Key Bond Investment Considerations

Interest Rate

A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Bond maturities generally range from one day up to 30 years. Maturity ranges are often categorized as follows:

• Short—term notes: maturities of up to five years;
• Intermediate notes/bonds: maturities of five to 12 years;
• Long—term bonds: maturities of 12 or more years.

Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment you are seeking within your risk tolerance. Some individuals might choose short—term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long—term securities. Alternatively, investors seeking greater overall returns might be more interested in long—term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks as well as credit risk.

Credit Quality

Major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on in—depth analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB category or higher are considered investment—grade; securities with ratings in the BB category and below are considered “high yield,” or below investment—grade. While experience has shown that a diversified portfolio of high—yield bonds will, over the long run, have only a modest risk of default, it is extremely important to understand that, for any single bond, the high interest rate that generally accompanies a lower rating is a signal or warning of higher risk.

How can you find out if the credit factors affecting your bond investment have changed? Usually, rating agencies will signal they are considering a rating change by placing the security on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings). The rating agencies make their ratings available to the public through their ratings information desks.

Yield

Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at $1,000 and the interest rate is 8% ($80), the current yield is 8% ($80 ÷ $1,000). If you bought at $900 and the interest rate is 8% ($80), the current yield is 8.89% ($80 ÷ $900).

Virtually all investments have some degree of risk. When investing in bonds, it’s important to remember that an investment’s return is linked to its risk. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns.

How to Invest

There are several ways to invest in bonds. The two you should consider are individual bonds and bond funds.

Individual Bonds

There is an enormous variety of individual bonds to choose from. Most individual bonds are bought and sold in the over-the-counter (OTC) market, although some corporate bonds are also listed on the New York Stock Exchange. The OTC market comprises hundreds of securities firms and banks that trade bonds by phone or electronically. Some are dealers that keep an inventory of bonds and buy and sell these bonds for their own account; others act as agent and buy from or sell to other dealers in response to specific requests on behalf of customers.

Bonds sold in the over-the-counter market are usually sold in $5,000 denominations. In the secondary market for outstanding bonds, prices are quoted as if the bond were traded in $100 increments. Thus, a bond quoted at 98 refers to a bond that is priced at $98 per $100 of face value, or at a 2% discount.

Bond prices normally include a markup, which constitutes the dealer’s costs and profit. If a broker or dealer has to seek out a specific bond that is not in their inventory for a customer, a commission may be added to compensate for the costs and efforts of serving the customer’s special needs. Each firm establishes its own prices within regulatory guidelines, which may vary depending upon the size of the transaction, the type of bond you are purchasing and the amount of service the firm provides.

Bond Funds

Bond funds offer investors another way to invest in the bond markets. Bond funds, like stock funds, offer professional selection and management of a portfolio of securities. They allow an investor to diversify risks across a broad range of issues and offer a number of other conveniences, such as the option of having interest payments either reinvested or distributed periodically.

Investment Strategies

As you build your investment portfolio of fixed—income securities, there are various techniques you can use to help you match your investment goals with your risk tolerance.

Diversification

No matter what your investment objective, it makes good sense to diversify your portfolio. Diversification can provide some protection for your portfolio, so if one sector or asset class is in the midst of a downturn, the rising value of another class of assets may help offset the negative impact. For example, suppose your portfolio held a variety of high—yield and investment—grade bonds. You chose the high—yield securities for their greater returns. The investment—grade bonds probably generate somewhat lower yields, but their ability to weather economic downturns should offset potential credit—quality concerns which could affect the high—yield securities in the portfolio. Similarly, you might want to balance corporate issues with U.S. Treasury, municipal or mortgage—backed issues offered by government—sponsored agencies.

Laddering

Another diversification strategy is to purchase securities of various maturities. When you buy bonds with a range of maturities, a technique called laddering, you are reducing your portfolio’s sensitivity to interest rate risk. If, for example, you invested only in short—term securities, the kind least sensitive to changing interest rate risk, you would have a high degree of stability, but you might be giving up yield. Conversely, investing only in long—term securities may result in greater returns, but their prices will be more volatile, exposing you to losses should you have to sell before maturity.

