The bond book, third edition everything investors need to know about treasuries, municipals, GNMAs, corporates, zeros, bond funds, money market funds, and more

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THE

BOND
BOOK


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THE

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BOND
BOOK
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Everything Investors Need to Know
about Treasuries, Municipals, GNMAs,
Corporates, Zeros, Bond Funds,
Money Market Funds, and More

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Third Edition

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Annette Thau

New York Chicago San Francisco Lisbon London
Madrid Mexico City Milan New Delhi San Juan
Seoul Singapore Sydney Toronto


Copyright © 2011, 2001, 1992 by Annette Thau. All rights reserved. Except as permitted under the
United States Copyright Act of 1976, no part of this publication may be reproduced or distributed
in any form or by any means, or stored in a database or retrieval system, without the prior written
permission of the publisher.
ISBN: 978-0-07-171309-2
MHID: 0-07-171309-3
The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-166470-7,
MHID: 0-07-166470-X.

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All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after
every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit
of the trademark owner, with no intention of infringement of the trademark. Where such designations
appear in this book, they have been printed with initial caps.

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McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales
promotions, or for use in corporate training programs. To contact a representative please e-mail us at


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This publication is designed to provide accurate and authoritative information in regard to the subject
matter covered. It is sold with the understanding that neither the author nor the publisher is engaged
in rendering legal, accounting, securities trading, or other professional service. If legal advice or other
expert assistance is required, the services of a competent professional person should be sought.
—From a Declaration of Principles Jointly Adopted by a Committee of the
American Bar Association and a Committee of Publishers
TERMS OF USE

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CONTENTS

Preface xiii

THE BASIC BASICS 1

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PART ONE

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Acknowledgments xvii

Chapter 1

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The Life of a Bond 3

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First, What Is a Bond? 3
How Bonds Are Issued and Traded 3
Key Terms for Bonds 4

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Chapter 2

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The Bond Market: An Overview 7

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The Bond Market: An Overview 7
Bond Pricing: Markups and Commissions 8
How Bonds Are Sold: Dealers, Brokers, and Electronic Platforms 11
Terms Used in Buying, Selling, and Discussing Bonds 17

Chapter 3

Volatility: Why Bond Prices Go Up and Down 25
Interest Rate Risk, or a Tale of Principal Risk 25
Credit Ratings: How Credit Quality Affects the Value of
Your Bonds 31
A Short History of Interest Rates 43
The Federal Reserve and Interest Rates 48
Summary 50
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Contents

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Chapter 4
How Much Will I Earn, or Basic Bond Math 51
Bond Cash Flows 51
The Many Meanings of Yield 55

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Total Return 62
Duration and Bond Price Volatility 65
Summary 71

Chapter 5

What You Need to Know before Buying Bonds 73

PART TWO

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The Bond Market in the Financial Press and on the Internet 73
The Treasury Market 74
“Yield Spreads” and Benchmarks 81
Investinginbonds.com, FINRA.org/marketdata and
EMMA.msrb.org 85
Summary 94

INDIVIDUAL SECURITIES 97

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Chapter 6

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Treasuries, Savings Bonds, and Federal Agency Paper 99

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What Is Unique about Treasuries? 100
Treasury Bills, Notes, and Bonds 102
Inflation-Indexed Securities 105
Buying Treasuries: TreasuryDirect 110
Zero Coupon Bonds 112
U.S. Savings Bonds 117
Federal Agencies 124
Summary 126

Chapter 7
Municipal Bonds 129
What Is Unique about Municipal Bonds? 129
Should I Buy Munis? (or, Taxable-Equivalent Yield) 130


Contents

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Credit Quality: General Obligation versus
Revenue Bonds 133
The Rise and Fall of Bond Insurance 136
“Recalibrations” of Municipal Bond Ratings 139

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Municipal Bond Pricing 147
Shopping for Municipal Bonds Using the Internet 149
Selecting Municipal Bonds 165
Summary 169
Additional References 170
Appendix: The New York City Default 170

