Bond Investing For Dummies
Overview
Everything on bonds, bond funds, and more! Updated for the new economy
Whether you're looking for income, diversification, or protection from stock market volatility, bonds can play an important role in any portfolio. Newly updated, Bond Investing For Dummies covers the essentials of getting started and ways to select and purchase bonds for your needs. You'll get up to speed on the different bond varieties and see how to get the best prices when you sell.
We’ll help you wrap your mind around bond returns and risk and recognize the major factors that influence bond performance. With easily understandable explanations and examples, you can understand bonds from every angle—yield, credit risk, callability, fund selection, bond broker-dealers, web portals, and beyond. This is the expert information and advice you need to invest in bonds in today’s environment. Learn what bonds are and how you can use them to strengthen and protect your portfolio
- Understand how interest rates and other shifting sands affect bond investing
- Minimize your risk and maximize your returns with proven advice from an expert financial advisor
- Use online investing and apps to buy bonds and bond funds with confidence and ease
Novice and experienced investors alike will love this quick-and-easy approach to bond investing.
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About The Author
RUSSELL WILD (PHILIDELPHIA, PA) is an experienced financial advisor and writer who wants to help investors succeed. He has been working in the finance and investment industry for more than thirty years. Russell is the principal of Global Portfolios, which specializes in providing retirement planning and global portfolio diversification through the use of fund management. He is the author of Exchange Traded Funds For Dummies and the previous editions of Bond Investing For Dummies.
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bond investing for dummies
CHEAT SHEET
If you want to invest in bonds, you need to know how to read the bond ratings that the big three rating companies use and how to figure whether a taxable or tax-free municipal bond is the better investment. Knowing the right questions to ask about a bond can save you money, and you can find answers to many of those questions on the Internet.
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Here are some examples of investment portfolios based on real, live clients with bond portfolios. Their names have been changed to protect the identities of these good people. Perhaps you will see some similarities between their situations and yours.
Jean and Raymond, 61 and 63, financially quite comfortable
Married in 1982, Jean and Raymond raised three children; the third is just finishing up college.
Bonds
Stocks and bonds come in many flavors that can be added to your portfolio. Although the world of investments offers countless opportunities — and dangers! — all investments qualify as one of these two types:
Equity: Something you own (such as stocks, real estate, or gold)
Fixed income: Money you’ve lent in return for interest (such as bonds, CDs, or money market funds), or possibly money you’ve given up in return for steady payments (annuities)
For the sake of simplicity, this article deals largely with “stocks” and “bonds,” ignoring the many shades of gray that define both of these large umbrella terms.
The municipal bond market is now about $3.7 trillion, which is a little more than one-third the size of the Treasury market. But unlike Treasuries, which are held by investors all over the world — by both individuals and governments — municipal bonds are purchased primarily by U.S. households. Munis, due to their tantalizing tax advantage, are generally the only major kind of bond more popular with individual investors than with institutions.
Although Modern Portfolio Theory has its limitations, the science behind the theory is sound, and its real-world applications are profound. Given that just about all asset classes fell in 2008, some people have claimed that MPT is dead. Not so. Far from it.
First, 2008 was a once-in-our-lifetimes (so far) event.
Here are some answers to frequently asked questions about bond investing. So just what are bonds? A bond is basically an IOU. You lend your money to Uncle Sam, to General Electric, to Procter & Gamble, to the city in which you live — to whatever entity issues the bonds — and that entity promises to pay you a certain rate of interest in exchange for borrowing your money.
If you want to invest in bonds, you need to know how to read the bond ratings that the big three rating companies use and how to figure whether a taxable or tax-free municipal bond is the better investment. Knowing the right questions to ask about a bond can save you money, and you can find answers to many of those questions on the Internet.
Talk about good deeds. Churches in the United States have issued bonds for more than a century now. The bonds are most often secured by a deed of trust on church real estate or other property. Traditionally, most of these bonds have been sold as private offerings to bona fide members of the church congregation only.
Bonds
Socially responsible investing (SRI) can mean different things to different people, but for most, the goal of SRI is to shun bad-thinking-and-doing companies and embrace good-thinking-and-doing companies. Typically, companies that produce tobacco and alcohol, engage in gambling activities, produce lethal weapons, pollute the environment, discriminate in employment, or violate human rights are shunned.
