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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.
View ArticleArticle / 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.
View ArticleCheat 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.
View Cheat SheetArticle / 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.
View ArticleArticle / 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.
View ArticleArticle / 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. 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.
View ArticleArticle / Updated 07-06-2021
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. Jean and Raymond are public school teachers, and both will retire (he in two years, she in four) with healthy traditional pensions. Together, those pensions, combined with Social Security, should cover Jean and Raymond’s living expenses for the rest of their lives. The couple will also likely bring in supplemental income from private tutoring. Jean’s mother is 90. When Mom passes away, Jean, an only child, expects to receive an inheritance of at least $1.5 million. Mom’s money is invested almost entirely in bonds and CDs. So what should Jean and Raymond do with the $710,000 they’ve socked away in their combined 403(b) retirement plans? Jean and Raymond are in the catbird seat. Even if they were to invest the entire $710,000 nest egg in stocks, and even if we were to see the worst stock market crash in history, Jean and Raymond would likely still be okay. The couple certainly doesn’t need to take the risk of putting their money in stocks because they don’t need to see their portfolio grow to accomplish their financial goals. But given their pensions, is investing in stocks really that risky? No. If Jean and Raymond want to leave a large legacy (to their children, grandchildren, or charity), a mostly stock portfolio may be the way to go. Because equities tend to be so much more lucrative than fixed income in the long run, a greater percentage in equities would likely generate more wealth for future generations. Ignoring for the moment a slew of possibly complicating factors from the simple scenario above, they should feel comfortable with an aggressive portfolio: perhaps two-thirds in equity (stocks and such) and one-third in fixed income (bonds and such). It’s not what most people think of as appropriate for an aging couple, but it makes a whole lot of sense, provided Jean and Raymond are fully on board and promise not to cash out of stocks (as many investors do) the first time the market takes a dip. Kay, 59, hoping only for a simple retirement Kay, divorced twice, earns a very modest salary as a medical technician. She scored fairly well in her last divorce. Thanks to a generous initial cash settlement, as well as having made a good profit on the sale of her last home, Kay has a portfolio of $875,000. Kay doesn’t hate her work, but she isn’t crazy about it, either; she would much rather spend her days doing volunteer work with stray animals. After careful analysis, she figures that she can live without her paycheck quite comfortably if she pulls $45,000 a year from savings. Her children are grown and self-sufficient. Kay’s example illustrates why simple formulas (such as your age = your proper bond allocation) don’t work. Kay is roughly the same age as Jean in the previous example. And Kay, like Jean, is financially comfortable. But it would be a big mistake for Kay to take the same risks with her money. Unlike Jean, Kay does not have a spouse. Nor does Kay have a pension. And unlike Jean, Kay is not expecting a big inheritance. Kay can't afford to lose any significant portion of her nest egg. She is dependent on that nest egg to stay economically afloat. At her current level of savings and with a fairly modest rate of growth in her portfolio, Kay should be able to retire comfortably within four to five years. In Kay’s case, she has more to lose than to gain by taking any great risk in the markets. On the other hand, if things work out as she plans, Kay may be spending 30 or more years in retirement. So an all fixed-income portfolio, which could get gobbled up by inflation, won’t work. In Kay’s case, depending on her tolerance for risk, a good recommendation would be a portfolio of 50 to 55 percent stocks and 45 to 50 percent bonds, as shown. Juan, 29, just getting started Three years out of business school with an MBA, Juan, is single and happy in his city condo. And he's earning an impressive and growing salary. But because he has been busy paying off loans, he has just started to build his savings. Juan’s 401(k) has a balance of $3,700. Juan is another example of why simple formulas don't work. He should probably tailor his portfolio to look something like Jean and Raymond’s, despite the obvious differences in age and wealth. Juan is still many years off from retirement and doesn’t see any major expenses on the horizon. His budding 401(k) is meant to sit and grow for a very long time — at least three decades. History tells us that a portfolio made up of mostly stocks will likely provide superior growth. Of course, history is history, and we don’t know what the future will bring. So it would still be a good idea to allocate 20 to 25 percent bonds to Juan’s portfolio. Before moving any money into stocks or bonds, however, Juan would want to set aside three to six months’ worth of living expenses in an emergency cash fund, outside of his 401(k), just in case he should lose his job, have serious health issues, or face some other unforeseen crisis. Miriam, 53, plugging away Never married, with no children, Miriam wants to retire from her job as a freelance computer consultant while still young enough to fulfill her dreams of world travel. Her investments of $75,000 are growing at a good clip, as she is currently socking away a full 20 percent of her after-tax earnings — about $20,000 a year. But she knows that she has a long way to go. Miriam is right; she has a long way to go. To fulfill her dreams of world travel, Miriam needs considerably more than a nest egg of $75,000. In this case, the bond allocation question is a tough one. Miriam needs substantial growth, but she isn’t in a position to risk what she has, either. Cases like Miriam’s require delicate balance. She should most likely opt for a starting portfolio of mostly stocks and about 25 to 30 percent bonds, but as Miriam gets closer to her financial goal in coming years, she could up that percentage of bonds and take a more defensive, conservative position.
