How do investors select corporate bonds?

Question

I'm familiar with quite a few bond terms like yield to maturity, current yield, duration, and convexity but I don't really understand how these apply to corporate bond selection. If I'm looking at bonds on a site like Yahoo (http://screen.yahoo.com/bonds.html), what's the best way to compare them? Also, how many bonds do individual investors usually select for their portfolio?

Answer 1

As I am sure you probably know, duration means how long it takes, in years, for the cash flows to repay the price of the bond.  Not the maturity of the bond.  You can use it to compare bonds with different rates, maturities and yields.  The shorter the duration the better usually because it carries less risk and price volatilty.  The duration determines how a bonds value is affected by changes in interest rates.  The yield to maturity is the return you're going to get if you hold the bond to maturity.  Thats probably intuitive.  Thats what you compare your required return to as well as the yield to call.  The current yield is the coupon rate.  The rate of interest you're going to receive on the bond annually.  As price goes up yield goes down and vice versa.  But this is not a linear relationship as changes become larger.  It becomes a convex curve.  The lower the convexity the less the yield changes for a change in price.

So you decide the required yields and the duration and convexity are risk measures.

How much bonds you want in a portfolio depends on the percentage you want compared to the other classes of investments you have, like stocks and cash.

One strategy is to build a laddered portfolio.  Like with maturities of 1, 2, 3, 5, 7, 9 and 10 years.  When the 1 year matures you buy a 10 year to replace it.  Which gives you some protection against fluctuating interest rates.  If rates go down you're getting above market rates on the rest of your portfolio.  If they go up you'll have an opportunity take advantage of it as you replace the bonds.

Answer 2

Bonds are not very simple for individuals to buy.  The problem is that most bonds are not traded on an exchange but are sold through dealers.  Most if not all major brokers have an inventory of bonds that they will sell from.  What that means is that being assured of getting a competative price is somewhat difficult, not impossible but difficult.  Bonds do not have ticker symbols either.  They are quoted by their custip, an 8 digit alph numeric code.  The price of an individual bond might vary by more than $50 in one day depending on supply and demand.   Recent reported trades today on the Dow Chemical 4.1% due 6/15/2013 varied from 91.60 to 96.00.

How are they selected?  The main parameters in selecting a bond are its yield to maturity, yield to call,  duration,  call features,  price and bond rating.   Investment grade bonds are rated bbb or better by S&P or baa or better by Moodys.  Junk bonds fall below those ratings.  Duration is the next selection criteria.  Bonds can have up to durations of 30 years. Maybe more.  I am not sure on that point. You can select just about any duration you would like, 1 year, 3 year, 5 year, 10 year, 20 year, 30 year and all durations in between.  Next in importance is the yield of the bond to maturity and yield to call.  Many if not most have what are called call features.  That means they might be called before maturity by the issuer.  That is a common practice if interest rates fall.

Last but not least is the offering price.  If the bond is offered above par,  then you will loose money on the bond when it reaches maturity or perhaps when it is called.  Also of importance might be the dates on which interest is paid.  That can be important to someone who is looking for a uniform cash flow throughout the year.  Bonds generally pay interest only twice annually but the dates on which they pay the interest payment varies.

Municiple bonds all have a minimum purchase of $5000 par value.  Corporate bonds have a minimum purchase of $1000.

I suppose the number an individual selects depends on what that individual's portfolio requirements are.  Retired people who are dependent on a cash flow from their investments might have a portfolio of 100,  200, 500, or more bonds.  

There are mutual funds that specialize in bond portfolios.  For someone who does not have access to a large selection of bond offerings and does not know a great deal about buying bonds, these mutual funds can be a good way to participate in the bond market without much of the hastle involved.