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Chapter 8

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Corporate Bonds 173

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What Is Unique about Corporate Bonds? 173
Risk Factors of Corporate Bonds 175
Corporate Bonds with Special Features 178
Junk Bonds 181
Shopping for Corporate Bonds Using the Internet 186
Summary 202

Chapter 9

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Mortgage-Backed Securities 205

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Why GNMAs Are Unique 206
How Prepayments Affect GNMA Cash Flows 211
The Vocabulary of GNMA Returns 213
CMOs and Other Sons of GNMA 224
Agency Backing of Mortgage-Backed Securities:
Ginnie, Fannie, and Freddie 229
Collateralized Debt Obligations (CDOs) and
Collateralized Debt Swaps (CDSs) 232
The Financial Crisis: 2007–2008 235
Current State of the Mortgage-Backed and
Asset-Backed Securities Market 236
Summary 239
Additional References 241

Contents

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Chapter 10
International Bonds 243
The International Bond Market: An Overview 244
Currency Risk 248

INVESTING THROUGH FUNDS 263

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PART THREE

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Emerging Markets Debt: Brady Bonds 250
Buying Individual International Bonds 254
Is There a Case for Investing in International Bonds? 260
Obtaining Information on International Bonds 261
Summary 262

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Bond Mutual Funds: An Overview 265

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Differences between Bond Funds and Individual Bonds 265
How Much Will I Earn? 267
The Costs of Investing in Bond Funds 273
Why the NAV of Your Fund Will Go Up and Down 277
Selecting, Buying, and Monitoring Bond Funds 285
Sources of Information Concerning Bond Funds 288
Taxes and Bond Funds 297
Summary 299

Chapter l2

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Money Market Funds and Tax-Exempt Bond Funds 301
Money Market Funds 301
Bond Funds Whose Price Goes Up and Down: “Plain Vanilla” and
More Speculative Funds 310
Municipal Bond Funds 314
Summary 324

Chapter 13
Taxable Bond Funds 327
Domestic “Plain Vanilla” Taxable Bond Funds 328
Treasury Inflation Protected Securities Funds 336
GNMA (and Other Mortgage) Funds 339


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More Speculative Funds 341
Miscellaneous Funds 354
Summary 358

Chapter 14

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Closed-End Bond Funds, Exchange-Traded Funds (ETFs), and
Unit Investment Trusts 361

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Closed-End Bond Funds 361

Summary: Closed-End Funds 372
Sources of Information on CEFs 373
Exchange-Traded Funds 374
Advantages and Disadvantages of Bond ETFs 385
Summary: Exchange-Traded Funds 390
Unit Investment Trusts 392
Summary: Unit Investment Trusts 394

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MANAGEMENT OF BOND PORTFOLIOS AND
ASSET ALLOCATION 395

PART FOUR

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Chapter 15

Management of Bond Portfolios 397

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When Will I Need the Money? 398
Portfolio Structures 399
Finding Attractive Buy Points 401

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Swaps 405
Managing a Bond Portfolio for Total Return 407

Chapter 16
Portfolio Allocation 411
Portfolio Allocation 411
Asset Allocation 413
The Case for Bonds Revisited 414
The Current Environment and the Bond Market 415
Conclusion 419
Index 421


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P R E FAC E

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his is the third edition of a book that was initially published in
December of 1991. After working for a number of years as a credit analyst,
I had started personally investing in bonds. At the time, I looked for a book
that would explain in clear English some of the basic concepts used by professionals to manage bond portfolios; and that would contain detailed
information about the various types of bond investments available to individual investors. None of the books I found fit that description. Most
books that dealt seriously with bonds were not comprehensible to anyone