View ArticleArticle / Updated 07-01-2021
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. But interest rates are almost as unpredictable as the stock market. Yes, the government has more control over interest rates than it does the stock market, but it doesn’t have complete control, and the actions it decides to take or not take are not for you to know. And furthermore, even if you could predict interest rates (which you can’t), and even if you did know that they were going to rise (which you don’t), now still is a good time to buy bonds. This is assuming, of course, that you’ve done the proper analysis, and you’ve decided that more bonds belong in your portfolio, and you have cash in hand. What do you do with it? You have three savings/investing options, really: Keep it in cash. Invest it in equities. Invest it in fixed income. If you invest in equities (stocks, real estate, commodities), you mess with your overall portfolio structure, making it perhaps too risky. If you keep cash (a savings or money market account), you earn enough interest to maybe keep up with inflation — but after taxes, probably not. In either scenario, you lose. Now, suppose you choose to go ahead and buy the bonds, and interest rates, as you feared, do rise. That isn’t necessarily a bad thing. Yes, your bonds or bond funds — especially those with long maturities — will take a hit. The value of the bonds or the price of the bond-fund shares will sink. In the long run, though, you shouldn’t suffer, and you may even benefit from higher interest rates. After all, every six months with individual bonds, and every month with most bond funds, you get interest payments, and those interest payments may be reinvested. The higher the interest rate climbs, the more money you can make off those reinvestments. Waiting for interest rates to fall — which they may or may not do — just doesn’t make sense. When interest rates are very low, as they are these days, it makes sense to lean your bond portfolio more toward the short-intermediate side than the long-term. Yes, you’ll get a lesser yield, but you’ll take a softer punch when interest rates do rise. A good aim normally is an average maturity in your bond portfolios of five to seven years. These days, you might accept the lower yield that comes with a bond portfolio with an average maturity of three to five years. Don’t pay too much attention to the yield curve Another difficult decision for bond investors putting in fresh money occurs at those rare times in history when we see an inverted yield curve. The yield curve refers to the difference between interest rates on long-term versus short-term bonds. Normally, long-term bonds pay higher rates of interest. If the yield curve is inverted, that means the long-term bonds are paying lower rates of interest than shorter-term bonds. That situation doesn’t happen often, but it happens. The reasons for the yield curve are many and complex, and they include inflation expectations, feelings about the economy, and foreign demand for U.S. debt. Whatever the reasons for an inverted yield curve, it hardly makes sense to tie up your money in a long-term bond when a shorter-term bond is paying just as much interest or possibly a slight bit more. Or does it? Some financial planners disagree, but it’s not always a bad idea to invest in longer-term bonds even when the yield curve is a slight bit inverted. Remember that a large reason you’re investing in bonds is to have a cushion if your other investments (such as stocks) take a nosedive. When stocks plunge, money tends to flow (and flow fast) into investment-grade bonds, especially Treasuries. Initially, the “rush to safety” creates the most demand for short-term bonds, and their price tends to rise. Over time, however, a plunge in the stock market often results in the feds lowering interest rates (in an attempt to kick-start the economy), which lifts bond prices — especially the price of longer maturity bonds. In other words, long-term Treasuries are your very best hedge against a stock market crash. Consider another reason for investing in longer-term bonds, even if they aren’t paying what short-term bonds are paying. What if interest rates drop, regardless of what’s going on in the stock market? Sometimes interest rates fall even when the stock market is soaring. If that’s the case, once again, you may wish that you were holding long-term bonds. Adhere — or not — to dollar-cost averaging Instead of throwing all your money into a bond portfolio right away, some people say it makes more sense to buy in slowly over a long period of time. As the argument goes, you spread out your risk that way, buying when the market is high and when the market is low. And if you invest equal amounts of money each time, you tend to buy more product (bonds or fund shares) when the market is low, potentially adding to your bottom line. This approach to investing is called dollar-cost averaging. Dollar-cost averaging makes some sense if you are taking freshly earned money and investing it. If you have an existing pool of cash, however, it simply doesn’t make sense. The cash you leave behind will be earning too little for the whole scheme to make any sense. If you have a chunk of money waiting to be invested, and you have an investment plan in place, go for it. Buy those bonds you were planning to buy. There’s no reason to wait for just the right moment or to buy in dribs and drabs.
