"A MUCH NEEDED BOND BOOK. In The Only Guide to a Winning Bond Strategy You'll Ever Need, the authors cover the very complex issue of bonds in great detail. This book is a must-read for anyone who's thinking of investing in bonds and really wants to understand what they're all about. Readers will also gain insight into how the bond market works. I feel every bond investor could benefit from reading this book; I know I did. This book definitely should be a part of every bond investor's library." --Mel Lindauer, Forum Leader, Morningstar's Vanguard Diehards Forum and co-author, The Bogleheads' Guide to Investing

Bondspeak
 
Good fortune is what happens when opportunity meets with planning.    —Thomas Edison
 
While we search for the answers to the complex problem of how to live a longer life, there are simple solutions that can have a dramatic impact. For example, it would be hard to find better advice on living longer than do not smoke, drink alcohol in moderation, eat a balanced diet, get at least a half an hour of aerobic exercise three to four times a week, and buckle up before driving. The idea that complex problems can have simple solutions is not limited to the question of living a longer life. As Charles Ellis points out in Winning the Loser’s Game: “Investment advice doesn’t have to be complicated to be good.” And this is certainly true, as you will learn, about the world of fixed-income investing.
 
The world of fixed-income investing was once a very simple one. It was also very conservative. When investors thought of fixed-income investing they thought of Treasury bonds, FDIC-insured savings accounts and certificates of deposits, and perhaps the bonds of blue chip corporations such as General Electric. Today, the world is a much more complex one. The research and marketing departments of investment firms regularly create new and highly complex debt instruments. Investors are now deluged with marketing campaigns from bond salesmen urging them to buy instruments such as MBS (mortgage-backed securities), IOs (interest-only bonds), POs (principal-only bonds), and inverse floaters (this one is too complex to describe in a short space).
 
The complexity of these debt instruments creates huge profit opportunities for Wall Street’s sales forces. These complex securities are often sold to investors who generally don’t understand the nature of the risks involved. And you can be sure that it is the rare salesman who fully explains the nature of the risks (most couldn’t if they had to, as they are trained to sell, not to explain the risks of what they are selling). Thus investors end up taking risks that are not appropriate for their situation. They also incur large transaction costs that are often hidden in the form of markups and markdowns—a subject we will discuss in detail.
 
Unfortunately, there are investment firms that prey on retail investors who lack the knowledge to understand the risks involved and how these securities are valued by the market. One reason is that the prices for many fixed-income instruments, unlike those of stocks, cannot be found in the local newspaper, or even on the Internet. The lack of visibility in pricing allows for investor exploitation. Brian Reynolds, former institutional fixed-income portfolio manager at David J. Bradson & Company, commenting on this exploitation, stated: “When I went to buy bonds for myself, I was stunned at the difference between buying them as an institutional investor and as a retail investor.”1 Friend, and fellow investment author, William Bernstein put it this way: “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.”2
 
As was stated in the introduction, the first objective of this book is to provide you with the knowledge you need in order to make prudent investment decisions regarding fixed-income investments. It is unlikely that Wall Street will ever provide you with this knowledge. In fact, the Wall Street Establishment does its best to follow W. C. Fields advice to “never smarten up a chump.” Prudent investors never invest in any security unless they fully understand the nature of all of the risks. If you have ever bought (or been sold) a mortgage-backed security (e.g., a Ginnie Mae) the odds are pretty high that you bought a security the risks of which you did not fully understand. And those risks include paying too high a price.
 
As you will learn, it is not necessary to purchase complex instruments in order to have a good investment experience. Fortunately, the solutions to complex problems are often quite simple. In fact, the great likelihood is that you will do far better by simply hanging up the phone whenever someone tries to sell you one of these complex securities. The greatest likelihood is that they are products meant to be sold and not bought. A good question to consider asking the salesman is: “If these bonds are such good investments, why are you selling them to me instead of to your big institutional clients?” The answer should be obvious—either the institutions won’t buy them, or the firm can make far greater profits from an exploitable public.
 
