So I'm learning about buying bonds

In My Humble Opinion (IMHO)
#1

Now that interest rates and bond yields are creeping up, I’m incentivized to do something with spare cash, rather than leaving it sitting on its fat ass earning nothing (or next to nothing in a savings account).

I like CD’s, but holding them for less than a year doesn’t earn much. In addition, if I were to suddenly need that money, I’d get penalized if I cashed out early.

So I’ve been trying buying Treasury bonds through my Schwab account. It’s actually pretty easy, and there are no fees appended to the transaction. I can buy three, six, or nine month bonds if I want to. I tried buying a three month bond and got my 2.2% yield when it matured.

What’s this I see on Schwab’s bond transaction page about selling bonds? Something about asking for bids. What’s involved with this? It’d be good to know if I have an emergency and have to get my hands on cash.

Who’s an expert in this field. Keep in mind I’m a newbie and I’m still struggling to learn the new vocabulary.

#2

If you break a CD before maturity, you are dealing with the bank, and are limited to whatever penalties they have in the contract in order to get your money.

If you want the money out of most bonds before maturity, the bank, company, or US Government say tough luck, wait till maturity. So the only way to get your money out is to the sell the bond itself as a whole on the secondary market (IE to another buyer). For some bonds that secondary market is highly illiquid and you have to take a big haircut on the value of the bond to get it sold quickly. For US treasuries should be liquid, but how much you get on the secondary market will depend on what interest rates on Treasuries have done since you bought the bond.

#3

Treasuries are called “Bills” for maturities less than 1 year, “Notes” for 1-10yr, “Bonds” only for longer maturities.

Bills are zero coupon. You buy them at a discount from par, and all of the interest is implicit in that discount, so all your interest comes at maturity when they redeem at par.

“No fees” is fairly meaningless, since all the profit for the dealer will be built into the price itself. You will get a better price for a larger amount. They are extremely liquid. Fidelity are very good for bonds of all kinds if you have a reasonably large account, I don’t know about Schwab. Fidelity show real time pricing online, and you can just pick your maturity and do the whole thing online.

For example, for a T-Bill around 7 months maturity, Fidelity’s current quote:
US T-Bill Zero Coupon 3/28/19
Bid Price 98.749 (yield 2.275) Offer Price 98.768 (yield 2.239) minimum size 75 (=$75,000)
For a smaller size the bid price is a little lower, the offer price a little higher.

So if you bought 100 Bills, you would pay the offer price = $98,768
At maturity, you would receive $100,000
If you wanted to sell it immediately, you would receive the bid = $98,749

The spread between the bid and offer represents the dealer profit margin, i.e. the “penalty” you can expect to pay (if interest rates don’t move) if you were to cash out immediately. You can see that it’s very competitive, just $19 for $100,000 principal. Of course, the interest rate market is dynamic, so both bid and offer may move higher or lower if interest rates move, so these prices/yields are not guaranteed in the future.

If you want to judge how competitive Schwab’s pricing is, you look for for two-way prices, i.e. current bid and offer, for the sizes that you are contemplating.

#4

ETA: terminology
coupon = periodic interest payment (zero coupon for Bills)
1 bill/note/bond is $1000 principal
prices are quoted in percent
par = a price of 100, and what you get back if you keep it until maturity
dealer offer/ask = the price you will pay to buy something now
dealer bid = the price you will receive if you sell something now
But remember that the market moves, you are never guaranteed to receive the current bid price if you sell in the future
spread = difference between dealer’s bid and offer

#5

Thanks for the clarification post, Riemann. I did look up your terms on Investopedia, and re-read your post. It becomes clearer with each re-read.

I’m not investing grand amounts of money here, but getting a few dollars for every thousand I put into bonds is better than nothing. Even if I must sell a bond before its time, the loss (if any) would be minimal.

Now I’m looking at the corporate bond part of Schwab’s bond listings. I know about bond ratings and how riskier bonds (like corporate) are graded according to their level of risk. Some of those riskier, higher-yield-paying ones still look like they are for solid corporations. For instance, Prudential’s paying 7.35% for a six-month bond, and are rated Baa1 by Moody’s (for comparison, Microsoft’s bonds are AAA). Why is Prudential’s risky? Prudential seems like a big fat solid company to me.

#6

This page shows the current market Treasury interest rates for various maturities. The third column, “yield”.
https://www.bloomberg.com/markets/rates-bonds/government-bonds/us

#7

If the OP is working with smaller quantities of money, Schwab does offer bond ETFs. IIRC SCHZ is one of them.