According to the classical laws of Islam, paying or charging interest is a forbidden. You’d think, therefore, that bond investing would be considered sinful. Well, it depends on the bond. Some very special bonds, called sukuk (pronounced soo-cook), actually allow for virtuous investing . . . at least according to some followers of Islam.
If you want to invest in individual bonds, the first thing you need is a reliable broker or dealer — a person or institution to place the actual trades for you.
Many bond dealers are traders or brokers who buy a bond from Client A at one price, sell it to Client B at another, leave the office for a few rounds of golf, and then come back to harvest more profits.
Here are a few examples of bond portfolio allocation solutions. Just as there are no hard and fast rules for the percentage of a portfolio that should be in bonds, there are no absolutes when it comes to what kind of bonds are optimal for any given investor.
Jean and Raymond, 61 and 63, financially fit as a fiddle
These folks have a solid portfolio of nearly three-quarters of a million dollars.
Bonds
Chances are that you have both a taxable account where you can store your investments and a tax-advantaged account, such as an IRA, a Roth IRA, a 401(k), or a 529 college savings plan. Think of these as containers of sorts, which you fill up with your various investments.
Yesteryear, when corporations and municipalities were still offering bearer bonds — bonds that came with a certificate and were registered nowhere, with no one — you didn’t have to concern yourself with keeping them in any particular account.
All agency bonds are considered high quality with very little risk of default, but they aren’t all created exactly equal. Here, sort through some considerations to keep in mind when researching agency bonds for your portfolio.
Eye default risks, yields, markups, and more
The honest-and-true federal agencies, such as the Small Business Administration (SBA), are said to have no risk of default; therefore, their bonds pay more or less what Treasuries do.
Mortgage-backed bonds, usually best purchased in mutual fund form, add a smidgen of diversification to a portfolio and potentially a bit more return than do most other agency bonds. Again, there’s no urgency to add mortgage-backed bonds to a portfolio, but if you have a large fixed-income allocation, a position in mortgage-backed bonds may make sense.
An entire industry is devoted to rating companies by their financial strength. The most common ratings come from Moody’s and Standard & Poor’s, but other rating services exist, such as Fitch Ratings, Dominion, and A.M. Best.
Your broker surely subscribes to at least two of these services and will be happy to share the ratings with you.
Bonds
To figure out what percentage of your portfolio should be in bonds, there's just one thing to remember: There are no simple formulas, because each person's financial situation is unique. One factor, however, is key: volatility.
Minimize volatility in your portfolio
The long-term return on all bonds, judging by the past 80-plus years, is about half that of all stocks.
If you think of debt securities as safe and boring, look at some of these investments, which are built on derivatives and defaulted bonds. You could double or triple your money overnight . . . or see it shrink and fade faster than the bankroll of a drunken gambler in Vegas on a not-so-hot night.
Daring to delve into derivatives
In general, a derivative is a financial something-or-other whose value is based on the price of some other financial something-or-other.
A growing number of financial supermarkets and specialty bond shops now allow you to trade bonds online, and they advertise that you can do so for a fixed price. In the case of Fidelity, the price is generally $1 per bond.
Whoa, you may say. That’s a great deal! Well, yes and no. If that were all that Fidelity and the other middlemen were making, it would be a great deal.
They sound like exchange-traded funds (investments similar to mutual funds, usually indexed mutual funds that trade like stocks), but exchange-traded notes (ETNs) are as different from ETFs as jellyfish are from fish. ETNs are debt instruments, bonds of sorts, but the income they produce is far from fixed. In fact, unlike most other debt securities, they offer no coupon rate, and the maturity date, although it exists, is rather inconsequential.
Here are a few reasons Treasury bonds likely belong in your investment portfolio and what kind of returns you can realistically expect from these investments.
Turn to Treasuries in times of turmoil
When you buy Treasury bonds, not only do you get the full faith and credit of the U.S. government assuring you your money back, but you get other perks as well.
Bonds
A bond is really not much more than an IOU with a serial number — you lend someone your money for a period of time, and they promise to pay you back (with interest) after that time is over. There is money to be made in bond investments, but before you wade into that ocean, here are some of the basic concepts and vocabulary you need to know.
You will want to research bonds before investing your money. Here are the first three things you will want to find out about a bond:
What is its face value?
What is the coupon rate?
How much are you being asked to pay for the bond?
These can all be ascertained quite readily, either by looking at the bond offer itself or by having a conversation with the broker.
What’s the difference between an annuity and a bond? With an annuity, you don’t expect to ever see your principal back. In return for giving up your principal, you expect a higher rate of return.
A cross between an insurance product and an investment, annuities come in myriad shapes and sizes. The general theme is that you give your money to an institution (usually an insurance company or a charity), and that institution promises you a certain rate of return, typically for as long as you live.
When most investors speak of bond funds, they’re talking about mutual funds. And it’s no wonder. According to Morningstar, the total number of distinct mutual funds (ignoring different share classes of certain mutual funds) clocks in at an astounding 7,087. Of those 7,087 funds, 1,739 of them — nearly 25 percent — represent baskets of bonds.
Okay, okay, so diversification is a good thing, but why must a diversified portfolio include bonds? After all, there are many investments to choose from in this world.
True enough: There are many investments to choose from in this world. And if your portfolio is large enough, go ahead, invest in commodities and foreign real-estate funds and emerging-market stocks and stocks in small value international companies and hedge funds and emerging-market debt.
All bonds are fixed-income investments, but not all fixed-income investments are bonds. Anything that yields steady, predictable interest can qualify as fixed income. That includes not only bonds but also CDs, money market accounts, and a few other not-as-common investments. Any and all of these may serve as sources of cash, either to boost a pre-retirement portfolio or to help mine cash from a post-retirement portfolio.
When it comes to adding stability to a portfolio — the number one reason that bonds belong in your portfolio — Treasuries and investment-grade (high quality) corporate bonds are your two best choices. They may have saved your grandparents from destitution during the Great Depression. They may have spared your 401(k) when most stocks hit the skids in 2000–2002 or when your savings again took a nosedive in 2008.
Bonds
The 20 times rule is a thumbprint that gives you a very rough guide of how big a investment portfolio you need before you retire. In short, figure out how much you need in a year, subtract whatever retirement income you have outside of investment income (such as Social Security), and multiply the remainder by 20.
Buying a Treasury bill, note, bond, or inflation-protected security is a heck of a lot easier than buying most other bonds. With Treasuries, you needn’t worry about such things as credit rating, callability, liquidity, and getting socked with high broker markups.
Uncle Sam’s bonds can be purchased directly from, and sold to, the old man himself.
Here are a few online resources and tips for choosing a bond broker or agent, so that with the tap of some keys and the click of a mouse, you can access the most modern methods — the most efficient, friendly, and profitable methods — for buying and selling individual bonds.
Do you need a broker or agent at all?
Bonds
As a bond investor, you’re probably most interested in the bonds that will leave you with more money at the end of the day. If it comes to a choice between taxable and tax-free municipal bonds, grab your calculator and apply the following rather simple formula to determine the potentially more profitable bond:
Start with 100.
Here’s how you start thinking about how to achieve your investment goal, whatever it may be. You may be saving and investing to buy a new home, to put your kid(s) through college, or to leave a legacy for your children and grandchildren.For most people, however, a primary goal of investing (as well it should be) is to achieve economic independence: the ability to work or not work, to write the Great (or not-so-great) American Novel… to do whatever you want to without having to worry about money.
Picking individual treasury bonds has little value and looks a lot like gambling. That’s because the markets for Treasuries are extremely efficient: So many buyers and sellers are involved, and any information worth having is so public, that any true “deal” is very hard to find.
The only really important questions you should ask yourself about Treasuries are the following:
Do I want Treasuries in my portfolio and, if so, how much?
You usually don’t pay commissions when you trade individual bonds, as you do when you trade stocks. Instead, someone called a broker (an individual wearing a fancy suit) usually trades your bonds. A broker buys a bond at one price and sells it at a higher price.
The difference, known as the bid/ask spread, is what the broker brings home.
Before you buy a bond, get an idea of how much financial muscle the issuer has. Bond ratings are available through any brokerage house. Three of the most popular rating services are Moody’s, Standard & Poor’s, and Fitch. The following table shows the system each uses to rate bonds:
Bond Credit Quality Ratings
Credit risk ratings
Moody’s
Standard & Poor’s
Fitch
Investment grade
Tip-top quality
Aaa
AAA
AAA
Premium quality
Aa
AA
AA
Near-premium quality
A
A
A
Take-home-to-Mom quality
Baa
BBB
BBB
Not investment grade
Borderline ugly
Ba
BB
BB
Ugly
B
B
B
Definitely don’t-take-home-to-Mom quality
Caa
CCC
CCC
You’ll be extremely lucky to get your money back
Ca
CC
CC
Interest payments have halted or bankruptcy is in process
C
D
C
Already in default
C
D
D
Bond ratings are available through any brokerage house.
Successful bond investing isn’t about luck, it’s about researching markets, comparing offers . . . and luck. These seven websites serve as your navigation guide through the vast universe of bonds and bond funds.
Investing in Bonds.com
Run by the Securities Industry and Financial Markets Association, this is the place to go to find out overall bond market yields and, perhaps more importantly, what individual bonds (which you can look up by their CUSIP number or issuer) are selling for.
Far more complicated even than floaters are the mortgage-backed securities issued by federal agencies such as Ginnie Mae and by some government-sponsored enterprises, such as Fannie Mae and Freddie Mac.
Mortgage-backed securities— the vast majority of which are issued by agencies — are very different than most other bonds.
Bonds
Before you get into the nitty-gritty of buying and selling bonds, you need to make a decision between individual bonds and bond funds. Thanks to the many recent changes in the bond markets, either choice can be a good one. Still, most investors are better off, most of the time, with bond funds.
Many people prefer bond funds for a number of reasons, but far and away the largest reason is the diversification that bond funds allow.
Individual bonds and bond funds, like politics and money, are even closer than most people think. Here are some things to consider when deciding whether individual bonds make sense for you.
Dispelling the cost myth
People who imagine great differences often say that bond funds are more expensive than investing in individual bonds.
After suggesting a bond portfolio — or any other kind of portfolio — to a new client, dealers often hear, “But . . . is now a good time to invest in bonds?” The answer is yes.
You can’t predict the future of interest rates
With stocks, the big concern people have is usually that the market is about to tumble. With bonds, the big concern — especially these days — is that interest rates are going to rise, and any bonds purchased today will wither in value as a result.
When investment pros talk of volatility, they are talking about risk. When they talk about risk, they are talking about volatility. Volatility in an investment means that what is worth $1,000 today may be worth $900 . . . or $800 . . . tomorrow.
Bonds are typically way less risky than stocks (that’s why we love bonds so much), but bonds can fall in value.
Bonds
It’s important to understand how tax law affects your retirement accounts, while investing and while withdrawing. The Internal Revenue Service, in cahoots with Congress, gives the U.S. investor two basic kinds of tax-advantaged retirement accounts:
Plans that allow for the deferral of income tax until the money is withdrawn (IRAs, SEP-IRAs, 401k plans)
Plans that, provided you follow certain rules, allow for tax-free withdrawals after reaching age 59-1/2 (Roth IRAs, Roth 401k plans)
Minimize income to lower your taxes
Interest payments from bonds or bond funds (other than municipal bonds) are generally taxable as normal income.
Most municipal bonds are tax-free, but your personal federal tax bracket, as well as the income taxes you pay in your state or to your local government, have a great bearing on whether munis make sense for you. If you decide to invest in munis, what kind should you select: national or local?
You need to consider a great many things when choosing which munis to buy.
So, what kinds of investments, whether stocks, bonds, or annuities, go well together, and which kinds clash? You want to include different kinds of investments in any portfolio, preferably investments from different asset classes and, best of all, investments that have little or no correlation.
An asset class is a group of investments that share common characteristics.
Bonds
When rock star David Bowie decided in 1997 to produce his own bonds using his considerable talent (and future song royalties) as collateral, it struck some as a rocking good idea. Bowie got $5.5 million out of the deal, but some investors haven’t fared as well as they thought they would.
Here are a few types of bonds that fall a few notes shy of being totally safe investments but nonetheless may make a reasonable addition to some people’s portfolios.
As you enter the world of bond investing, you may choose to work with a broker. But use some caution. Ask the questions in the following list — and get acceptable answers — before parting with your cash.
Who is the bond issuer?
Is it the U.S. Treasury? General Electric? Dade County, Florida? The Russian Federation?
Rebalancing means getting your investment portfolio back in order. It won’t be easy. You’ve seen your stocks go up while your bonds have languished; rebalancing is the smart thing to do.