who was not a finance professional. Years later, I decided to write the kind
of book I would have liked to have read. Evidently, it would fill a need.
Little did I imagine when the first edition was published that I would be
revising this book again, for the third time, almost 20 years later.
Over the past 20 years, both the bond market and the stock market
have had dramatic ups and downs. Investor psychology toward the bond
market has also had its ups and downs. For example, the second edition
of this book was written around the year 2000. In retrospect, that was
almost the last year of the great bull market in stocks that had started in
1982. At that time, pundits were proclaiming that we were in a “new era.”
“Experts” were recommending that individuals invest 100% of their portfolios in equities (or perhaps keep a small percentage, say 10%, in cash),
and nothing at all in bonds. The decade between 2000 and 2010 proved
the “experts” wrong. Between 2000 and 2010, the stock market suffered
two devastating bear markets: in 2002 and in 2008. Even though many
sectors of the bond market suffered significant declines during the financial panic of 2008, for that decade, investments in many sectors of the
bond market had positive returns and enabled investors to ride out a lost
decade in the stock market.
Investor psychology seems to have changed once more: for the past
year, more money has been flowing into bond funds than into stock
funds. But if these flows reflect the search for a safe harbor, then some
investors may be in for an unpleasant surprise. Investors need to be aware
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Preface

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that all sectors of the bond market are not equally safe and predictable.
Many bonds and bond funds are as volatile and unpredictable as stock
funds, posting equity like returns one year, and dismal losses the next.
Indeed, some steep losses have occurred in bond funds that had been initially marketed as very low risk investments.
This book, like prior editions, is intended to be a complete introduction to the bond market and to the different types of investments in bonds:
individual bonds, as well as different types of bond funds.
There is virtually no section of this book that has not been heavily or
totally rewritten. My emphasis has been on changes that have occurred
since the 2000 edition. One of the more important changes is that investors
can now access a great deal of information, such as pricing data, that in the
past was available only through brokers. That information is available on
the Internet, and it is free. In addition, all chapters on individual securities
include new information. The chapters on bond funds have been totally
rewritten. They include a detailed analysis of the performance of all types

of bond funds, during and since the financial panic of 2008, as well as
ten-year returns through December 2009. There is also a new section on
bond exchange-traded funds (ETFs) as well as an expanded section on
closed-end bond funds.
This book is divided into four parts. The first part is introductory,
and it is basic to understanding everything that follows. It explains the
fundamentals of bond investing, including the basic vocabulary of bond
investments; how bonds are brought to market and sold; bond pricing
and markups; how to research the price history of bonds; why the price of
bonds (and bond funds) goes up and down; key concepts used to measure bond returns; and much more. That part of the book should be read
first, in entirety.
The second part of the book discusses individual securities:
Treasuries, munici¬pal bonds, corporate bonds, GNMAs and other mortgage-backed securities, and international bonds. One chapter is devoted
to each security. The third part of the book analyzes the major types of
bond funds: open end mutual funds; as well as closed-end bond funds
and the newest kids on the block, ETFs. The fourth part of the book deals
in a more general way with the management of bond portfolios. Parts 2,
3, and 4 may be read in any order desired.
While much of the material in the book is new, my initial orientation
remains the same. This book assumes little or no knowledge of any bond
investment, but it explains the critical information required to buy any
security, be it a Treasury bond, a municipal bond, or a bond fund.


Preface

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Several basic themes run through the book. First, I explain in detail
the risks that underlie the purchase of any security. The main reason for
this is that it is patently silly to lose money because you are buying a security thought to be riskless only because the risk factors are unknown.
After you read this book, this will no longer happen. Equally important,
while it is not possible to forecast where interest rates are going, if you
understand the risks of specific bond investments, then you can control
the amount of risk you take. If you want to be sure that you are investing
in the safest corners of the bond market, then this book will clearly
explain what those are. If you want to speculate in the riskier corners of
the bond market, this book will point what those are.
Second, this book will define areas of opportunity. Just as you can
lose money because you don’t realize that an investment is risky, you can
also earn less because you are restricting yourself unnecessarily. There
may be areas of opportunity that you just don’t know are out there.