#8

Your impression of a company probably has to do with things like brand and longevity. A bond appraiser’s rating is based on things like amount of outstanding debt, cashflow, current and expected business, etc.

A company can be large and well-established and also on shaky financial footing. You can’t really tell without some more analysis.

Think about a company that has gone bankrupt recently. Did you know it was about to fail?

Since you are just learning, and are fairly conservative investing-wise, I suggest not buying the bonds of an individual company. If you want to invest in corporate bonds, maybe find a fund that invests in many companies. Much lower risk of catastrophic losses.

#9

You are probably looking at coupon, you need to look at yield.

#10

In addition, there may be some bonds that can fail to pay out in circumstances less than the company’s bankruptcy, and these have understandably higher yields and risks since they can go under even if the company is still standing, but I do not know how common they are nor how obvious the wording is when you go to purchase them.

#11

I already have capital in a couple of bond funds and bond ETF’s, which as far as I can see, can lose share value just as easily as any stock or mutual fund. I was looking for something where the capital was much more secure (almost as much as cash), yet I could make a few dollars on it as compared to a savings account.

I’ll be cautious of corporate bonds, especially ones with lower ratings. I’m just trying to figure out all the ins and outs.

#12

Currently, I don’t believe treasuries are a great investment. In a rising interest rate environment they are almost certain to lose resale value, forcing you to hold to maturity or to sell at a loss.

Example:

A bond at interest rate of 2.18%(as of this second by my tools) sells for, say, par. Fine. You pay $1000 for it.

Over the next little while interest rates go up to 2.3% (fictional example). Suddenly, your bond at 2.18% is significantly devalued. Why would anyone purchase it if they can get a higher interest rate elsewhere? Therefore to sell, you need to sell the bond at less than $1000 to bring it’s equivalent yield value to be competitive with current bonds.

For compliance purposes I can’t really give advice in clear on a message board. If you want specifics, feel free to send me a PM. I’ll be glad to help.

#13

I happen to agree with you at the moment (for longer maturities), but teela should bear in mind that this is a market prediction no different from saying something like “stocks are expensive”, and both of us might just be wrong. Interest rates have been rising over the past couple of years, but there is no certainty that they will continue to do so, especially if there is a downturn in the economy.

I’d always prefer to approach this from an asset allocation & risk profile perspective focused on the what you need the money for. Whatever your market view, longer term bonds or bond ETFs should really only be part of a long term investment portfolio, because (as you’ve discovered) prices can move significantly as market interest rates change. You don’t want to put money that you might need in 6 months into a risky 30 year bond fund, any more that you want to put it into stocks.

But there’s little interest rate risk for maturities shorter than 1 year, and savings account rates have lagged rising T-Bill rates. And there’s nothing more liquid that T-Bills if you want to cash in early. So I think it’s worth switching money from savings accounts to T-Bills if you’re talking about large enough amounts, say $10k or more. Less than that, and the razor thin margins mean that it’s just not worth it for dealers to book the trades without charging you more, and there’s probably little benefit over a high yielding savings account or money market fund.

As has been mentioned, ultra-short fixed income ETFs that hold rolling portfolios of treasuries or high quality corporates are also a possibility. You need to work out the effective cost factoring in the ETF management fees and broker commissions, the economics relative to a savings account will depend upon your size and frequency of trading.

#14

I think I get what you’re saying, JC. But I’m not buying 30 year bonds, I just want to do three months here, six months there. I plan on holding hem until maturity, and not selling except in dire need.

If I keep sitting on cash waiting for interest rates to go up, it’ll never get invested. I sat on it for years while pundits kept saying that interest rates were about to rise, but nothing really happened until the last year or so. So for the moment I’m looking to ladder out chunks of cash here and there, at varying short maturity dates, so that a few dollars at least will be coming in. If interest rates actually rise to an interesting amount, I’m going to be all over that.

Oh, and I didn’t mention, this is just part of my portfolio. I’m already allocated according to a moderate/conservative template. It’s just that the cash portion, sitting there doing nothing, bugs me and I want it to generate a little yield at least.

#15

The OP seems like a good candidate for a money market fund. They invest in short term securities. It’s a like a savings account that pays higher interest and is not insured by the FDIC.

Schwab has them. But the key goal is to get one with a low expense ratio. I recommend going over to Vanguard.