Building a laddered portfolio involves buying an assortment of bonds with maturities distributed over time. For example, you might invest equal amounts in securities maturing in two, four, six, eight and 10 years. In two years, when the first bonds mature, you would reinvest the money in a 10—year maturity, maintaining the ladder.

Your return would be higher than if you bought only short—term issues. Your risk would be less than if you bought only long—term issues. You would be better protected against interest rate changes than with bonds of one maturity.

If interest rates fell, you’d have to reinvest the securities maturing in two years at a lower rate, but you’d have the above—market return from the other issues. If rates rose, your total portfolio would pay a below—market return, but you could start correcting that in two years or less when your shortest issue matured.

Risks of Investing in Bonds

All investments offer a balance between risk and potential return. The risk is the chance that you will lose some or all the money you invest. The return is the money you stand to make on the investment.

The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also have the lowest returns.

The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for several reasons:

• Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.
• Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.
• Historically the bond market has been less vulnerable to price swings or volatility than the stock market.

The average returns from bond investments have also been historically lower, if more stable, than average stock market returns.

Higher Risks = Higher Yields

A specific bond’s risk level is reflected in its yield, another name for return on a bond investment. “Current” yield is a function of the bond’s:

• Coupon rate: the annual interest rate the issuer promises to pay the investor, stated as a percentage of the bond’s face value or “par,” which is the amount the investor can expect to have returned on the bond’s maturity date.
• Current price, which may be a premium (more than) or discount (less than) in relation to the bond’s face or par value.

Yield-to-maturity reflects the relationship between the total coupon interest payments remaining between now and maturity, and the difference between today’s market value (price) and par value. Yield-to-call is the same calculation based on the total coupon interest payments remaining between now and the first call date (rather than the maturity date) as well as the difference between today’s market value (price) and the call price.

The higher the risk in a given bond, the higher its yield needs to be to compensate the investor for taking the risk. When the market perceives the yield on a bond to be too low, its price will fall to bring the yield in line with market expectations or prevailing interest rates.

Bond Investment Strategies

The way you invest in bonds for the short-term or the long-term depends on your investment goals and time frames, the amount of risk you are willing to take and your tax status.

When considering a bond investment strategy, remember the importance of diversification. As a general rule, it’s never a good idea to put all your assets and all your risk in a single asset class or investment. You will want to diversify the risks within your bond investments by creating a portfolio of several bonds, each with different characteristics. Choosing bonds from different issuers protects you from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds of different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in any particular market sector.

With that in mind, consider these various objectives and strategies for achieving them.

Preserving Principal and Earning Interest

If keeping your money intact and earning interest is your goal, consider a “buy and hold” strategy. When you invest in a bond and hold it to maturity, you will get interest payments, usually twice a year, and receive the face value of the bond at maturity. If the bond you choose is selling at a premium because its coupon is higher than the prevailing interest rates, keep in mind that the amount you receive at maturity will be less than the amount you pay for the bond.

When you buy and hold, you need not be too concerned about the impact of interest rates on a bond’s price or market value. If interest rates rise, and the market value of your bond falls, you will not feel any effect unless you change your strategy and try to sell the bond. Holding on to the bond means you will not be able to invest that principal at the higher market rates, however.

If the bond you choose is callable, you have taken the risk of having your principal returned to you before maturity. Bonds are typically “called,” or redeemed early by their issuer, when interest rates are falling, which means you will be forced to invest your returned principal at lower prevailing rates.

When investing to buy and hold, be sure to consider:

• The coupon interest rate of the bond (multiply this by the par or face value of the bond to determine the dollar amount of your annual interest payments)
• The yield-to-maturity or yield-to-call. Higher yields can mean higher risks.
• The credit quality of the issuer. A bond with a lower credit rating might offer a higher yield, but it also carries a greater risk that the issuer will not be able to keep its promises.

Benefits of Investing in Corporate Bonds

Investors buy corporates for a variety of reasons:

Attractive yields. Corporates usually offer higher yields than comparable-maturity government bonds or CDs. This high-yield potential is, however, generally accompanied by higher risks.

Dependable income. People who want steady income from their investments, while preserving their principal, may include corporates in their portfolios.

Safety. Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment as measured by the likelihood of repayment of principal and interest.

Diversity. Corporate bonds provide an opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives.