Bond Investing For Dummies book cover

Bond Investing For Dummies

Author:
Russell Wild
Published: August 28, 2012

Overview

Your friendly guide to trading the bond and bond fund market

Bonds and bond funds are among the safest and most reliable investments you can make to ensure an ample and dependable retirement income—if you do it right! Bond Investing For Dummies helps you do just that, with clear explanations of everything you need to know to build a diversified bond portfolio that will be there when you need it no matter what happens in the stock market.

This plain-English guide clearly explains the pros and cons of investing in bonds, how they differ from stocks, and the best (and worst!) 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.

  • Covers the ups and downs of today's market, which reinforces the importance of bonds in a portfolio
  • Explains how a radical fall in interest rates make bond investing trickier than ever
  • Explores the historic downgrade of U.S. Treasuries and its possible effects on government bonds

If you're an investor looking for a resource that helps you understand, evaluate, and incorporate bonds into your portfolio, Bond Investing For Dummies has you covered.

Your friendly guide to trading the bond and bond fund market

Bonds and bond funds are among the safest and most reliable investments you can make to ensure an ample and dependable retirement income—if you do it right! Bond Investing For Dummies helps you do just that, with clear explanations of everything you need to know to build a diversified bond portfolio that will be there when you need it no matter what happens in the stock market.

This plain-English guide clearly explains the pros and cons of investing in bonds, how they differ from stocks, and the best (and worst!) 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.

  • Covers the ups and downs of today's market, which reinforces the importance of bonds in a portfolio
  • Explains how a radical fall in interest rates make bond investing trickier than ever
  • Explores the historic downgrade of U.S. Treasuries and its possible effects on government bonds

If you're an investor looking for a resource that helps you understand, evaluate, and incorporate bonds into your portfolio, Bond Investing For Dummies has you covered.

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.

Articles From The Book

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Bonds Articles

How to Invest for the Future

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. For now, the pertinent question is this: Just how far along are you toward achieving your nest-egg goal?

Estimate how much you’ll need

Please think of how much you will need to withdraw from your nest egg each year when you stop getting a paycheck. Whatever that number is ($30,000? $40,000?), multiply it by 20. That is the amount, at a minimum, to have in your total portfolio when you retire. (Or even 25 times, preferably.)

Now multiply that same original-year withdrawal figure ($30,000? $40,000?) by 10. That is the amount, at a minimum, to have in fixed-income investments, including bonds, when you retire. We’re assuming here a fairly typical retirement age, somewhere in the 60s. If you wish to retire at 30, you’ll likely need considerably more than 20 times your annual expenses (or else very wealthy and generous parents).

Assess your time frame

Okay. Got those two numbers: one for your total portfolio, and the other for the bond side of your portfolio at retirement? Good. Now how far off are you, in terms of both years and dollars, from giving up your paycheck and drawing on savings?

If you’re far away from your goals, you need lots of growth. If you currently have, say, half of what you’ll need in your portfolio to call yourself economically independent, and you are years from retirement, that likely means loading up (to a point) on stocks if you want to achieve your goal. Vroom vroom.

If you’re closer to your goals, you may have more to lose than to gain, and stability becomes just as important as growth. That means leaning toward bonds and other fixed-income investments. Slooow down. For those of you far beyond your goals (you already have, say, 30 or 40 times what you’ll need to live on for a year), an altogether different set of criteria may take precedence.

Factor in some good rules

No simple formulas exist that determine the optimal allocation of bonds in a portfolio. That being said, there are some pretty good rules to follow. Here are a few:
  • Rule #1: You should keep three to six months of living expenses in cash (such as money market funds or online savings bank accounts like EmigrantDirect.com) or near-cash. If you expect any major expenses in the next year or two, keep money for those in near-cash as well.

    When you read near-cash, think about CDs or very short-term bonds or bond funds.

  • Rule #2: The rest of your money can be invested in longer-term investments, such as intermediate-term or long-term bonds; or equities, such as stocks, real estate, or commodities.

  • Rule #3: A portfolio of more than 75 percent bonds rarely, if ever, makes sense. On the other hand, most people benefit with some healthy allocation to bonds. The vast majority of people fall somewhere in the range of 70/30 (70 percent equities/30 fixed income) to 30/70 (30 percent equities/70 fixed income).

    Use 60/40 (equities/fixed income) as your default if you are under 50 years of age. If you are over 50, use 50/50 as your default. Tweak from there depending on how much growth you need and how much stability you require.

  • Rule #4: Stocks, a favorite form of equity for most investors, can be very volatile over the short term and intermediate term, but historically that risk of loss has diminished over longer holding periods. Over the course of 10 to 15 years, you are virtually assured that the performance of your stock portfolio will beat the performance of your bond-and-cash portfolio — at least if history is our guide.

