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The Secret Life of Bonds

You can increase your bond investing profits by learning a little about bonds. You can make enough money over the next few years to make reading this short article worth the time and effort.


The profit you receive on a bond is called a “yield.”


There are four interrelated elements that create almost every bond. Each of these elements are highly interactive with a bond’s yield. Small changes in any of these four elements will significantly impact your bond’s return.


The Four Elements of a Bond:

1. Principle: Your investment or how much you paid for the bond

2. Interest: The percentage you are paid in interest on the bond’s total price or par (price listed on bond)

3. Term: The length of time before the bond matures

4. Fees: Fees you are charged to purchase the bond and/or any fees you pay to have the bond held in your investment accounts


How These Four Elements Impact the Bond’s Yield:


Par/Bond Price:

The price of the bond you buy is inversely related to the bond’s yield when it is more than face value or par of the bond. If it is below par, this increases a bond’s yield, but opportunity costs are likely involved if there are better investment options. Opportunity costs imply there was a more profitable option for the use of your money.


As a quick review, when the interest rate rises on newly issued bonds, the old bonds you have with a lower interest rate become worth a little less in the resale market and can only be resold at a discount. If interest rates drop, however, your bonds suddenly become worth more on the resale market. If you hold the bond until it matures, you will earn the guaranteed interest rate when you purchased the bond.


Interest Rate/Coupon:

The higher the interest rate, the greater a bond’s yield. The coupon rate is set by the prevailing interest rate offered on other bonds and is also directly impacted by the Federal Reserve’s “prime rate.” The interest rate is also impacted by the issuer’s creditworthiness. Poor creditworthiness means an issuer must offer a higher rate to entice buyers to purchase their bonds.


Term:

The longer the term, the higher a bond’s yield. The term can be any length, but the majority of bonds range from one to 30 years. The longer the term, the higher the interest rate must be (coupon rate) to offset interest rate risk. Interest rate risk is the danger that interest rates will rise and your bond will become less valuable based on opportunity costs.


Fees:

Like everything else on Wall Street, brokers manage to attach fees to the purchase of bonds. If you think you are not paying fees, you are likely wrong—unless you are purchasing them directly from the U.S. Treasury and personally hold them at home or in a safe deposit box. If you buy them through your tax-favored (retirement) accounts, you are paying fees!

Investments are either bought and sold in exchanges, such as the New York Stock Exchange, or bought and sold in over-the-counter (OTC) sales. Bonds are exclusively traded OTC. The primary reason being the lower volume of bonds being sold compared to other investments. Bonds are also resold much less frequently than stocks. Consequently, advisors are given bonds to resell to their customers. This allows them to attach fees.


Bond fees are inversely related to yield. The higher your fee, the lower your yield.


Fees Matter.

For example, if you bought a $1,000 bond with 3% interest for 10 years:

3% Yield to Maturity (YTM)

If you add $15 fee to the above bond, your yield is reduced to 2.83% YTM.

(I used omnicalculator.com to determine YTM.)


The Fees You Likely Pay

Mark-up Fee: Charged by a broker, and the fees range from $1 a bond purchase all the way up to $16. Some brokers charge a percentage of your total purchase.


Custody Fee: The amount a brokerage firm charges you hold bonds in your investing or retirement accounts. The fees can range anywhere from $15 per account all the way up to a percentage of your account’s total.


Figuring out your fees for a bond purchase can be difficult, as the fees are rarely published or even mentioned. Federal regulations only require a brokerage firm to publish how much they charged you after the bond transaction is completed (lobbying Congress really pays off).


So the strategy is to ask your broker or brokerage firm how much they charge for bonds and how much they charge to hold them in your retirement account(s). If they are evasive or don’t know, that is a danger sign. Do more research about your brokerage firm’s fees on bond purchases.


Conclusion

You need to keep your bond fees as low as possible. Lisa and I have done some research. We learned that Fidelity charges a low $1 fee for every bond purchased or sold. According to Fidelity’s website, this only reduces the yield to 2.99% when used in the example we calculated above. This is the best fee rate we could find. We are not recommending Fidelity, this is just the result of our research.


Keep investing and make sure you continue purchase bonds. Remember, though, fees matter!


Larry



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