Monday, June 24, 2013

BONDS; Alcoa bond for your retirement

Alcoa (Photo credit: Wikipedia)

You know I never advocate bond funds, yet, often times individual bonds fit nicely into an income investor’s diversified portfolio.   In this post, I profile a bond I bought yesterday. 

I want to remind you that I like bonds with short maturities, that cost less than par, have an interest rate that is better than a dividend, and whose underlying company has a good interest coverage ratio.  

Bonds with short maturities:

When you buy bonds, your goal is to build a portfolio of bonds with varying maturities.  Long bonds, those that mature in more than ten years, cost too much and do not pay enough income to make such a commitment.  You tie up your principle for too long a time. 

Short maturities, those between three and then years, are the sweet spot of bond investing today.  Everyone is worried that interest rates will explode over the next few years.   If that comes true, the value of bonds that you buy with coupon yields that are less than government treasuries will go down.   You will not want to sell your bond at a discount so you should hold it to maturity when you will get back your principle.   You can then reinvest your principle in another bond with a higher coupon yield.    If you keep the maturities short, you tie up your principle for less time and you can take advantage of rising interest rates.

Bonds priced at less than par:

Most investors are familiar with the concept of total return when we talk about buying stocks.  You expect dividend income but you also hope your principle will increase over time.   When you buy a bond at par and hold it to maturity, you will get back par.   Your total return is only the value of the interest payments.   

If you buy a bond that costs more than par and hold it to maturity, your return is even less than the value of the interest payments because you will get back only par which would be less than you paid.    You can see why I never buy bonds at a price greater than par.

If you buy a bond at a discount and hold it to maturity, your return is a combination of the interest payments and the increased value of your principle.  You get the capital gain difference between the discounted price you paid and par.   Sometimes, (and this happens more than you may think) the value of your bond increases enough that you can sell it at greater than par.  In circumstances of that type, your return includes the interest received while you held the bond and the capital gain.

Interest coverage ratio:

If you have not yet familiarized yourself with “interest rate coverage ratio,” you should do so now.   Interest coverage ratio is simple to find.   I use MSN Money to find this the interest coverage ratio of the company that has issued the bond.  Interest coverage ratio is a measure of how well a company can pay its interest payments.    Later in this post, I have provided a link to the MSN site.

Alcoa Aluminum Company – April 15, 2021 bond

Alcoa, symbol AA, is a dividend stock but their bonds are a more compelling investment.  AA issues bonds periodically and the bond I bought today (June 24, 2013) matures on April 15, 2021; this is just under eight years until maturity. 

This bond pays a coupon yield of 5.4%.  It sells at a discount; I paid $96.291.  At this price, the yield is about 6%.   In addition, if I hold the bond to maturity I will get back my principle plus $3.709.   

This bond is rated BBB-.   I put very little faith in the rating agencies; I do my own homework and I like to use the interest coverage ratio of the underlying company to determine if that company will be able to pay the interest and return to me the principle.   In the case of this bond, the interest coverage ratio of AA is 36.59.  This means the company has a good chance of paying interest to the tune of 36.59  times what they need to cover the interest payout.  This is an excellent margin for this company and makes the bond compelling to me.   If you want to see the data on MSN click here for the link.

AA 4/15/2021 5.4%
CUSIP 013817AV3
               $    100.000
               $      96.291
Coupon Yield
Yield to Maturity
AA D/E ratio
AA Interest Coverage Ratio

You need to know the CUSIP of the bond in order to buy it.   Many brokers, I use Schwab, will have these bonds in their inventory.   If you do not see this bond on your broker’s website, call their bond desk and ask for a price using the CUSIP.   See the table at right for this bond’s details.


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