioner]

Nothh,
Thanks for the great explanation. Trying to read the bond basics out on the internet had my head spinning. Your explanation stopped the spin.

So, when bond fund lists "yeild" are they talking about above inflation (CPI)??

 

[retire@40]

My big question is why buy a 5% yielding, non-protected bond when you could by a FDIC protected 5 year CD that pays the same 5%.

Seems the only way for the bond to increase in value is the unlikely event that interest rates go down.

Potential capital appreciation on the corporate (non-protected) bond would be the only reason.  With rates heading up, it may not be a wise move to buy corporate bonds these days.  I would stick with 5% CDs, or even better, 4% 1 year CDs if you want to stay conservative.

I would rather take a risk in equities since I think they will outperform CDs in the next 5 years.

 

[cute fuzzy bunny]

Yield is a function of the bonds value as of today, and the interest rate the bond lists.

So if a $100 bond that pays 5% becomes worth $200 (a reach, but it makes the math easy), the effective yield is 2.5%, as 5% is 2.5% of 200. Both are five dollars. Both still pay 5%, but if you have to pay $200 to get the $5, you're really only getting 2.5% return on your money as a payout.

Yield is a good tool for comparing two bonds without having to do math. If you own a bond fund, and the value of the bonds in your fund goes up, your NAV and what you could sell a fund share for goes up, your yield goes down, but the payments would stay the same.

Yield basically tells you what you're going to get for your money if you buy a bond or bond fund. Similarly with stocks, the yield tells you what you get as a function of dividend payout per share and share price...share price goes up, yield goes down...dividend payout increases, yield goes up.

 

[cute fuzzy bunny]

I would stick with 5% CDs, or even better, 4% 1 year CDs if you want to stay conservative.

Maybe,

I'm still trying to figure out why banks will pay more or the same for a 2 or 3 year cd as a 5 year. They'd be paying more on the longer term ones if they felt there was any way interest rates would continue to rise, just to stay competitive. That long term cd rates increases stopped cold about six months ago tells me that NOBODY feels comfortable with offering a non-teaser non-special deal rate higher than 5% on long term cd's.

I'm waiting a few days to see if my credit union bumps the rates on 5 year cd's from 4.61%. Either way, i'll be buying them on monday. I have a funny feeling a 4.5-5% 5 year cd will become a topic of conversation around here 2-3 years from now with people saying "I shoulda got them while I could..." as cd's go back to paying 2-3% and money markets drop back below 1%...

If that doesnt happen and rates continue up, I lose 6 months interest to bail out and buy new ones. If I do that in year 3, thats 4.61% this year, 4.61% next year, and 2.3% the third year. Still pretty good $.

 

[OldAgePensioner]

Notth,
Thanks.  so are you saying if I buy a bond at $100 and 5% yield ( $5 )and the value goes to $200 that the bond issuers still gives me $5.

In other words, the issuers payout doesn't change?  But the yield percentage does?

 

[retire@40]

Maybe,

I'm still trying to figure out why banks will pay more or the same for a 2 or 3 year cd as a 5 year.

Because long-term rates (10 year bond) haven't moved in step with short-term rates.  I don't get it either.  It makes no sense.

I understand long-term rates are tied in more with inflationary expectations, but I can't figure out why the market doesn't expect inflation to rise above current levels.  Unless there's that one piece of financial information that just hasn't come out yet that will smack people on the head and will cause a quick jolt in long-term rates.

 

[OldAgePensioner]

retire@40,
My thoughts exactly.  I'm considering laddering CDs )1,2,3,4,5 yr and then rolling to 5 year  )and trying to live off the interest and already taxed dollars and let my "growth" be in stocks and non-dividend funds for the next 5 years.

I don't want to clutter the place by starting another thread, so OFF TOPIC.
I get all my dividends (9 diff. funds)  posted each month in my account on the 24th.  Is that some standard date.

If so could a person buy high dividend yieldsing closed end funds on say the 20th and then sell them on the 25th.  After paying the in/out transaction fee you would come out ahead if you sold before the market corrected for the dividend payout.

Are there other fees that would be invoked, like short term penalty or such?

 

[retire@40]

I have a funny feeling a 4.5-5% 5 year cd will become a topic of conversation around here 2-3 years from now with people saying "I shoulda got them while I could..." as cd's go back to paying 2-3% and money markets drop back below 1%...

I think if CD rates go down again, A LOT of people are going to make a decision to get into equities and you will see double-digit returns in the market until CD rates get into the 6% and higher range.  There are just so many years somebody can put up with below-inflation returns.  And when the stock market train starts rolling (like the real estate train), it will blow up like a bubble again.

 

[OldAgePensioner]

retire@40,
In IBD last week, there was an article preding a new bull market. There supporting evidence was that G-span has slowly raised rated just like 94-95 year and that the market has already reacted. This fellow predicted that rates will rise 2 more times by .25% and then hold for a long time.

I really like the market from 1994-2000, it helped me retire early. Hope he's right.

 

[OldAgePensioner]

Here is todays best CD yields for $10,000 minimum.

1 yr Corus Bank, Chicago Il 4.11 / 4.16 APY

2 yr Washington Savings Bank, Bowie,MD 4.32 / 4.35 APY

3 yr Washington Savings Bank, Bowie,MD 4.47 / 4.50 APY

4 yr Intervest Bank, NY 4.65 / 4.65 APY

5 yr Intervest Bank, NY 4.80 / 4.80 APY

Question, should you purchase only the FDIC minimum at each bank?

 

[haha]

 And when the stock market train starts rolling (like the real estate train), it will blow up like a bubble again.

If so, it will be the first time ever, in any country, that a bubble has deflated and not gone back to trend. I believe  "bubble" was defined as the market reaching 2 SDs above trend.

See Jeremey Grantham for support.

Ha

 

[omni550]

Here are the current CD rates at Pentagon Federal Credit Union.

MONEY MARKET CERTIFICATE RATES

Term Dividend
Rate APY

6-Month 2.63% 2.65 %

1-Year 3.20 % 3.25 %

2-Year 3.54 % 3.60 %

3-Year 4.88 % 5.00 %

4-Year 4.88 % 5.00 %

5-Year 4.88 % 5.00 %

7-Year 4.88 % 5.00 %

$1,000 minimum deposit

Effective June 01, 2005 - June 29, 2005

APY = Annual Percentage Rate

They will be 'reset' tomorrow. Pen Fed always seems to have among the highest yields. Anyone can join this CU -- if you don't have the military connection, check the PenFed website, there's some group you can join for 1 year (and $20) that qualifies you to join PenFed.

omni

 

[ats5g]

Hi OAP,

Here's a beginner's bond tutorial from Investopedia. Vanguard has a good supplemental tutorial, Understanding bonds and interest rates, like this chart about the effect on a bond fund's return with rising or falling interest rates:

- Alec

 

[OldAgePensioner]

Alec,
Thanks a lot for that post. That is exactly why I asked this question, there are so many points of view and analyses.

So, if I understand the graph correctly, long term bonds (greater than 5 year) benefit from interest rate increases?

 

[haha]

So, if I understand the graph correctly, long term bonds (greater than 5 year) benefit from interest rate increases?

As Bill Clinton would say, it depends on the definition of "benefit".

As the graph shows, if the bond has an initial duration of 5 years, and if you re-invest all coupon payments, the price of the original bonds will immediately take a dive when interest rates increase.  In the case of increased interest rates which stay above the level at which you bought the bond, that original bond will not get back to the level where you bought it until maturity.

However, eventually, the benefit of being able to re-invest at higher coupon rates will let your total postion (original bonds plus higher coupon bonds you have bought with the coupons) cross into positive territory, compared to the situation when interst rates remain unchanged.

Ha

 

[Mr._johngalt]

I think if CD rates go down again, A LOT of people are going to make a decision to get into equities

Not me. Not in this lifetime.

JG

 

[OldAgePensioner]

Ha and Ha,
Thanks for that clarification, it shows very well how charts are info with need for further info.

So, are bonds worth buying and why?  Seems to me they can't match a CD for safety and return.

Notth pointed out his move to CDs and I feel like minded.  What advice says otherwise?

 

[ats5g]

Alec,
Thanks a lot for that post. That is exactly why I asked this question, there are so many points of view and analyses.

