Bond Basics for Today’s Market
There’s an investment rule of thumb that says “don’t buy anything you don’t understand.” As investors, we all understand the relatively straightforward concept of stock ownership. In exchange for our cash, we receive an ownership interest in a going business. As owners, of course, we’re entitled to share in the success—and occasionally failure—of that business. (How we share in that success can vary, of course. Some companies distribute profits to their shareholders via regular dividend payments, while other companies reward investors with extensive share buyback programs or even stock splits.) While knowing what you’re buying is obviously important, many do-it-yourselfers may shy away from other types of investments—particularly bonds—because they don’t fully understand them.
In theory, bonds couldn’t be much simpler. They are IOUs—typically from large corporations or governments—to investors. When you buy an individual bond—for example a $10,000 corporate bond that pays 6% annual interest (sometimes called the “coupon rate”) that matures, i.e. will be repaid, in 10 years—and hold it to maturity, you will receive annual interest payments of $600 (typically distributed semi-annually), plus your original $10,000 when the 10 years is up.
In practice, however, bonds can present a host of challenges for the do-it-yourself investor. First of all, buying individual bonds can be expensive, as the example above illustrates, and it can be risky, because of the high cost of diversification using individual bond issues. Moreover, with very few exceptions, bonds are not listed on exchanges. To buy and sell bonds, then, you must get quotes and execute orders through a brokerage.
The proliferation of bond mutual funds and exchange traded funds has removed many of the obstacles to bond investing for do-it-yourselfers. The price of admission for bond ETFs, for instance, can be as little as the cost of a single share, and most actively managed bond mutual funds have similarly low minimum initial investments. Along with a lower price of admission, bond funds also provide much greater diversity than most individual investors could achieve on their own. A bond fund or ETF typically holds hundreds of different bonds with different maturities and thus provides greater protection against non-payment of interest and outright default—two of the biggest risks bond investors face.
In addition to the advantage of diversity, bond mutual funds and ETFs also have greater liquidity than individual bonds. In other words, redeeming shares in a frequently traded bond fund is typically much easier than selling an individual bond. And investors who aren’t looking for income benefit from bond funds because dividends are reinvested automatically. For do-it-yourselfers, the biggest advantage of owning an actively-managed bond fund may be the portfolio manager, who handles all the details, including analyzing credit ratings to determining which bonds to buy and sell.
Indeed, the “details” involved in trading bonds successfully can be mind-boggling. Most investors do not hold bonds to maturity but rather trade them on the secondary market. To do this successfully requires an understanding of the factors that affect a bond’s yield, which is best understood as the fixed annual interest rate (the 6% from our corporate bond example above) divided by the ever-changing current market price of the bond.
Many investors know that bond prices have an inverse relationship to interest rates, but perhaps not every investor knows that bond prices also have a similar inverse relationship to inflation. Another important factor affecting bond prices is the issuer’s credit rating. The recent spate of credit ratings downgrades—particularly of financial sector firms struggling with the subprime mortgage meltdown and tight credit markets—is a reminder that even seemingly rock-solid bond issuers can present serious and sometimes unexpected risks to investors. A bond’s price thus reflects the prevailing interest rate, the rate of inflation, and the bond issuer’s current credit rating at any given moment. Depending on these factors, the bond may be trading at a discount or a premium to its face value.
While credit ratings are obviously key to pricing a bond, the most important determinant of a bond’s risk is known as duration. Think of duration as the number of years required to recover the true cost of a bond, taking into account the present value of all coupon and principal payments to be received in the future. As a general rule, the longer the duration, the riskier the bond. Why? A long duration makes a bond more vulnerable to inflation or higher interest rates, both of which cause bond prices to decline.
Although the Federal Reserve recently left interest rates untouched at their current level of 2.0 percent, many Fed watchers believe the central bank could begin raising rates within the next several quarters to combat rising inflation. In a potentially rising interest rate environment, investors can mitigate risk by investing in bond funds with average maturities in the 1 to 5 year range. Investors seeking moderate growth should increase exposure to high-yield and short-term bond funds and decrease exposure to longer duration issues. High-yield funds offer high income through investment in lower-rated, lower-quality corporate bonds. Companies that issue high-yield bonds have to offer investors attractive returns in exchange for the attendant higher risk.
For more conservative, risk-averse investors, investment-grade bond funds with shorter average duration are a good choice. In addition, shorter-term high-yield bond funds may help to reduce the level of inflation risk in one’s portfolio. It is important to choose a bond fund whose yield has the potential to exceed the inflation rate.
Investing successfully with bonds often means taking into account a host of factors—including interest rates, credit quality and duration—and choosing the fund or ETF best suited to your particular circumstances is far from a “no-brainer.” But that doesn’t mean you should avoid bonds. As with stock market investing, remaining diversified is crucial, but bond investors must also be able to respond to changes in the interest-rate environment quickly.
If you have questions about investing with bonds, call us at (877) 432-7447, Ext 191. Based on your investment goals, we can help you decide what types of bond funds and ETFs are be appropriate for you today and, more important, what percentage of your overall portfolio should be exposed to bonds.
