Investing Classroom: How To Buy Bonds

Ready to start investing in the bond market? First, you will need to know how to go about trading bonds.

You can purchase government bonds (gilts) on the secondary market or directly from Her Majesty's Treasury. When you purchase bonds directly from the Treasury, you must buy new issues, but there are no broker commissions.

You can also buy new-issue corporate bonds through bond dealers. Corporate bonds are IOUs issued by private and public corporations both in and outside the UK. They are issued by public utilities, as well as private sector firms such as transportation companies, financial services companies, and industrial corporations.

When bonds are first issued, their prices, or face values, are fixed. Once issued, these prices can fluctuate in the secondary market due to changing interest rates. When bonds are first issued, bond dealers assist the issuer (a company or governmental body) in selling the bonds to the public, and for this they are paid a commission from the proceeds of the sale.

Older bonds are sold through brokers on the secondary market. The secondary market consists of the over-the-counter (OTC) market, and stock exchanges such as the London Stock Exchange (LSE). Most bonds are sold over the counter. The OTC market consists of hundreds of financial institutions and brokerages that buy and sell over the phone or via computer networks. Brokerage firms that deal in bonds have latitude to set prices for bonds they sell. However, all prices are negotiable. Bonds sold on the OTC market are usually sold in sizeable amounts.

Financial publications such as The Financial Times publish prices of bonds traded on the exchanges each day. However, very few bonds are actually traded on a daily basis. A broker's advice can be invaluable in helping you select and purchase the bonds that meet your investment objectives.

Bond pricing terminology
There are many things to consider when judging a bond's market value. Understanding the various factors that impact bond prices can help you track how your bonds change in value, and when the time is right to buy or sell.

The face value of a bond is known as its par. A bond's par is its price when it is issued, which is the same price that will be repaid when the bond matures.

A bond's coupon rate is the annual percentage rate that will be paid to the owner of the bond, based on the bond's original face value. A bond with a coupon rate of 5% pays 5% of the bond's face value each year. Bond interest is usually paid twice a year.

Here are a few more pricing tips:

1. You can sell your bond on the secondary market before it reaches maturity. The price you get for the bond before it matures is known as its market price.

2. When the price of a bond goes above its face value, it is said to be a premium bond.

3. When the price is below its face value, it is known as a discount bond.

When you buy a bond on the secondary market, you are probably going to pay a price above or below the par of the bond. This will affect your yield-to-maturity, a calculation based on the bond's original purchase price, redemption value, time to maturity, coupon rate, and the time between interest payments. For example, if you buy a bond and then sell it after interest rates have risen, you will get a lower price for the bond than you originally paid for it. The second buyer will get a higher yield than you because he or she paid less for the bond, but the buyer will still get its full par value when it matures.

Bonds that are traded on the secondary market can have prices that are quite different from the prices at which they were originally issued. Traders look at a number of factors when assessing the market prices of bonds.

Bond trading transaction costs
No matter where you decide to buy or sell your bonds, you should be prepared to pay a transaction cost. The costs you will pay depend on the market on which you buy your bonds.

The difference between the price a broker-dealer pays for a bond and the price at which it is sold to you is known as the bond's markup. The markup is a transaction cost. With new issues, the broker-dealer's markup is included in the par value, so you do not pay separate transaction costs.

Everyone who buys a new issue pays the same price, known as the offering price. If you are interested in a new issue, you can get an offering statement describing the bond's features and risks.

Instead of charging you a commission to perform the transaction for you, the broker-dealer marks up the price of the bond to above its face value. When you buy or sell bonds through a broker-dealer on the secondary market, the bonds will have price markups. Instead of charging you a commission to perform the transaction for you, the broker-dealer marks up the price of the bond to above its face value. Markups are usually from about 1%-5% of the bond's original value. Bond dealers generally charge higher markups on smaller bond sales than larger ones. If you are buying a gilt bond over the counter, you may have to pay a small, additional flat fee.

If you sell a bond before it matures, you may receive more or less than the par value of the bond. Either way, your broker-dealer will mark down the price of your bond, paying you slightly less than its current value. He or she will then mark up the price slightly upon resale to another investor. This is how broker-dealers are compensated for maintaining this active secondary market.

Bonds bought on the exchanges generally have much higher markups than bonds bought over the counter. It is difficult to know how much of a markup you are paying, because the markup is built into the price of the bond.

Buying bonds indirectly
Having trouble choosing the right bonds for your portfolio--or coming up with the funds to buy them all? The answer may be one of the indirect ways for investors to profit from the bond market.

The benefit of a unit investment trust is that you know exactly how much you'll earn from the trust when the bonds mature. You earn interest during the life of the trust on the amount you initially invest as well as on the trust's income. The bonds in the trust remain fixed until your initial investment is completely returned to you when the bonds mature. A trustee supervises the bonds in the trust, but the trustee cannot sell or add new bonds.

Another way to invest in bonds is through a bond fund. A bond fund is a portfolio of bonds managed by an investment professional. The big advantage to a bond fund is that your investment buys shares of a diversified managed portfolio of bonds, which lowers your overall risks. Interest, dividends, and capital gains from a bond fund can be paid or reinvested in the fund. Open-end funds let you buy into or sell out of the fund whenever you wish. Bonds are actively added and sold from the fund by the fund manager. There is no maturity date to a bond fund.

UITs and funds offer the benefits of a bond portfolio and more affordable buy-in costs for investors who want the rewards of bonds without having to trade them directly. Morningstar offers investors quantitative and qualitative research on investment trusts, bond funds and ETFs.

Doing your homework before buying bonds
As an educated investor, you should know what to look for when buying a bond, what costs to expect, where to buy bonds, and the different ways you can buy them, such as individually, through trusts, or in funds. Depending on your investment needs, you might consider short-term or long-term bonds, and you might choose between new issues and bonds purchased at a premium or discount on the secondary market.

Check out our Learning Centre for more investment lessons on bonds, funds, stocks and portfolio management.