A Language of Its Own
 
Imagine you are an executive for a multinational corporation. You have been offered the position of general manager at your company’s Paris office. Unfortunately, you don’t speak French. Certainly one of the first things you would do would be to take an immersion course in the French language and culture. Doing so would enable you to more quickly gain an appreciation of your new environment, as well as prevent you from making some embarrassing, and potentially costly, mistakes.
 
Unfortunately, far too many investors take a trip to the land of bonds without knowing the language. Without such basic knowledge it is impossible to make informed decisions. In order to meet our objective of providing you with the knowledge needed to make prudent investment decisions we need to begin by exploring the language known as “bondspeak.”
 
The world of fixed-income investing has its own language. This brief section defines the terms you need to understand in order to make prudent investment decisions. You will learn the difference between the primary (initial issue) and secondary (after initial offering) markets, and the wholesale (interdealer) and retail (individual investor) markets. You will also learn how bonds are bought from and sold to individual investors and the games broker-dealers play at your expense. After completing this relatively brief section you will have the knowledge required to understand the critical terminology of the world of bondspeak. We begin with some basic definitions.
 
A bond is a negotiable instrument (distinguishing it from a loan) evidencing a legal agreement to compensate the lender through periodic interest payments and the repayment of principal in full on a stipulated date. Bonds can either be secured or unsecured. An unsecured bond is one that is backed solely by a good-faith promise of the issuer. A secured bond is backed by a form of collateral. The collateral can be in the form of assets or revenue tied to a specific asset (e.g., tolls from a bridge or turnpike).
 
The document that spells out all of the terms of the agreement between the issuer and the holders is called the indenture. It identifies the issuer and their obligations, conditions of default, and actions that holders may take in the event of a default. It also identifies such features as calls and sinking fund requirements. All of the important terms contained in the indenture are spelled out in the prospectus—the written statement that discloses the terms of a security’s offering.
 
The maturity of a bond is the date upon which the repayment of principal is due. This differs specifically from “term-to-maturity” (or simply term) that reflects the number of years left until the maturity date. While most bond offerings have a single maturity, this is not the case for what is called a serial bond issue. Serial bonds are a series of individual bonds, with different maturities, from the same issuer. Investors do not have to purchase the entire series—they can purchase any of the individual securities. Typically, municipal bonds are serial bonds.
 
Although there are no specific rules regarding definitions, the general convention is to consider instruments that have a maturity of one year or less to be short-term. Instruments with a maturity of more than one and not more than ten years are considered to be intermediate-term bonds. And those whose maturity is greater than ten years are considered long-term bonds.
 
Treasuries are obligations that carry the full faith and credit of the U.S. government. The convention is that Treasury instruments with a maturity of up to six months are called Treasury bills. (The Treasury eliminated the one-year bill in 2001.) Treasury bills are issued at a discount to par (explanation to follow). The interest is paid in the form of the price rising toward par until maturity. Treasury instruments with a maturity of at least two years, but not greater than ten, are called notes. If the maturity is beyond ten years they are called bonds. Treasuries differ specifically from debt instruments of the government-sponsored enterprises (GSEs). The GSEs are the Federal Home Loan Banks (FLHBs), the Federal Farm Credit Banks, the Tennessee Valley Authority (TVA), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and a few others. While each was created by Congress to reduce borrowing costs for a specific sector of the economy, their obligations do not carry the full faith and credit of the U.S. government. In fact, Fannie Mae and Freddie Mac are publicly held corporations. In contrast, the securities of the Government National Mortgage Association (GNMA), because it is a government agency, do carry the full faith and credit of the U.S. government.
 
Par, Premium, and Discount
 
These terms refer to the price at which a bond is trading relative to its initial offering. Most bonds have a face value (the amount paid to the investor at maturity) of $1,000. They are also traded in blocks of a minimum of $1,000. Par, or 100 percent, is considered $1,000. A bond trading at 95 is trading below face value, and would be valued at $950 for each $1,000 of face value. A bond trading ...