Third, at minimum, any investor needs to understand enough
technical information to be able to discriminate between sound analysis
and hot air. You will learn a lot of technical terms and concepts so that,
in the future, no one can intimidate you. If you sound like an informed
investor, the next time you talk to a bond salesman, he will be much
more likely to be honest with you and less likely to try to sell you a bill
of goods.
Fourth, another theme is how to obtain information. Many chapters
contain sample tables and graphs along with explanations on how to
interpret them. The most useful information is now found on the Internet.
References for additional research are listed at the end of many chapters.
If you wish to pursue any topic in greater depth, you will know where to
look.
I kept in mind that investors differ both in the amount of time they
have to devote to investing and the amount of personal interest. Throughout
the book, I have pointed out techniques that minimize risk for safetyminded investors who have limited time to devote to investing.
Above all, this book is intended to be practical and to answer fundamental questions such as: Should I invest in individual bonds or in bond
funds? How do open-end funds differ from closed-end funds, or from
ETFs? Should I invest in taxable or in tax-exempt bonds? If I am right
about a particular investment in bonds, how much can I earn? And if
things go wrong, how much can I lose? For all types of bond investments,
it will address what is perhaps the most fundamental question in the bond
market: What risks am I taking in order to earn a higher yield? Ultimately,


Preface

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this book should enable you to select fixed-income investments that match
your tolerance for risk and your overall investment goals and strategies.
Some vocabulary notes are in order. First, a word about the term
“bond”: the term designates any debt instrument or fixed-income security
available on the market. No single term exists to cover this type of instrument. For the sake of variety, the terms bond, fixed-income security, or
debt instrument are used interchangeably throughout the book. Second, it
was necessary to decide how to deal with gender to refer to men and
women as investors, or as salespeople. I considered using “he/she” but
rejected it as too clumsy. Instead, I decided to use either “he” or “she” in
random fashion. This should introduce some variety in the text.
Finally, I have no ax to grind. This is not a book for bonds or
against bonds. Bond investments are more complex and less predictable
than is generally realized. This book will explain how and why. You

may, after reading it, decide to allocate more of your portfolio, or less, to
bonds. My objective in writing this book is to enable you to navigate the
bond market—whatever its future shape turns out to be—in a more
informed manner.
So, many happy returns!


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ACKNOWLEDGMENTS

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have been fortunate when writing each edition of this book to be able
to benefit from the many insights, suggestions, and knowledge of many
people within the industry who were kind enough to take time out from
busy working lives in order to help me put this book together. Once again,
I would like to acknowledge and thank those individuals whose help
made this book possible.
I would like to thank, first of all, those individuals who read portions of the manuscript and who made valuable suggestions for changes.
They include Maria Crawford Scott, former editor of the AAII Journal;
Cecilia Gondor, Executive V.P., Thomas Herzfeld Advisors; Matt Tucker,
Managing Director in BlackRock’s Fixed Income Portfolio Management
Group; and Chris Shayne, CFA, Manager of Marketing Communications,
BondDesk Group, LLC.
I would also like to acknowledge and thank the many individuals
who not only provided data but who spent time answering innumerable
questions and discussing fine points of certain securities. They include
Cecilia Gondor, Executive V.P., Thomas Herzfeld Advisors; Chris Shayne,
CFA, Manager of Marketing Communications, BondDesk Group, LLC;
Dominic Maister, Executive Director at Morgan Stanley; Christine Pollak,
Vice President, Morgan Stanley; Professor Edward Altman, Professor, New
York University Salomon Center; Christine Hudacko, Director, BlackRock
Corporate Communications; Kathryn Edmundson, Team Leader,
Investinginbonds.com; and Justin Pica, Director, Uniform Practices Group,
at EMMA.msrb.org.
I would like to single out for particular thanks Jeff Ttornejoh,
Research Manager for the United States and Canada of the Lipper organization (now Thomson Reuters) not only for generously supplying data
on bond funds but also for being particularly unstinting with his time
both for this book and for prior writing projects.
Finally, there are a number of individuals whose help I cannot
acknowledge due to policies of the firms that employ them. They know
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Acknowledgments

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who they are, and that their help was greatly appreciated; and they also
know that I regret I cannot thank them by name.
To one and all who made this book possible: Thank you! The opinions expressed in this book are my own. Any omissions or errors are, of
course, entirely my own responsibility.