Vanguard Treasury Money Market Fund currently pays 1.96%. Its yield will rise for the rest of this year, assuming the Fed raises rates in September and December. You pay federal taxes on it, but not state taxes, so the after tax yield is a little higher. Treasuries are very safe. https://investor.vanguard.com/mutual-funds/profile/VUSXX

Vanguard Prime Money Market currently pays 2.09%. Ditto about rising rates. You pay state and federal income taxes on all of it. https://investor.vanguard.com/mutual-funds/profile/VMMXX

Admiral shares have lower expense ratios, but have higher initial balance requirements.

ETA: Personally I’d wait until January before considering going long.

#16

You can also buy Treasuries directly from the US government at auction, via Treasury Direct. They charge $45 I think if you want to sell the securities before they mature. No fees when you buy them at auction. Small investors typically make noncompetitive bids, which means that the price you get will be what the market offers. https://www.treasurydirect.gov/tdhome.htm

Buying a 3 or 6 month tbill won’t get you in too much trouble if rates change. But you won’t have the convenience of the money market fund. Vanguard charges an expense ratio of 9/100 of a percentage point for their treasury money market fund. Schwab US Treasury Money Market fund currently charges 35/100 of a percentage point, substantially higher.

#17

Yup, and to clarify what MfM said on lack of FDIC insurance: if you pick a fund like that Vanguard VUSXX that’s invested 100% in T-Bills, obviously FDIC insurance is superfluous, since it’s the U.S. government promising to pay you back your principal. Whereas if it’s a money market fund that buys commercial paper, it could have some exposure to the next Lehman, although the risk is small.

#18

If this is just the cash portion of your portfolio, and you’re already invested in bond funds with the fixed income portion of your portfolio, I wouldn’t worry about it too much. It’s supposed to be liquid so that if the market drops significantly, you can rebalance your portfolio and pick up some stuff cheap. Leaving it sitting in Schwab’s generic cash sweep will earn you something and is absolutely safe, which is the most important property of your cash allocation. If you want something more, I would put it into one of the money market funds mentioned, preferably one that invests in government securities.

If you want to be a bit fancier, you could also go into a 3-month CD ladder where you have 1/3 of your cash portfolio maturing within a month, or 1/6 within half a month, so as to have free cash on semi-short notice should markets drop, and you won’t be investing the entire cash portfolio unless markets really crash, so just a portion maturing each time you rebalance should be fine. By going with 3-month securities you get a slightly better rate than 1 month ones, and for your cash allocation of your portfolio you shouldn’t be going beyond 3 months even if you don’t plan on ever selling early. The downside is that you have to manage it yourself through Schwab. The CDs they offer change continuously, and once one matures, you need to actively find another to put it in. It’s not hard, since there are always tons available, but it requires paying attention and rebuying the CDs every time they mature. It’s not like buying CDs directly from the bank - Schwab is just reselling you CDs that they bought in bulk from banks, and will rebuy it at whatever price the market bears if you really need to sell, but you’ll pay the bid/ask spread. It also allows you (if your portfolio is massive) to be able to pick different banks in case you’re already maxed out of your FDIC protection somewhere.

Putting it in a government-backed money market fund instead will pay professionals to do all that legwork for you and be just as safe, with slightly lower return but slightly more flexibility of buying and selling which may easily make it worth it.

#19

I found this hard to believe, but I looked it up and yeah, you’re paying quite a premium for the liquidity and soundness for earning less than 2% on your money. Schwab has very good expense ratios for their equity index funds; I’m guessing they can’t match Fiedlity in this area because it’s not as much of a buy-and-hold as equity index funds are.

They’re quoting 1.6% right now on that fund. 1-month CDs they are quoting around 1.8% and 3-month just above 2%, in line with a .35% expense ratio for something investing in guaranteed short-term instruments.

So again, you’re paying for liquidity and someone else to do the work for you. Checking on things every 2 weeks to rebuy CDs will net you around .4% more.

#20

But at that point all you’re doing is slowing the rate at which you’re losing money.

Get me on this, kids: No Money Market fund will ever make you money. They’re not designed to do so.

As MfM pointed out, above, the Vanguard Fund - I’m not familiar with that one in particular but I’ll trust his numbers - is paying 1.96%. Fine.

On the other hand, the current rate of inflation from August 17 to Julu 18 is 2.9%. So you’re losing 1% on your money holding it in that fund. It one of the things people tend to be blind to. Last year’s dollars are inherently more valuable than this year’s dollars.

So yes, you’re ahead of where’d you’d be had you left it in cash. Great. But you’re still behind where you were. And Vanguard is up a small fractional amount. I’m sure they’re grateful.

If you’re goal is to at least break even while not being locked down you need to find a bond fund or ETF paying at least 4%. After expense ratio and taxes - if applicable - you should break even there.