How we structure a bond portfolio will greatly depend on the risk tolerance and time horizon for the client – and current yields available in the marketplace.
Many investment advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Since bonds typically have a predictable stream of payments and repayment of principal, many investors buy them to preserve and increase their capital or to receive dependable interest income. Whatever the purpose, investing in bonds can help you achieve your objectives.
Key Bond Considerations:
Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face value, or the principal amount. For example, a $1,000 bond that pays a 6% coupon, will pay an investor $60 annually, typically $30 twice yearly.
Maturity
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
Bond choices range from the highest credit quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment—grade and considered speculative. Since a bond may not be redeemed, or reach maturity, for years—even decades—credit quality is another important consideration when you’re evaluating a fixed—income investment. When a bond is issued, the issuer is responsible for providing details as to its financial soundness and creditworthiness. But how can you know whether the company or government entity whose bond you’re buying will be able to make its regularly scheduled interest payments in five, 10, 20 or 30 years from the day you invest? Rating agencies assign ratings to many bonds when they are issued and monitor developments during the bond’s lifetime.
Credit Rating
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 6% ($60), the current yield is 6% ($60 /$1,000). If you bought at $850 and the interest rate is 6% ($60), the current yield is 7.0% ($60/$850).
Yield-to-maturity and yield-to-call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield-to-maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield-to-call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date.
Assessing Risk
All investments carry 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 typically offer lower returns.
How to Invest
There are several ways to invest in bonds. The two you should consider are individual bonds and bond ETFs.
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 ETFs
Bond ETFs offer investors another way to invest in the bond markets. Bond ETFs, like stock ETFs, 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.
An ETF tracks a market, sector, index or various asset classes, but can be traded like a stock. Bond ETFs can be a very cost-effective way to build a fixed income portfolio and offer many advantages. Here is a quick summary of the advantages of investing in bond ETFs:
Advantages:
- They are highly liquid. Since ETFs trade like stocks, you can buy or sell them throughout the trading day as opposed to traditional mutual funds where you can only do so once per day, at the end of the trading session and at an undetermined price. ETFs allow for immediate liquidity anytime during normal trading hours.
- Great variety of bond ETF offerings. Like stock ETFs, there are bond ETFs that track pretty much every imaginable bond asset class (short-, mid-, long-term) and every variation of quality ratings too. This allows you to diversify across many bond asset classes or tweak the portfolio to the short end of the yield curve for less risk or further out on the yield curve to pick up additional income, but with added risk. With hundreds of offerings in the marketplace one can easily build a bond portfolio comprised only of ETFs.
- Low ongoing costs. As is the case with stock ETFs, bond ETFs a structured in a manner that allows for very low operating costs. Vanguard or iShares offerings often charge less than 0.20% annually. This can be a clear advantage over higher cost traditional bond mutual funds, particularly in a low-yield environment where every quarter percentage makes a difference.
- Immediate diversification. Bond ETFs offer immediate diversification of risk, often among hundreds of bonds, with the purchase of one single ETF. Since bond ETFs are often comprised of hundreds of bonds, one could argue there is no need to purchase many individual bonds and the costs associated with that approach, rather, simply buy a few bond ETFs that meet your objectives and you have a well-diversified portfolio with little effort.
- Consistent income. Bond ETFs often pay income on a monthly or quarterly basis. This can be an advantage for some income-seeking retirees who are looking for cash flow to help pay for their daily expenses. Most individual bonds only pay income twice per year, but again, many bond ETFs pay their income more regularly (monthly or quarterly) which can be an advantage for those living off a portfolio or trying to match cash flow with expenses.
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 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, possibly exposing you to losses should you have to sell before maturity.