Bonds Articles

Cheat Sheet / Updated 11-21-2023

If you want to invest in bonds, you need to know how to read the bond ratings that the big three rating companies use in order to help you select bonds in a risk-aware way. 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.

Article / Updated 09-01-2023

In a down economy, U.S. savings bonds are one of the safest investments you can make. Savings bonds are nonmarketable securities — when you purchase them, they’re registered to you and you can’t sell them to another investor. Uncle Sam offers two types of savings bonds, Series EE and Series I, which are backed by the full faith and credit of the U.S. government and are considered the safest of all investments. Here’s more info on each type: Series EE bonds: These bonds earn a fixed rate of return set by the U.S. Treasury. They’re accrual bonds, which means the interest accumulates and is compounded semiannually (rather than being paid to the owner as it’s earned each month). If you hold one of these bonds, you receive the interest when you redeem the bonds. Series I bonds: The interest you earn from I bonds comes in two parts: A fixed-rate component established when you purchase the bond A second component that’s equal to the rate of inflation, adjusted semiannually (based on the consumer price index for March and September) Although the fixed-rate interest component for Series I bonds is low, these bonds help protect you against inflation. If inflation goes up, so does the interest rate you earn because the variable-rate portion is adjusted every six months; for example, when the fixed-rate component is 2 percent and the inflation adjustment is 5 percent, an investment in a Series I bond is guaranteed to return 7 percent. But remember, the total interest rate can also go down as the inflation adjustment decreases. For both bonds, the purchase limit is $5,000 per Social Security number for each calendar year. You can easily purchase and redeem the bonds in electronic format through the Department of the Treasury’s Web site. If you purchase the bonds electronically, you can get any denomination of $25 or more, including penny increments. The purchase price is equal to the face value. You can also purchase the bonds in paper form through various financial institutions and payroll savings plans. Paper I bonds are offered in denominations of $50, $75, $100, $200, $500, $1000, and $5,000; they’re purchased for their face value. However, you can get paper versions of EE bonds at half their face value; they’ll be worth face value at maturity. Paper EE bonds are offered in denominations of $50, $75, $100, $200, $500, $1000, $5,000, and $10,000. The interest on both bonds compounds semiannually for 30 years, but you don’t have to hold the bonds for that long. You can redeem the bonds after 12 months, but you pay a three-month interest penalty if you redeem the bonds within five years of the purchase date. As for tax treatment, U.S. savings bonds are exempt from state and local income tax. Federal income tax on interest earned can be deferred until redemption or final maturity, whichever occurs first. Tax benefits are available when you use the bonds for education purposes.

Article / Updated 08-07-2023

Returns on savings bonds are so low that they’ll never make you rich. In fact, returns are so low that large pension funds and other big investors don’t purchase savings bonds. However, for many individuals, savings bonds are the best approach for saving money. Factors favoring savings bond are that you can Save automatically. Employers who sponsor savings bond programs can automatically deduct amounts you designate from your paychecks to purchase bonds. Diversify your risk. If you already have investments in stocks and bonds, you may want to invest in savings bonds. Doing so adds a no-risk element to your investment portfolio. End up with a safe investment. In exchange for a low return, savings bonds offer absolute safety for the principal investment; they’re absolutely no-risk investments. Avoid paying any sales commission. Investing in saving bonds doesn’t require the services of a broker to help you purchase them. Invest minimal amounts. The minimum investment in a savings bond is $25. If you subscribe to an employer-sponsored program, the minimum amount you pay each week can be even lower. Pay no or low taxes. The difference between the purchase price and the redemption value of Series EE bonds and the payment made on HH bonds comes in the form of interest. Interest income is subject to federal income tax but not state or local income taxes. You can defer paying federal income tax on the interest until you cash in the bonds. Gain educational tax benefits. The Education Bond Program allows interest to be completely or partially excluded from federal income tax when the bond owner pays for qualified higher education expenses at an eligible institution or state tuition plan in the same calendar year the bonds are redeemed. Disadvantages of savings bonds include the fact that you Face penalties for early redemption. If you cash in your Series EE bonds after you’ve held them for six months, you’ll pay three months’ worth of interest — ouch! Series EE and Series I bonds cease paying interest after 30 years. Need to be careful when you redeem your bonds. Make sure that you know when interest is posted. If you redeem a bond right before interest is posted, you won’t reap your interest payment. If you redeem your bond early on in the same month that interest is posted, you may lose six months’ worth of interest. Sometimes you can spend and save at the same time. At BondRewards, you can shop online at your favorite stores (more than 150 online stores participate in the program) and receive a small percentage of your purchase price in the form of a U.S. Savings Bond. Check in your safe-deposit box or among the papers of elderly relatives for old bonds. More than $2 billion in savings bonds never have been redeemed.

Cheat Sheet / Updated 08-02-2023

You may think of bonds as thoroughly modern financial instruments, but they have a long history. They played an important part in helping the Allies win World War II, for example. Every bond needs to be identified, which is where its CUSIP comes in. When you reach a certain age, the government requires that you begin withdrawing at least some money from your accounts, and you need to pay close attention to this, because if you don’t cash out the minimum amount, big fines are levied.