Unless your life circumstances have changed, you probably still want a 60/40 portfolio. That means that your new $116,000 portfolio should be ($116,000 x 60 percent) $69,600 in stocks, and ($116,000 x 40 percent) $46,400 in bonds.
Bonds
A bond, no matter its quality or maturity, tends to rise and fall in value with the general conditions of the markets and of the economy. Prevailing interest rates, the rate of inflation, and supply and demand all affect a bond’s value.
It’s like your home; no matter how well you maintain it or whether you renovate the kitchen, tends to rise or fall in value along with the value of all other houses in your neighborhood.
Bonds
After you have done basic research on a bond and know the face value, coupon rate, and sale price (discount or premium), you are ready to start a little digging. Here’s what you want to know next about the bond:
Is the bond issuer capable of repaying you your money? Or could the issuer go belly-up and default on (fail to repay) all or part of your loan?
Until recently, U.S. savings bonds had been popular as gifts in part because they were sold as nicely designed certificates. On January 1, 2012, however, they became electronic entities, just like other Treasury securities.
It remains to be seen if they will still be desirable as gifts in this less attractive, less personal format.
Bonds
In the foreign bond market, you can invest in developed-world markets or emerging markets. Emerging markets is something of a euphemism for “poorer countries of the world.” Those who invest in them hope that these nations are emerging, but no one can say with any certainty.
In any case, if you want to buy bonds issued in Brazil, Turkey, Russia, Venezuela, Mexico, or Argentina, the opportunities are out there.
The ratio between what Americans invest in domestic bonds and what Americans invest in foreign bonds is somewhere in the ballpark of 30 to 1. Given the gargantuan size of the foreign bond market, you may find that a bit surprising — especially because foreign bonds sometimes make very sensible investments.
And although it was once difficult to invest in this arena, it’s very easy today, especially since the advent of exchange-traded funds; dozens of foreign-bond funds have materialized just in the past couple of years.
Stocks and bonds are yin and yang — they go together perfectly. Stocks are where you’re likely to get your growth. Bonds provide predictability and stability. Any other reasons for having bonds in your portfolio — such as getting a stream of income — are nice, but secondary.
Some bonds are more volatile than others.
Bonds
In the year 1926, if somone had invested $100 in long-term government bonds, their original investment of $100 would now be worth $9,400. It grew at an average annual compound rate of return of 5.5 percent.
Even though you aren’t rich, $9,400 doesn’t sound too shabby. But you need to look at the whole picture.
Investing in bonds is easy. Investing well in bonds is hard. Bonds can be more complicated than they appear. It’s easy to get bamboozled, easy to make dumb mistakes. But if you watch out for these ten do’s and don’ts, you’ll be far ahead of the game.
Allowing the broker to churn you
Bond brokers generally make their money when you buy and sell bonds.
A bond selling for 100 and paying 5 percent looks like the clearest, most easy-to-understand investment possible. Yet it is, in reality, a much more complex organism. Read these ten common bond misconceptions, and you’ll no doubt see why.
A bond “selling for 100” costs $100
Welcome to the first complexity in bonds: jargon!
Here are ten questions and answers about bond investing with Dan Fuss, who is vice chairman of Loomis, Sayles & Company. He’s been managing investments for more than half a century.
The Loomis Sayles Bond Fund has returned more than 10 percent a year over the past 20-plus years — about 3 full percentage points above the return for the entire bond world.
Most people view bonds as low-risk investments. You give your money to a government or corporation. You receive a steady flow of income, usually twice a year, for a certain number of years. Then, typically after a few years, you get your original money back. Sometimes you pay taxes. A broker usually takes a cut.
Bond investing has a reputation for safety not only because bonds provide steady and predictable streams of income, but also because as a bondholder you have first dibs on the issuer’s money. A corporation is legally bound to pay you your interest before it doles out any dividends to people who own company stock.
Here are the four largest (and most popular with retail investors): the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal Home Loan Banks (FHLB), and the Government National Mortgage Association (GNMA or Ginnie Mae).
How big is a big agency?
Investment bonds are issued by thousands of different governments, government agencies, municipalities, financial institutions, and corporations. They all pay interest. Following are some important considerations about each of the major kinds of bonds.
Treasury bonds
Politicians like raising money by selling bonds, as opposed to raising taxes, because voters hate taxes.