View ArticleArticle / Updated 06-29-2021
About 98 percent of the approximately $5 trillion in outstanding Treasury debt is made up not of savings bonds but of marketable (tradable) securities known as bills, notes, and bonds. Technically, bills, notes, and bonds are all bonds. They are all backed by the full faith and credit of the U.S. government. They are all issued electronically (you don’t get a fancy piece of paper as you do with savings bonds). They can all be purchased either directly from the Treasury or through a broker. They can all trade like hotcakes. The major difference among them is the time you need to wait to collect your principal: Treasury bills have maturities of a year or less. Treasury notes are issued with maturities from two to ten years. Treasury bonds are long-term investments that have maturities of 10 to 30 years from their issue date. The bills, like savings bonds, are sold at a discount from their face value. You get the full amount when the bill matures. The notes and bonds, on the other hand, are sold at their face value, have a fixed interest rate, and kick off interest payments once every six months. The minimum denomination for all three is $1,000, and you can buy them all in any increment of $1,000. Keep in mind that you don’t have to hold any of these securities (bills, notes, or bonds) till maturity. You can, in fact, cash out at any point. The longer until the maturity of the bond, however, the more its price can fluctuate and, therefore, the more you risk losing money.
View ArticleArticle / Updated 03-16-2021
You can invest in bonds in one of two major ways: You can purchase individual bonds, or you can invest in a professionally selected and managed portfolio of bonds via a bond mutual fund or exchange-traded fund. If you want to take the individual-bond route, that path is covered here, where you learn how to decipher bond listings you find in financial newspapers or online. Also learn about the purchasing process for treasuries (a different animal in that you can buy them directly from the government) and all other bonds. Decide between individual bonds and bond funds Unless the bonds you’re considering purchasing are easy to analyze and homogeneous (such as Treasury bonds), you’re generally better off investing in bonds through a mutual fund or exchange-traded fund. Here’s why: Diversification is more difficult with individual bonds. You shouldn’t put your money into a small number of bonds of companies in the same industry or that mature at the same time. It’s difficult to cost-effectively build a diversified bond portfolio with individual issues, unless you have a substantial amount of money ($1 million) that you want to invest in bonds. Individual bonds cost you more money. If you purchase individual bonds through a broker, you’re going to pay a commission. In most cases, the commission cost is hidden—the broker quotes you a price for the bond that includes the commission. Even if you use a discount broker, these fees take a healthy bite out of your investment. The smaller the amount that you invest, the bigger the bite—on a $1,000 bond, the commission fee can equal several percent. Commissions take a smaller bite out of larger bonds—perhaps less than 0.5 percent if you use discount brokers. On the other hand, investing in bonds through a fund is cost-effective. Great bond funds are yours for less than 0.5 percent per year in operating expenses. Selecting good bond funds isn’t hard. You’ve got better things to do with your time. Do you really want to research bonds and go bond shopping? Bonds are boring to most people! And bonds and the companies that stand behind them aren’t that simple to understand. For example, did you know that some bonds can be called before their maturity dates? Companies often call bonds (which means they repay the principal before maturity) to save money if interest rates drop significantly. After you purchase a bond, you need to do the same things that a good bond mutual fund portfolio manager needs to do, such as track the issuer’s creditworthiness and monitor other important financial developments. Understanding bond prices Business-focused publications and websites provide daily bond pricing. You may also call a broker or browse websites to obtain bond prices. The following steps walk you through the bond listing for PhilEl (Philadelphia Electric) shown in the figure below: Bond name: This column tells you who issued the bond. In this case, the issuer is a large utility company, Philadelphia Electric. Funny numbers after the company name: The first part of the numerical sequence here—7-1⁄8—refers to the original interest rate (7.125 percent) that this bond paid when it was issued. This interest rate