Article / Updated 06-20-2023

One of the hottest debates among investors — one that will never end — is whether actively managed investments are any wiser than index fund investments. The simple answer is usually no, they are not. The vast majority of index investors do better than the vast majority of active investors. Although various studies show various results, none contradicts the basic premise that indexing works, and works very well. When you look at bond funds in particular, however, things get a bit muddled. On one hand, bond index funds are way cheaper than actively managed bond funds, just as stock index funds are cheaper than actively managed stock funds. But because bond funds tend to yield more modest returns, costs are more important. A fund made up of bonds that collectively yield 5 percent that costs 1 percent to hold suddenly yields 4 percent; that's a difference in your return of one-fifth. But there's another side to the story, explains Matthew Gelfand, PhD, CFA, CFP, managing director and senior economist with Rockefeller Financial. Despite the cost/yield equation, which Gelfand doesn't deny for a second is very important, he argues that active management of bonds can make sense — in fact, it makes very good sense, because bonds are so much more complicated than stocks. "There are many, many more bonds and kinds of bonds than there are stocks on the market," says Gelfand. "The analyst coverage is much more sparse. Although more and more trading now is through electronic markets via the web, trading is still mostly over-the-counter, so bid/ask spreads remain wider than in stock markets. All this makes for a less 'efficient' market and allows for good active managers to add real value," he says. "If you can find a reasonably priced, well-managed active bond fund, it stands a better chance of outperforming a bond index fund." There's certainly nothing wrong with passively managed (index) bond mutual funds or exchange-traded funds. They can, and often do, make excellent investments. Still, handpicking the right actively managed bond fund, if you do so smartly, can juice the returns of your fixed-income portfolio, with limited additional risk.

Article / Updated 09-15-2022

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. 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 tax risk. When comparing taxable bonds to other investments, such as stocks, some investors forget to factor in the potentially high cost of taxation. Except for municipal bonds and bonds kept in tax-advantaged accounts, such as an IRA, the interest payments on bonds are generally taxable at your income-tax rate, which for most people is in the 25 to 28 percent range but could be as high as 35 percent . . . and, depending on the whims of Congress, may rise higher. In contrast, stocks may pay dividends, most of which (thanks to favorable tax treatment enacted into law just a few years back) are taxable at 15 percent. If the price of the stock appreciates, that appreciation isn’t taxable at all unless the stock is actually sold, at which point, it’s usually taxed at 15 percent. So would you rather have a stock that returns 5 percent a year or a bond that returns 5 percent a year? From strictly a tax vantage point, bonds lose. Paying even 25 percent tax represents a 67 percent bigger tax bite than paying 15 percent. (Of course — getting back to the whims of Congress — these special rates are also subject to change.) Tax risk on bonds is most pronounced during times of high interest rates and high inflation. If, for example, the inflation rate is 3 percent, and your bonds are paying 3 percent, you are just about breaking even on your investment. You have to pay taxes on the 3 percent interest, so you actually fall a bit behind. But suppose that the inflation rate were 6 percent and your bonds were paying 6 percent. You have to pay twice as much tax as if your interest rate were 3 percent (and possibly even more than twice the tax, if your interest payments bump you into a higher tax bracket), which means you fall even further behind. Inflation is not likely to go to 6 percent. But if it does, holders of conventional (non-inflation-adjusted) bonds may not be happy campers, especially after April 15 rolls around.

Article / Updated 09-14-2022

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. 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 downgrade risk. Even if a bond doesn’t go into default, rumors of a potential default can send a bond’s price into a spiral. When a major rating agency, such as Moody’s, Standard & Poor’s, or Fitch, changes the rating on a bond (moving it from, say, investment-grade to below investment-grade), fewer investors want that bond. This situation is the equivalent of Consumer Reports magazine pointing out that a particular brand of toaster oven is prone to explode. Not good. Bonds that are downgraded may be downgraded a notch, or two notches, or three. The price of the bond drops accordingly. Typically, a downgrade from investment-grade to junk results in a rather large price drop because many institutions aren’t allowed to own anything below investment-grade. The market therefore deflates faster than a speared blowfish, and the beating to bondholders can be brutal. On occasion, downgraded bonds, even those downgraded to junk (sometimes referred to as fallen angels), are upgraded again. If and when that happens (it usually doesn’t), prices zoom right back up again. Holding tight, therefore, sometimes makes good sense. But bond ratings and bond prices don’t always march in synch. Consider, for example, that when U.S. Treasuries were downgraded by Standard & Poor’s in 2011 from an AAA to an AA rating, the bonds did not drop in price but actually rose, and rose nicely. Why? In large part, it was because of the credit crisis in Europe and the realization of Japan’s rising debt. In other words, although the United States appeared to be a slightly riskier place to invest vis-à-vis other nations, it actually started to look safer.

Cheat Sheet / Updated 09-01-2022

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.

Article / Updated 08-16-2022

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.

Article / Updated 08-03-2022

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.