Bonds have been a bulwark of portfolios throughout much of modern history, but that’s not to say that money — some serious money — hasn’t been lost. Here are examples of some bonds that haven’t fared well so you’re aware that even these relatively safe investment vehicles carry some risk.
Corporate bonds
Corporate bonds — generally considered the most risky kind of bonds — did not become popular in the United States until after the Civil War, when many railroads, experiencing a major building boom, had a sudden need for capital.
Although bonds are known for being safe investments, there is risk inherent in every investment. Bondholders do have first dibs on the issuer’s money. A corporation is legally bound to pay you your interest before it doles out any dividends to people who own company stock.
If a company starts to go through hard times, any proceeds from the business or (in the case of an actual bankruptcy) from the sale of assets go to you before they go to shareholders.
The vast majority of bond offerings are rather staid investments. You give your money to a government or corporation. You receive a steady flow of income, usually twice a year, for a certain number of years. Then, typically after a few years, you get your original money back. Sometimes you pay taxes. A broker usually takes a cut.
The vast majority of bond offerings are rather staid investments. You give your money to a government or corporation. You receive a steady flow of income, usually twice a year, for a certain number of years. Then, typically after a few years, you get your original money back. Sometimes you pay taxes. A broker usually takes a cut.
Bond investing has a reputation for safety, not only because bonds provide steady and predictable streams of income, but also because as a bondholder you have first dibs on the issuer’s money. A corporation is legally bound to pay you your interest before it doles out any dividends to people who own company stock.
Bonds
Determining the true value of a bond investment, and how much you’re really going to get out of it in the end, requires three levels of research. You could compare it to buying a home. Shopping for a home, here are the three levels of research you conduct:
Level one: You notice the curb appeal. You take note of the size of the home and whether or not you find it attractive.
Below are three descriptions of specific types of bonds you might invest in: repos, treasury strips, and savings bonds for education. Umpteen different kinds of debt securities are issued by the U.S. Treasury.
Savings bonds, which can be purchased for small amounts and, until recently, came in certificate form (making for nice, if not slightly deceptive, bar mitzvah and birthday gifts), are but one kind.
Perhaps because the municipal bond market is made up mostly of individuals rather than institutional buyers, the number of sharks in fancy suits out to rip the hide off unwary investors is highest in the muni bond market. Buyer beware! Some people have paid markups on individual bonds in some cases exceeding a full year’s interest.
Bonds
About 99 percent of the approximately $15 trillion in outstanding Treasury debt is made up not of savings bonds but of marketable (tradable) securities known as bills, notes, and bonds. This “bills, notes, and bonds” stuff can be a little confusing because technically they are all bonds.
They are all backed by the full faith and credit of the U.
Like the I bonds, Treasury Inflation-Protected Securities (TIPS), introduced in 1997, receive both interest and a twice-yearly kick up of principal for inflation. As with interest on other Treasury securities, interest on TIPS is free from state and local income taxes. Federal income tax, however, must be coughed up each year on both the interest payments and the growth in principal.
Stocks can generate returns in two ways: They can appreciate in value and they can pay dividends. Historically, dividends have actually accounted for the lion’s share of stock returns. Not long ago, however, dividends fell out of favor, reduced to a pittance throughout the 1980s and 1990s.
But in the past few years, they’ve come raging back into vogue.
An outfit called RiskMetrics offers a new, easier way of comparing investment risk. Instead of using standard deviation (the most common way of measuring risk), the folks at RiskMetrics have come up with a scale that allows for a much simpler understanding of risk.
Check out the RiskMetrics tool on the Nasdaq website.
Bonds
Diversifying with bond funds isn’t the easiest thing in the world. Many bond funds have minimums, often in the $1,000 to $10,000 range. And exchange-traded funds, even though they have no minimums, often carry trading fees. In other words, if you haven’t got a fair chunk of change, building a diversified bond portfolio can be a challenge.
Most mutual bond funds are open-ended, and some are not. The closed-end funds are a universe unto themselves. Unlike open-end funds, closed-end funds have a finite number of shares. The price of the fund does not directly reflect the value of the securities within the fund. Nor does the yield directly reflect the yield of the bonds in the basket.
Although relatively new, exchange-traded funds (ETFs) and bond ETFs have caught on big in the past several years. ETFs, like closed-end funds, trade on the exchanges like individual stocks. (Yes, even the bond ETFs trade that way.)