So, if I understand the graph correctly, long term bonds (greater than 5 year) benefit from interest rate increases?

Not exactly. The point of duration is that if you hold a bond or bond fund to its duration [and reinvest the coupons of course] it doesn't matter what happens to interest rates. Duration is an estimated measure of a bonds interest rate sensitivity. The longer the duration of a bond or bond fund, the more sensitive it is to changes in interest rates. Short term bonds have shorter/smaller durations than longer term bonds, and thus, shorter term bonds are less sensitive to changes in interest rates than longer term bonds.

As HaHa said, when interest rates rise, the value of the bonds goes down, however after the duration point, the investor is better off because he/she gets to reinvest all those coupon payments at higher interest rates.

- Alec

 

[Mr._johngalt]

Ha and Ha,
Thanks for that clarification, it shows very well how charts are info with need for further info.

So, are bonds worth buying and why?  Seems to me they can't match a CD for safety and return.

Notth pointed out his move to CDs and I feel like minded.  What advice says otherwise?

I too am "like minded". Guess it's one of those rare times when th and I
agree on something

JG

 

[Mr._johngalt]

My big question is why buy a 5% yielding, non-protected bond when you could by a FDIC protected 5 year CD that pays the same 5%.

Why indeed? And the same reasoning also applies to other similar
yielding investments.

JG

 

[ats5g]

CD's are certainly an alternative for bonds. Non-marketable CD's, like some you can buy directly from your local credit union, cannot fluctuate in value b/c you cannot resell them. There are some brokered CD's that can certainly be resold, and thus fluctuate in value.

The good news is that some CD's cannot lose value, when interest rates rise. The bad news is that some CD's cannot gain value, when interest rates fall.

While a rise in interest rates will cause bonds to decline in value, the long term bond investor is actually better off if interest rates rise b/c he/she can reinvest all those coupon payments at higher interest rates, and thus get a higher return.

CD's usually cost nothing to buy from your local CU. Bonds have expenses [sometimes high expenses if individual muni or corporate bonds]. Some bonds are free, like buying Treasury bonds directly from the Treasury. Those people in a high tax bracket usually favor muni bonds, and muni bond funds, b/c the after tax return on those bonds is higher than fully taxable bonds and CD's.

Bond funds also usually pay dividends monthly [Vanguard's do], while most CD's don't. Though this isn't really a problem is one is laddering CD's, and has a cash reserve.

Also, for long term liabilities, shorter term bonds/CD's are not risk free because an investor must roll over the coupon payments at future unknown interest rates of future shorter term bonds/CD's. For nominal long term liabilities, nominal long term bonds are less risky than short term bonds/CD's. Thus, insurance companies with long term nominal liabilities use mostly long term bonds. Interest rate fluctuations affect both assets and liabilites.

For those of us with real long term liabilities, TIPS are the risk free assets, not short term bonds/CD's. For money needed in five years, a 5yr CD would probably be more risk free than a 1 yr CD.

If you're comparing a 5 yr CD with a 5 yr corp bond or a 5 yr treas, a lot of the time a 5 yr CD with be more attractive b/c it is easy, fairly cheap, simple, and currently the differences [e.g. spreads] between the yields on CD and corporate bonds, treasuries, is large enough to favor CD's over other fixed income.

Now I'm not saying that bonds are better than CD's. They are just different. CD's are simple, easy, and a good alternative.

- Alec

 

[OldAgePensioner]

Alec,
I appreciate that insight. I'm new here and asking questions to learn. Your advice is truly appreciated. Good food for thought.

Moving from accumulate to withdrawal is tough. Good to have found this board.

Galt,
I'm a recent retiree and you, charlie, um2, notth, nords, and several others have me thinking get safe, get frugal, get simple. So, my questions here are about doing just that.

If I could just get Ben and Lancelot to set me up in BKK, I could quit worrying.

 

[haha]

So, are bonds worth buying and why?  Seems to me they can't match a CD for safety and return.

I think when Cds offer comparable yields, they dominate bonds. Especially for an unsophisticated holder.

BTW, why do you need Ben and Lance to go to Thailand? Don't you have a Thai GF? Haven't you lived all over the world?