PA R T

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his part of the book is introductory and basic to understanding all that
follows. Its purpose is to explain the fundamentals of bond investing. The
idea behind these introductory chapters is to familiarize you, the reader,
with concepts that will enable you to understand potential returns of different types of investments in the bond market, as well as the risks you
are taking with those investments.
Chapter 1 defines bonds and explains how they are originated
and sold.

◆

Chapter 2 is an overview of the bond market. It also introduces
key terms used in discussing bonds and the bond market.

◆

Chapter 3 is at the heart of the book. It explains why bond
prices go up and down through a detailed discussion of the two
major risks in the bond market: namely, interest rate risk and
credit risk. It also includes a brief history of interest rates as well
as a brief discussion of the role of the Federal Reserve in
determining interest rates.

◆

Chapter 4 is an introduction to basic bond mathematics. It
defines the key concepts used to measure return (that is, what
you will actually earn) from investments in bonds, as well as
bond cash flows. The chapter also introduces duration, which
can help you evaluate the riskiness of investments in bonds.

◆

Chapter 5 discusses topics and data commonly used in the
press and on the Internet to analyze what is happening in the
bond market. It also introduces three Web sites which have
been developed by several regulatory and trade agencies:
FINRA.org/marketdata, Investinginbonds.com, and

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PART 1 The Basic Basics

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EMMA.msrb.org. These Web sites make information available to
investors that in the past was available only to brokers,
including, for example, trade data about bonds within
15 minutes of a trade. Finally, Chapter 5 introduces some
guidelines to shopping for individual bonds.


CHAPTER

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The Life of a Bond

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This chapter
Defines a bond

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Explains how bonds are issued and traded

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Defines some key terms used in buying and selling bonds

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FIRST, WHAT IS A BOND?

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Basically, a bond is a loan or an IOU. When you buy a bond, you lend your
money to a large borrower such as a corporation or a governmental body.
These borrowers routinely raise needed capital by selling (or, using Wall
Street vocabulary, by “issuing”) bonds for periods as brief as a few days to
as long as 30 or 40 years. The distinguishing characteristic of a bond is that
the borrower (the issuer) enters into a legal agreement to compensate the
lender (you, the bondholder) through periodic interest payments in the
form of coupons; and to repay the original sum (the principal) in full on a
stipulated date, which is known as the bond’s “maturity date.”

HOW BONDS ARE ISSUED AND TRADED

The process of issuing bonds is complex. Because the sums involved are
so large, issuers do not sell bonds directly to the public. Instead, bonds are
brought to market by an investment bank (the underwriter). The investment bank acts as an intermediary between the issuer and the investing
public. Lawyers are hired by both parties (that is, the issuer and the
underwriter) to draw up the formal terms of the sale and to see to it that
the sale conforms to the regulations of the Securities and Exchange
Commission (the SEC).
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To illustrate the process, let us say that the State of New Jersey needs
to borrow $500 million in order to finance a major project. New Jersey
announces its intention through trade journals and asks for bids.

Underwriters (major broker-dealer firms such as Merrill Lynch, Goldman
Sachs, Morgan Stanley, etc.) or smaller, less well-known firms (there are
dozens of them) compete with each other by submitting bids to New
Jersey. A firm may bid for the business by itself in its own name. More
often, firms form a group called a syndicate, which submits a joint bid.
The State awards the sale to the firm or syndicate which submits the bid
which results in the lowest interest cost to the state. The underwriters
then get busy selling the bonds.
The underwriter (or the syndicate) handles all aspects of the bond
sale, in effect buying the bonds from the issuer (New Jersey) and selling
them to the investing public. The investing public is made up of large
institutions such as banks, pension funds, and insurance companies as
well as individual investors and bond funds. The large institutional
investors are by far the biggest players in the bond market.
Once the bonds have been sold, the underwriter retains no connection
to the bonds. Payment of interest and redemption (repayment) of principal
are—and will remain—the responsibility of the issuer (New Jersey). After
the sale, the actual physical payment of interest, record-keeping chores, and
so forth are handled for the issuer by still another party, a fiduciary agent,
which is generally a bank that acts as the trustee for the bonds.

