<FOOLISH FOUR PORTFOLIO>

Exploring Bonds
Exciting stuff. Really!

by Ann Coleman
([email protected])

Alexandria, VA (November 18, 1998) -- Bonds? Sounds like a fun topic, but first a word from our sponsor, Forrest Gump. Mr. Gump, what have you to say?

"Stupid is as stupid does." How true. And how apt. Yesterday, in a brain spasm the likes of which has not been seen since I tried to bring the sunroof inside the car while we were doing about 50 mph, I, wearing my editor hat, inserted a comment into TMF Sandy's column to the effect that capital gains were not possible with bonds. Well, they are. I knew that. (I knew those latches were the only things holding the sunroof on, too.)

If you buy a bond at face value and hold it to maturity, there are no capital gains involved because you receive the face value (the original price) of the bond back at maturity. But bond prices fluctuate according to how their interest rates compare with the prevailing interest rates. After they are issued, a bond may sell for more or less than its face value. If you buy it for less than its face value and hold it until maturity, or if interest rates go down while you are holding it, you can get more for it than you paid. That's a capital gain.

Bonds are very interesting creatures. We Fools are not too crazy about investing in them because the capital gains are so totally linked to interest rates, and predicting interest rates is beyond our poor Foolish capacities. Still, knowing how they work is good, especially since right now some people are making a lot of money trading them.

Many complicated factors go into bond pricing, but a simplified example may illustrate how you can get a capital gain with a bond. Assume that you have two bonds issued by the same entity, each with a face value of $1000. The first bond was sold 10 years ago as a 30 year bond while the second is being sold today as 20 year bond, so they both have 20 years to maturity. Interest rates were much higher years ago, and the older bond is paying a whopping 10%. The new bond is paying only 5%. (Most companies would have made that old bond callable and paid it off long ago, but ignore that so that the math is easier on us all.)

Now you have a choice -- you can buy the new bond or the old bond. Wow, you say, I'll take the one paying 10%! Good move, except this is a free market, so everybody else is saying that, too. In fact, bond traders are all bidding for that bond and offering to pay more than its face value. The market acts to drive the price of the higher-interest bond up to the point where its return is equal to the current interest rate. Hang on -- I will explain that.

You know you can get a 5% return on the new bonds, so if you invest $10,000 in 10 new bonds, you will receive interest of $500 per year. Since there is no difference between the old bonds and the new bonds except the interest rate, a rational investor should be willing to pay twice as much for the old bonds.

[Twice as much? Are you kidding? Only a little bit. In 20 years the new bonds will be redeemed by the issuer for $1000 each, and so will the old ones (which I said you should pay twice as much for). Obviously, that is a factor in the pricing, but if that day is a long way off, the effect is small. Let's ignore it.]

If Mr. Rational Investor pays twice as much for the higher interest rate bond, the annual return on his money will be the same. If he invests $10,000 in 5 old bonds ($2,000 each) he will receive $100 in interest from each bond for a total return of $500 per year -- exactly what he would receive from 10 of the new bonds. Since bond traders are extremely rational, about bond pricing anyway, that's how bond pricing works -- the part related to interest rates, at least, and interest rates are the biggest factor when the maturity date is not coming up real soon.

Even though it makes no difference to the bond buyer which bond he buys, for sellers of the old bonds, this is good news -- and a 100% capital gain. Capital gains are what have people excited about bonds right now. Since interest rates have been falling, prices for older bonds have been going up and up.

Of course, if interest rates turn around, the price of bonds purchased now will drop. Suppose you bought that 20 year bond and next year, interest rates went up to 6%. $10,000 worth of new bonds would pay $600 per year. To get $600 per year from the old bonds, you would have to own 12 bonds, so for the bonds to be equivalent, the old bonds would have to sell for $833.33. ($10,000/12 = $833.33). That's a capital loss.

The easy way to remember it is: When interest rates go down, bond prices go up. When interest rates go up, bond prices go down.

On Friday, truly exciting topics: Diamonds and SPYs!

The sunroof?

Uh, well... I don't think they make the detachable kind any more.

Fool on and prosper!

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11/18/98 Close

Stock Change Last -------------------- UK - 5/16 44.19 IP + 7/16 45.75 MO + 7/16 54.69 EK + 13/16 76.06

Day Month Year FOOL-4 +0.56% 4.48% 15.87% DJIA +0.62% 5.23% 14.33% S&P 500 +0.45% 4.17% 17.94% NASDAQ +1.01% 7.12% 20.83% Rec'd # Security In At Now Change 12/31/97 206 Eastman Ko 60.56 76.06 25.59% 12/31/97 276 Philip Mor 45.25 54.69 20.86% 12/31/97 289 Int'l Pape 43.13 45.75 6.09% 12/31/97 291 Union Carb 42.94 44.19 2.91% Rec'd # Security In At Value Change 12/31/97 206 Eastman Ko 12475.88 15668.88 $3193.00 12/31/97 276 Philip Mor 12489.00 15093.75 $2604.75 12/31/97 289 Int'l Pape 12463.13 13221.75 $758.63 12/31/97 291 Union Carb 12494.81 12858.56 $363.75 Dividends Paid YTD $1092.81 TOTAL $57935.75 </FOOLISH FOUR PORTFOLIO>