Bond Basics: Buying Cheap Bonds

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Buying cheap bonds is one of the great joys of investing. But most people miss out on this growth and income play because they cling to the myth that bonds do not fluctuate in price.

They do! Bonds drop in value if the underlying fundamentals of the company that issues them take a hit.

Municipals drop in value if the city’s, county’s or state’s tax base or revenue base that pays the interest and principal weakens.

And all bonds will drop in value when interest rates go up, some more than others.

Buying bonds below par (less than $1,000 per bond) gives the buyer a higher interest rate than the coupon (current yield, yield/price) and capital gains (the difference between the market price and $1,000 at maturity) – often before maturity.

Nothing feels better than paying pennies on the dollar for a bond and getting double-digit yields. You got a bargain, and you’re often beating the stock market by a significant margin.

Picking Which Cheap Bonds to Buy

Buying bonds on the cheap is an art, but it’s not brain surgery.

The first step is to ignore all the fundamentals and technicals for a moment, and ask yourself this: Is this company in a death spiral, or is this just a temporary setback from which it can recover?

It’s usually best to consider only companies that you know or industries that you understand. Taking wild guesses and buying the cheapest bonds with the highest yields is almost always a mistake.

During the oil crunch a few years ago when the Saudis were manipulating the oil market, survivability was easy to answer. The market was being artificially forced down, and it was obvious the well-managed companies would be fine.

Excellent oil companies’ bonds were available at $0.15 and $0.25 on the dollar and paid 30% and 40% returns to maturity. All of the ones that I followed made it!

That’s what cheap bonds can do for you.

Looking at Key Metrics

But we aren’t always handed a market like that one. Those are rare. So it usually comes down to management and fundamentals.

Fundamentals are the easy part. Does the company have the cash flow to cover its bills? Is it growing its earnings despite the down period? It’s all the usual things we consider with both stocks and bonds, but with a special focus on cash and cash flow.

If a company can cover the bills during a dip, it likely will survive.

But management issues are where experience in the market pays off.

Consider its history:

  • Has it been a well-managed company over time, or is it composed of a bunch of yahoos who spend like crazy?
  • Do you know anything about the people running the company? This includes their reputation, experience and past performance.
  • How is management addressing whatever has caused the company’s bonds (and probably its stock) to drop in price?
  • Is management proactive in addressing the problem, or is it just borrowing more to stay afloat?

Any information that gives you confidence that a company’s management team can lead the company back to profitability is key to your decision to buy or not to buy.

And bonds don’t have to drop a huge amount to make them worth a stab. Bonds in the 70s and 80s ($700 and $800 per bond) with a 6% coupon (6/70 or 6/80) return 8.5% and 7.5% just in income.

And a bond priced at $700, at maturity, returns a capital gain of 42% (30/700).

You’ll get total returns of as much as 50% with the lower risk and security of a bond. These aren’t the 7% savings bonds most of us bought back in our school days.

If you don’t own any bonds – which most people unfortunately do not – you are ignoring all the rules of diversification and putting your nest egg at unnecessary market risk. Plus, you’re missing some of the best returns we have seen in a decade.

Get to know bonds.

Good investing,

Steve