    It shouldn’t be our only guide! History sometimes does funny things. Most of the money you won’t need for 10 to 15 years or beyond could be — but may not need to be — in stocks, not bonds.

  • Rule #5: Because history does funny things, you don’t want to put all your long-term money in stocks, even if history says you should. Even very long-term money — at the very least 25 percent of it — should be kept in something safer than stocks.

Bonds Articles

The Interest Rate Risk in Bond Investing

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. Beginning and end of story. The reason for bonds’ staid status is not only that they provide steady and predictable streams of income, but also that 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. 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. However, bonds offer no ironclad guarantees. First dibs on the money aside, bonds are not FDIC-insured savings accounts. They are not without some risk. For that matter, even an FDIC-insured savings account — even stuffing your money under the proverbial mattress! — also carries some risk. Interest rates go up, and interest rates go down. And whenever they do, bond prices move, almost in synch, in the opposite direction. Why? If you’re holding a bond that pays 5 percent, and interest rates move up so that most new bonds are paying 7 percent, your old bond becomes about as desirable to hold as a pet scorpion. Any rational buyer of bonds would, all things being equal, choose a new bond paying 7 percent rather than your relic, still paying only 5 percent. Should you try to sell the bond, unless you can find a real sucker, the price you are likely to get will be deeply discounted. The longer off the maturity of the bond, the more its price will drop with rising interest rates. Thus long-term bonds tend to be the most volatile of all bonds. Think it through: If you have a bond paying 5 percent that matures in a year, and the prevailing interest rate moves up to 7 percent, you’re looking at relatively inferior coupon payments for the next 12 months. If you’re holding a 5 percent bond that matures in ten years, you’re looking at potentially ten years of inferior coupon payments. No one wants to buy a bond offering ten years of inferior coupon payments unless she can get that bond for a steal.

That’s why if you try to sell a bond after a period of rising interest rates, you take a loss. If you hold the bond to maturity, you can avoid that loss, but you pay an opportunity cost because your money is tied up earning less than the prevailing rate of interest. Either way, you lose.

Of course, interest rate risk has its flip side: If interest rates fall, your existing bonds, paying the older, higher interest rates, suddenly start looking awfully good to potential buyers. They aren’t pet scorpions anymore — more like Cocker Spaniel puppies. If you decide to sell, you’ll get a handsome price. This “flip side” to interest rate risk is precisely what has caused the most peculiar situation in the past three decades, where the longest-term Treasury bonds (with 30-year maturities) have actually done as well as the S&P 500 in total returns. The yield on these babies has dipped from over 14 percent in the early 1980s to just a little over 3 percent today. Hence, those old bonds, which are now maturing, have turned to gold. Will this happen again in the next 30 years? Not unless long-term Treasuries in the year 2042 are being issued with a negative 8 percent interest rate. Of course, that isn’t going to happen. More likely, interest rates are going to climb back to historical norms. Interest rate risk has perhaps never been greater than it is today. You would be foolish to put your money into 30-year Treasuries and assume that you are going to get 11.5 percent a year annual return, as some very lucky investors have done over the last 30 years. Chances are, well . . . anything can happen over 30 years, but keep your expectations modest, please.

Bonds Articles

The Reinvestment Risk in Bond Investing

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. Beginning and end of story. The reason for bonds’ staid status is not only that they provide steady and predictable streams of income, but also that 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. 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. However, bonds offer no ironclad guarantees. All investments carry some risk, such as reinvestment risk. When you invest $1,000 in, say, a 20-year bond paying 6 percent, you may be counting on your money compounding every year. If that is the case — if your money does compound, and you reinvest all your interest payments at 6 percent — after 20 years you’ll have $3,262. But suppose you invest $1,000 in a 20-year bond paying 6 percent and, after four years, the bond is called. The bond issuer unceremoniously gives back your principal, and you no longer hold the bond. Interest rates have dropped in the past four years, and now the best you can do is to buy another bond that pays 4 percent. Suppose you do just that, and you hold the new bond for the remainder of the 20 years. Instead of $3,262, you are left with $2,387 — about 27 percent less money. This is called reinvestment risk, and it’s a very real risk of bond investing, especially when you buy callable or shorter-term individual bonds. Of course, you can buy non-callable bonds and earn less interest, or you can buy longer-term bonds and risk that interest rates will rise. Tradeoffs! Tradeoffs! This is what investing is all about.

Note that one way of dealing with reinvestment risk is to treat periods of declining interest rates as only temporary investment setbacks. What goes down usually goes back up.