ALL ABOUT BONDS, BOND MUTUAL FUNDS, AND BOND ETFs O T H E R T I T L E S I N T H E “A L L A B O U T. . .” S E R I E S All About Stock Market Strategies by David Brown and Kassandra Bentley All About Technical Analysis by Constance Brown All About Derivatives by Michael Durbin All About Investing by Esmé Faerber All About Asset Allocation by Richard A. Ferri All About Index Funds by Richard A. Ferri All About Hedge Funds by Robert A. Jaeger All About Market Timing by Les Masonson All About Options, 3rd edition by Thomas A. McCafferty All About Dividend Investing by Don Schreiber and Gary E. Stroik All About Commodities by Russell R. Wasendorf All About Futures by Russell R. Wasendorf All About Stocks, 3rd edition by Esmé Faerber All About Exchange Traded Funds by Archie Richards, Jr. This page intentionally left blank ALL ABOUT BONDS, BOND MUTUAL FUNDS, AND BOND ETFs Third Edition ESME´ FAERBER New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2009 by Esmé Faerber. 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: 978-0-07-154428-3 MHID: 0-07-154428-3 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-154427-6, MHID: 0-07-154427-5. 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. 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 visit the Contact Us page at www.mhprofessional.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the serv- ices 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 and Associations All investing concepts, ideas, strategies, methods, etc. in this book are intended for educational purposes only. They are not meant to recommend or promote any investing strategy or philosophy. You are advised to consult a financial professional before investing. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR- ANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMA- TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupt- ed or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. C O N T E N T S Preface ix Acknowledgments ix Chapter 1 What Bonds Can Do for You and Why You Should Consider Investing in Them 1 Chapter 2 Characteristics of Bonds 17 Chapter 3 Risks of Bonds 31 Chapter 4 Yield and Price 41 Chapter 5 Duration and Convexity 55 Chapter 6 The Economy and the Bond Markets 67 Chapter 7 Money Market Securities 91 Chapter 8 Treasury Securities 113 Chapter 9 Government Agency and Pass-Through Securities 139 Chapter 10 Corporate Bonds 167 Chapter 11 Municipal Bonds 199 vii viii CONTENTS Chapter 12 Convertible Bonds 227 Chapter 13 Zero Coupon Bonds and Zero Coupon Mutual Funds 255 Chapter 14 International and Emerging Market Debt 273 Chapter 15 Closed-End Funds 289 Chapter 16 Portfolio Management and Evaluation 303 Index 323 P R E FA C E This third edition includes information to assist bond investors to become more knowledgeable about their investments. Among the many changes to this edition are new chapters on foreign and emerging market debt, how to use duration and convexity concepts, and the inclusion of investing in bond exchange traded funds. Each chapter includes many new sections to provide both beginning and sophisticated bond investors with the tools to make more informed bond investments. Bond exchange traded funds are compared with bond mutual funds and investing in individual bonds. The early chapters present information on the characteristics of bonds with the purpose of providing readers with an understand- ing of the workings of a bond, and their performance with regard to risk and return. The following chapters present the different types of bonds (Treasuries, government agency bonds, GNMA, FNMA, collateralized mortgage obligations, municipal bonds, corporate bonds, convertible bonds, zero coupon bonds, and foreign bonds) along with a comparison of the corresponding mutual funds and bond exchange traded funds. These chapters provide readers with the information to make their choices as to whether to invest in indi- vidual bonds, or bond mutual funds, or bond exchange traded funds. The last chapter provides the information to manage a bond portfolio. As a more informed investor, it is easier for you to make better decisions regarding your bond investments. ACKNOWLEDGMENTS Many people facilitated the preparation of this book, and I am grateful for their assistance. My husband, Eric, and our children, Jennifer and Michael, deserve a special note of thanks for their continued support and patience. ix