is known as the coupon rate, which is a percent of the maturity value of the bond. The second part of the numbers—23—refers to the year that the bond matures (2023, in this case). Current yield: Divide the interest paid, 7.125, by the current price per bond, $93, to arrive at the current yield. In this case, it equals (rounded off) 7.7 percent. Volume: Volume indicates the number of bonds that traded on this day. In the case of PhilEl, 15 bonds were traded. Close: This shows the last price at which the bond traded. The last PhilEl bond price is $93. Change: The change indicates how this day’s close compares with the previous day’s close. In the example figure, the bond rose 2-1⁄8 points. Some bonds don’t trade all that often. Notice that some bonds were up and others were down on this particular day. The demand of new buyers and the supply of interested sellers influence the price movement of a given bond. In addition to the direction of overall interest rates, changes in the financial health of the issuing entity that stands behind the bond strongly affect the price of an individual bond. Purchasing treasuries If you want to purchase Treasury bonds, buying them through the Treasury Direct program is the lowest-cost option. Call 800-722-2678 or visit the U.S. Department of Treasury’s website. You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through Treasury Direct requires you to transfer the bonds to a broker. The advantage of a fund that invests in treasuries is that it typically holds treasuries of differing maturities, thus offering diversification. You can generally buy and sell no-load (commission-free) Treasury bond mutual funds easily and without fees. Funds, however, do charge an ongoing management fee. How to shop for other individual bonds Purchasing other types of individual bonds, such as corporate and mortgage bonds, is a much more treacherous and time-consuming undertaking than buying treasuries. Here’s my advice for doing it right and minimizing the chance of mistakes: Don’t buy through salespeople. Brokerage firms that employ representatives on commission are in the sales business. Many of the worst bond-investing disasters have befallen customers of such brokerage firms. Your best bet is to purchase individual bonds through discount brokers. Don’t be suckered into high yields—buy quality. Yes, junk bonds pay higher yields, but they also have a much higher chance of default. Nothing personal, but you’re not going to do as good a job as a professional money manager at spotting problems and red flags. Stick with highly rated bonds so you don’t have to worry about and suffer through these consequences. The 2020 COVID-19 financial market meltdown clobbered lower-rated bonds. Did you know what a subprime mortgage was before 2007, when stories of rising defaults were all over the news? Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default. Understand that bonds may be called early. Many bonds, especially corporate bonds, can legally be called before maturity. In this case, the bond issuer pays you back early because it doesn’t need to borrow as much money or because interest rates have fallen and the borrower wants to reissue new bonds at a lower interest rate. Be especially careful about purchasing bonds that were issued at higher interest rates than those that currently prevail. Borrowers pay off such bonds first. To buffer changes in the economy that adversely affect one industry or a few industries more than others, invest in and hold bonds from a variety of companies in different industries. Of the money that you want to invest in bonds, don’t put more than 5 percent into any one bond; that means you need to hold at least 20 bonds. Diversification requires a good amount to invest, given the size of most bonds and because trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond mutual fund or exchange-traded fund. Shop around. Just like when you buy a car, shop around for good prices on the bonds that you have in mind. The hard part is doing an apples-to-apples comparison because different brokers may not offer the same exact bonds. Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating. Unless you invest in boring, simple-to-understand bonds such as treasuries, you’re better off investing in bonds via the best bond mutual funds. One exception is if you absolutely, positively must receive your principal back on a certain date. Because bond funds don’t mature, individual bonds with the correct maturity for you may best suit your needs. Consider treasuries because they carry such a low default risk. Otherwise, you need a lot of time, money, and patience to invest well in individual bonds.
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