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KEY TERMS FOR BONDS

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The exact terms of the loan agreement between the issuer (the State of
New Jersey) and anyone who buys the bonds (you or an institution) are

described fully in a legal document known as the indenture, which is
legally binding on the issuer for the entire period that the bond remains
outstanding.
First, the indenture stipulates the dates when coupons are paid, as
well as the date for repayment of the principal in full; that is, the bond’s
maturity date.
The indenture then discusses a great many other matters of importance to the bondholder. It describes how the issuer intends to cover debt
payments; that is, where the money to pay debt service will come from. In
our example concerning the State of New Jersey, the indenture would
specify that the State intends to raise the monies through taxes; and in
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CHAPTER 1 The Life of a Bond

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discussion of the State’s economy. The indenture also describes a set of
conditions that would enable either the issuer or the bondholder to
redeem bonds at full value before their stipulated maturity date. These
topics are discussed in greater detail in the sections dealing with “call”
features and credit quality.
All of the major terms of the indenture, including the payment dates
for coupons, the bond’s maturity date, call provisions, sources of revenue
backing the bonds, and so on, are summarized in a document called a
prospectus. It is a good idea to read the prospectus. Until recently, a
prospectus was available only for new issues. Bond dealers were allowed
to destroy a prospectus six months after a bond was issued. The prospectus of all new municipal bonds, as well as many older issues, is now
archived and available online (see Chapter 5).
When the prospectus is printed before the sale, it is known as a
“preliminary prospectus,” or a “red herring”—that term derives from the
printing of certain legal terms on the cover of the prospectus in red ink.
After the sale, it is sometimes called an official statement, or OS.
The most elementary distinction between bonds is based on who
issued the bonds. Bonds issued directly by the U.S. government are
classified as Treasury bonds; those issued by corporations are known as
corporate bonds; and those issued by local and state governmental units,
which are generally exempt from federal taxes, are called municipals or
“munis” for short. The actual process of selling the bonds differs somewhat from sale to sale but generally conforms to the same process.
Many bonds are issued in very large amounts, typically between
$100 million and $500 million for corporates and munis; and many
billions for Treasuries. To sell the bonds to the public, the investment bank

divides them into smaller batches. By custom, the smallest bond unit is
one bond, which can be redeemed at maturity for $1,000. The terms par
and principal value both refer to the $1,000 value of the bond at maturity.
In practice, however, bonds are traded in larger batches, usually in minimum amounts of $5,000 (par value).
Anyone interested in the New Jersey bonds may buy them during
the few days when the underwriter initially sells the bonds to the investing public (this is known as buying “at issue”) or subsequently from an
investor who has decided to sell. Bonds purchased at the time of issue are
said to have been purchased in the “primary market.” Bonds may be held
to maturity, or resold anytime between the original issue date and the
maturity date. Typically, a bondholder who wishes to sell his bonds will
use the services of a broker, who pockets a fee for this service.


PART 1 The Basic Basics

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There is a market in older issues, called the “secondary market.”
Some bonds (for example, 30-year Treasuries) enjoy a very active market.
For many bonds, however, the market becomes moribund and inactive
once the bonds have “gone away” (that is an expression used by traders)
to investors. It is almost always possible to sell an older bond; but if the
bond is not actively traded, then commission costs for selling may be very
high. Pricing, buying, and selling bonds, as well as bond returns, are discussed in greater detail in Chapters 2 and 4.
During the time that they trade in the secondary market, bond prices
go up and down continually. Bonds seldom, if ever, trade at par. In fact,
bonds are likely to be priced at par only twice during their life: first, when
they are brought to market (at issue), and second, when they are redeemed,
at maturity. But, and this is an important but, regardless of the purchase
price for the bonds, they are always redeemed at par.
But, you may well ask, if the issue price of a bond is almost always
$1,000, and the maturity value is always $1,000, why and how do bond
prices change? That is where the story gets interesting, so read on.