You usually pay a small brokerage fee ($10 or so) when you buy and another when you sell.
Unlike ETFs, the underlying investments (bonds, commodities, what have you) in exchange-traded notes are not necessarily owned by the issuer of the ETN.
Although they sound alike, exchange-traded notes (ETNs) and exchange-traded funds (ETFs) are hugely different. ETNs, which trade just like ETFs or individuals stocks, are debt instruments.
A unit investment trust (UIT) is a bundle of securities handpicked by a manager. You buy into the UIT as you would an actively managed mutual fund. But unlike the manager of the mutual fund, the UIT manager does not actively trade the portfolio.
Rather, he buys the bonds (or in some cases, bond funds), perhaps 10 or 20 of them, and holds them throughout the life of the bonds or for the life of the UIT.
Yield-to-maturity and yield-to-call are two ways of measuring a bond’s yield. Other ways of measuring return are coupon yield, current yield, and the 30-day SEC yield. It’s a good idea to look up and understand each of these terms.
Yield-to-maturity
A much more accurate measure of return, although still far from perfect, is the yield-to-maturity.
With hundreds upon hundreds of bond funds to choose from, each representing a different basket of bonds, where do you start? That part is actually easy: You start with the particular class of bonds you want to own. Treasuries? Corporate bonds? Munis? Long-term? Short-term? Investment-grade? High-yield? A blend of all of the above?
Emerging market bond funds are not for the faint of heart. If you're willing to deal with the volatility, emerging market bond funds — made up of bonds from countries such as Russia, Brazil, Mexico, and Turkey — offer excellent return potential.
Fidelity New Markets Income Fund (FNMIX)
Contact: 800-544-6666; Fidelity
Type of fund: Actively run mutual fund
Types of bonds: Emerging market, mostly government, with some corporate issues; the majority are U.
Bonds
Very short-term, high-quality bond funds are going to pay slightly higher rates of interest than money market funds and CDs but less than longer-term bond funds. They carry very little risk of default and have minimal volatility. Sometimes referred to as near-cash, these bond funds are often the best investments for money that you may need to tap within one to three years.
Target-Retirement date funds (otherwise known as life-cycle funds) are an easy option, best if you have limited funds ($10,000 or less) or a real aversion to dealing with your investments. Like the Vanguard STAR Fund, these funds give you the whole ball of wax. Bonds, stocks, and sometimes commodities are all rolled up into one simple fund.
What Modern Portfolio Theory is talking about is diversification: combining an investment (stocks or bonds) that zigs with another that zags, and possibly a third that zogs. In the investment realm, diversification is your very best friend.
Most investment pros are familiar with something called Modern Portfolio Theory.
Peer-to-peer lending is the new kid on the fixed-income block. If you haven’t checked out Prosper.com or LendingClub, you may want to do so. Even if you decide not to invest, you’ll likely find the cybertrip fascinating. These sites are something like eBay for cash. (They have some similarities to Match.com, too.
When comparing different kinds of bonds — or any investments, for that matter — it helps to know the standard deviation. This is the most oft-used measure of risk when comparing investments.
What does it mean? An investment with a standard deviation of, say, 3 will give you a return that is within one standard deviation (in this case, 3 percentage points) of the mean about two-thirds of the time.
There are newer ways of thinking about how much of a retirement portfolio belongs in bonds. Most financial pros have moved well beyond the old adage, held dearly for years, that the percent of your portfolio held in bonds should be equal to your age. (By age 60, you should be 60 percent in bonds; by age 70, 70 percent; and so on.
Ultimately you can’t know the exact total return of any bond investment until after the investment period has come and gone, even though bonds are called fixed-income investments, and even though bond returns are easier to predict than stock returns. That’s true for bond funds, and it’s also true for most individual bonds (although many die-hard investors in individual bonds refuse to admit it).
Yield is what you want in a bond. Yield is income. Yield contributes to return. Yield is confusion! People (including overly eager bond salespeople) often misuse the term or use it inappropriately to gain an advantage in the bond market.
Don't be a yield sucker! Understand what kind of yield is being promised on a bond or bond fund, and know what it really means.
Bonds
Just as maturity is a major consideration when choosing a Treasury, it should also be a big consideration when choosing corporate bonds. In general (but certainly not always), the longer the bond’s maturity, the higher its interest rate will be because your money will potentially be tied up longer.
