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The ABCs of Investing: Rediscovering Bonds

March 2009

Bond Certificate

As veteran financial planner Bruce A. Weininger notes in a brilliant critique of the wealth management con-game, only two categories proved their worth in the crash of ’08: cash (particularly in the form of CDs) and high-quality bonds. You didn’t have to be only in CDs and Treasuries to make money in bonds in 2008. Many managers who stayed with high-quality short and intermediate-term municipal bonds also posted positive returns in 2008.

High quality bonds, CDs and cash worked successfully to protect portfolios, while all other types of diversification failed, because these fixed-income investments provide one all-important benefit that other investments do not: safety of principal. It is time for investors, no matter what their wealth or age, to rediscover fixed-income investing.

This article will review some web and print resources that will take you from the basics to setting up and managing your first bond portfolio.

ABCs of Investing: Discovering Bonds

With a global markets stumbling, investors are searching for safe havens. Traditionally bonds have provided that haven in most portfolios. They can be especially useful tools for everything from saving for a child's college education to preparing for your first retirement years. They are not, however, simple investments. There are many different types of bonds and bond funds and, just as with stocks and stock mutual funds, it pays to learn about the different kinds of bonds and how to use them most effectively.

Bonds play a major structural role in a well-diversified portfolio. In fact, bonds are the classic portfolio diversifier. Bond prices tend to move in the opposite direction of stock market swings, because bonds are fundamentally different from other investments. Unlike stocks, commodities and real estate, bonds (and their close cousins, certificates of deposit or CDs) provide protection of principal and a defined return. Adding bonds to a portfolio can dramatically reduce volatility (the dreaded swings), without sacrificing much return. Yet many investors ignore bonds because the language of the bond market seems foreign and because the media “talking heads” rarely say anything about these quiet, useful portfolio servants.

For many years investment professionals advised individuals to match the percentage of your portfolio in bonds to your age. So someone who is 65 should have 65% of their investment portfolio in bonds and cash. Even younger investors can benefit from holding at least 20% to 30% of their long-term investment portfolio in bonds. And money that will likely be needed within one to five years should always be in CDs, savings accounts and short term bonds. Sadly, the go-go stock market years caused many to abandon this useful rule in search of higher returns.

Learning the Language of Bonds

Bonds are a form of debt. A company might, for example, decide to finance a planned business expansion by selling stock, or it might choose to raise money by issuing bonds. A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it “matures,” or comes due. Typically, the issuer of the bond will pay interest to the bondholder every six months until the bond matures. Most bonds are issued in $1,000 denominations (the par value), with fixed interest payments (the coupon). Once the bond has been issued, it then trades on the open market and the price of the bond can go up or down. Bonds trading at prices below $1,000 are said to be trading “below par value” or at a “discount,” while bonds trading at prices above $1,000 are trading at a premium to their par value.

Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are two basic types of bond yields you should be aware of: current yield and yield to maturity. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at $1,000 and the interest rate is 8% ($80), the current yield is 8% ($80 $1,000). If you bought at $900 and the interest rate is 8% ($80), the current yield is 8.89% ($80 $900).

Yield to maturity, which is considered more meaningful, tells you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons (or interest payments). To learn more about the language of bonds, be sure to explore this wonderful introduction from the Securities Industry and Financial Markets Association.

Different Types of Bonds

The main types of bonds are government bonds (issued by national governments, states and municipalities), government-backed bonds (such as those issued by mortgage giants Fannie Mae and Freddie Mac), corporate bonds, and securitized debt (such as the collateralized mortgage obligations that have gotten so much recent press). Bonds vary in quality. Those issued by the governments of major developed nations, such as the US, France, Germany and the UK are generally considered the safest. Next in terms of safety come so-called “investment-grade” bonds issued by healthy corporations such as Johnson & Johnson or Proctor & Gamble. At the bottom of the heap are the aptly named “junk bonds,” or as the Wall Street marketing whizzes like to call them, “high-yield bonds”; these are bonds issued by companies with risky businesses or governments that might back out of their commitment to pay interest on their debt and go into “default” or bankruptcy.

Inflation-protected bonds (including I bonds and TIPS issued by the US Treasury), are a special category of bonds that increase interest payments to keep pace with changes in the consumer price index. Inflation protected bonds can be particularly valuable in retirement accounts and other long term portfolios with time horizons of 20 or 30 years since the biggest problem bond investors face is staying ahead of inflation.

Buying Individual Bonds

Bonds can be bought individually or in the form of bond funds. Online investors can buy individual bones through discount brokers and many brokers have special help lines that can give investors guidance as they search through the hundreds of different bonds held in the brokers’ inventory. Just as with stocks, one should diversify bond holdings. It is dangerous to hold too many bonds issued by companies in the same industry, or to concentrate all of one’s bond investments in one’s home state (despite the tax advantages). Even Treasury bonds can decline in price if inflation spikes, or investors begin to move out of “safe havens” into riskier investments, such as stocks.

A properly diversified bond portfolio should include a minimum of 10 or more different bonds in different categories. This poses a special problem for smaller investors, since most bonds are issued with a face value of $1000, but are bought and sold in minimum lots of 10 identical bonds, meaning a commitment of about $10,000 for each bond investment. Some discount brokers, including giants Fidelity and Schwab, allow investors to buy bonds in smaller “odd lots.” Sometimes even single bonds can be purchased online. Unfortunately, the firms that allow odd-lot bond purchases typically charge a hefty mark-up that makes these bonds much more expensive than comparable bonds bought in lots of 10 or 20. It can be very difficult for the novice investor to know what the markup is, whether it is fair or whether the marked-up individual bond is even close to a reasonable value.

But if you have $100,000 to $200,000 to invest in a bond portfolio and can buy bonds in lots of 10 to 20, individual bonds are a good alternative to bond funds since you are likely to get back your original investment at maturity. Further, you know exactly what you own and are in complete control of the amount of risk, whereas with a fund, the manager is in charge and may be tempted to take on risks of which you are not aware.

For investors just starting out with only small amount to invest, US savings bonds have been traditionally a great way to save since they can be bought in amounts as small as $25. It’s easy to buy treasury bonds online at the US Treasury Department’s site. You can learn about bond market investing and compare the interest you will earn on different Treasury bonds. You can even set up automatic transfers from your checking account and buy a savings bonds each month with no commission or markup. Treasuries are among the world’s safer investments, and you can mix and match different types of treasuries to fit your savings plan. Sadly, the yield on US Treasuries and savings bonds is very low and investors run the risk that the bonds they buy today will go down in value as investors around the world begin to worry about ballooning US deficits. If you hold the bonds to maturity (30 years in the case of savings bonds), you’ll get the face value returned, but the extremely low current interest rates makes these bonds unappealing at the moment. By the way, don’t be fooled by the high current interest on inflation-protected I bonds, since it includes a temporary adjustment for the big spike in oil and commodity prices in ’08. Yields on I Bonds will be adjusted down in coming quarters to reflect the dramatic recession-induced drop in inflation.

Bond Funds

Bond funds are the best alternative for 401ks or for investors with too little money to build a diversified portfolio of individual bonds. The cornerstone of any bond fund portfolio should be a broad fund that includes most of the major categories of bonds, such as US Treasuries and US corporate bonds. Because bonds historically make only a little money each year, cost is all important. Be sure to look for the funds with the lowest expense ratio and load (or commission). To compare the cost of different bond funds, use the SEC’s excellent mutual fund cost calculator.

Two other types of bond funds can be useful, especially in portfolios geared towards the very long haul (20 to 30 years). International bonds funds that invest in bonds issued by foreign governments and corporations can help protect a portfolio against declines in the value of the US dollar. Bond funds that invest in inflation-protected securities are also useful in very long term portfolios. But beware: both of these special categories of bonds are more volatile (bounce around more) than US Treasury bonds.

Learning More About Bonds

To learn more about bonds, check out these resources: Investinginbonds.com is a wonderful web site devoted to bond investing. Pimco, the world’s largest manager of bond funds has interesting articles on the outlook for global economy and the bond market.

And in print, here are two helpful books: All About Bonds, Bond Mutual Funds, and Bond ETFs, 3rd Edition by Esme Faerber is particularly helpful on how to put together a portfolio of bonds or bond funds; Bonds: The Unbeaten Path to Secure Investment Growth by Hildy and Stan Richelson, is somewhat more technical, but includes plenty of detail about the types of bonds, plus a useful section on financial planning and bond selection. Both are available new or used from Amazon.com.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.