And the longer the maturity, the greater the volatility of the price of the bond should you wish to cash out at any point.
No definitive line exists between investment-grade and high-yield bonds, sometimes known as junk bonds. But generally, if a bond receives a rating less than a Baa from Moody’s or a BBB from Standard & Poor’s, the market considers it high-yield.
High-yield bonds offer greater excitement for the masses. The old adage that risk equals return is clear as day in the world of bonds.
Bond laddering is a fancy term for diversifying your bond portfolio by maturity. Buy one bond that matures in two years, another that matures in five, and a third that matures in ten, and — presto! — you have just constructed a bond ladder.
Why bother? Why not simply buy one big, fat bond that matures in 30 years and will kick out regular, predictable coupon payments between now and then?
Appropriately weighing potential risk and return is what good investing is all about, really. As for the risk and return on corporate bonds, the potential return (always something of a guessing game) is quoted in terms of yield, and there are many kinds of yield.
One of the most oft-quoted kinds of yield, used for example by The Wall Street Journal and most other business papers, is the yield-to-maturity.
Bonds
Diversifying your bonds is still a very good idea. As you know, some stocks can double or triple in price overnight, while others can shrink into oblivion in the time it takes to say “CEO arrested for fraud.” Unless you are investing in individual high-yield bonds (not a good idea), your risk of default — and the risk of your investment shrinking to oblivion — is minimal.
Municipal bonds, like corporate and federal government bonds, are rated by the major bond-rating agencies. For many years, munis had their own rating system. Recently, however, the rating systems have been unified.
You definitely want munis that are rated. Some municipal offerings are not rated, and these can be risky investments or very illiquid (you may not be able to sell them when you want, if at all).
The first rule to follow when choosing a bond fund is to find one appropriate to your particular portfolio needs, which means finding a bond fund made of the right material.
Select your fund based on its components and their characteristics
It you’re looking for a bond fund that’s going to produce steady returns with little volatility and very limited risk to your principal, start with a bond fund that is built of low-volatility bonds issued by credit-worthy institutions.
Will you never pay federal tax on a municipal bond? Never say never. In some very rare instances, the tax can grab you from behind and make you not want to wake up on the morning of April 15.
AMT tax on municipal bonds
The alternative minimum tax (AMT) is a federal tax that exists in a parallel universe, which you enter unwillingly when you make a fair chunk of change, claim too many exemptions, or take too many deductions.
There may be a few instances where precision in payment isn’t your main motivation to buy an individual bond rather than tap into a bond fund. If any of the following scenarios apply to you, individual issues may make sense:
You meet a bond broker extraordinaire. If you find a bond broker who is so talented in the ways of bond trading that she can do for you what a bond fund manager can do, only better, then go for it.
Lots of people today, including stock and bond brokers, call themselves financial planners. A good suggestion is that if you hire a financial planner, you seriously consider a fee-only planner, who takes no commissions and works only for you. To find one in your area, contact the National Association of Personal Financial Advisors (NAPFA) or call 847-483-5400.
Who or what issues agency bonds? The answer to that question is more complex than you may imagine. This article will help you sort it out.
A few common agencies
Following are just some of the many agencies that issue bonds:
Federal Farm Credit Banks (FFCB)
Federal Home Loan Banks (FHLB)
Federal Home Loan Mortgage Corporation (FHLMC)
Federal National Mortgage Association (FNMA)
Financial Assistance Corporation (FAC)
Financing Corporation (FICO)
General Services Administration (GSA)
Government National Mortgage Association (GNMA)
Government Trust Certificates (GTC)
Private Export Funding Corporation (PEFCO)
Resolution Funding Corporation (REFCORP)
Small Business Administration (SBA)
Tennessee Valley Authority (TVA)
U.
To put it bluntly, corporate bonds can be something of a pain in the pants, especially when compared to Treasury bonds. Here’s what you need to worry about when investing in corporate bonds:
The solidity of the company issuing the bond: If the company goes down, you may lose some or all of your money. Even if the company doesn’t go down but merely limps, you can lose money.
Like the corporations that issue corporate bonds, the entities (cities, hospitals, universities, and so on) that issue municipal bonds are of varying economic strength — although the degree of variance isn’t quite as large as it is in the corporate world.
Despite all the talk about a collapse looming over the muni market, municipal downfalls have been few.
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