Investing Articles |
Diversification With Bonds: The Potential Benefits And Risks
A bond is an "IOU" for money loaned by an investor to the bond’s issuer. In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate known as the "coupon rate." At the end of an agreed-upon time period — when the bond "matures" — the issuer’s objective is to repay the investor’s principal.
Benefits And Risks Of Bonds
Because bonds generally may not move in tandem with stock investments, they help provide diversification in an investor’s portfolio. They also seek to provide investors with a steady income.* Zero-coupon bonds and Treasury bills are exceptions: The interest income is deducted from their purchase price and the investor then receives the full face value of the bond at maturity. Keep in mind that the market value of zero coupon bonds fluctuates more than the regular corporate bonds; therefore, they may not be suitable for investors with liquidity needs.
*An investment in a money market fund is not insured or
guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any
other government agency. Although the fund seeks to preserve the value
of your investment at $1.00 per share, it is possible to lose money by
investing in the fund.
Individual Bonds Vs. Bond Mutual Funds |
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Because individual bonds require initial investments ranging anywhere from $1,000 to $100,000, many bond investors pursue their goals through mutual funds. Providing the professional management and diversification inherent to all funds, bond mutual funds can offer a fixed-income element to balance out a portfolio of other stock and money market investments. Investors should remember, however, that bond funds do not mature. This is critical as it means that risk to principal cannot be managed by holding these funds to maturity as with individual bonds. Also, although interest income and the principal amount invested in government bonds are guaranteed, the funds that invest in these bonds are not. While bonds are often listed second to stocks when it comes to long-term investing benefits, their variety (and, in some cases, their tax benefits) can be suitable to many investors. Keep in mind that stocks offer growth potential, but may fluctuate more and provide less current income than other investments, such as bonds. Discuss your goals with your financial professional and your tax advisor, and together you can decide whether bond investing is right for you. |
All bonds involve market risk, interest-rate risk, and inflation risk. Some bonds also present credit risk.
Market Risk — A Bond’s Value Varies With The Market
As with stocks, a bond’s value will fluctuate with changing market conditions. However, there is a big difference. The fact that bonds have maturity dates makes market risk a concern only if you decide to sell the bond before the maturity date.
In practice, therefore, if you intend to hold the bond until the maturity date (when principal and interest are generally repaid to the bondholder), current fluctuations in the bond price are normal.
However, if the bond’s price has fallen and you are forced to sell — or liquidate — a bond before it matures, then you will lose part of the principal investment as well as any future income stream.
Interest-Rate Risk — An Inverse Relationship
This is the risk that a bond’s price will fall with rising interest rates.
Interest-rate risk is common to all bonds. When interest rates rise in the economy, a bond’s price will usually drop, and vice versa.
Despite this, while past performance is not indicative of future results, bond investments have historically been more stable than their stock counterparts. Moreover, because bond investors may be concerned primarily with receiving income (instead of capital appreciation) from their bonds, they may not be as concerned with fluctuating bond prices. Many bond investors will hold their bonds until maturity, intending to receive their principal investment.
Credit Risk — Why Bonds Are Rated
Some bonds hold "credit risk," or the risk that the bond issuer will go into default before your bond reaches maturity. In that case, you may lose some or all of the principal amount invested and any outstanding income that is due. Bonds are often rated by Moody’s and Standard & Poor’s (S&P). Ratings run from Aaa (Moody’s) or AAA (S&P) through D, based on the issuer’s creditworthiness. Aaa and AAA are the highest credit ratings. Despite their negative name, "junk bonds," so called because of their lower credit ratings, are more formally known as "high-yield bonds" and are appropriate for investors who can withstand price volatility in search of higher yields. Keep in mind that high yield bonds are subject to greater risk of loss of principal and interest, including default risk, than higher rated bonds.Inflation Risk — The Downside Of Fixed Income
This is the risk that a bond’s total return will not outpace inflation. Because the "coupon" or interest payment is fixed until maturity, an inflationary environment will cause these payments to lose value relative to other investments.
The Four Major Types Of Bonds
Bonds come in a variety of forms, each bringing different benefits, risks, and tax considerations to an investor’s portfolio. Most bonds fall into one of four general categories: corporate, government, government agency, and municipal.
Corporate Bonds.
Issued by corporations, these bonds seek to provide an investor with a steady stream of income at a generally higher rate than other bonds.
Risk Considerations: Other than market and interest-rate risk, the primary risk associated with this type of bond is credit risk. Another risk with some corporate bonds is that the bond could be "called" by the issuer, who then repays the principal before the maturity date; the debt is paid ahead of time, and the investor may not be able to reinvest it at the same income stream.
Tax Considerations: All interest earned on a corporate bond will be taxed as ordinary income at your usual income tax rate. If you choose to sell a bond for profit, this "capital appreciation" will be taxed as a capital gain.
Government Bonds.
Government bonds are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government. They include intermediate- and long-term Treasury bonds. Intermediate-term bonds mature in three to ten years, whereas long-term bonds generally mature in periods of up to 30 years.
Risk Considerations: Perhaps the safest of all bond investments, these bonds have virtually no credit risk because they are guaranteed by the U.S. government. A government bond does present some inflation risk — the risk of its comparatively lower return not keeping pace with inflation. As a result, an investment could actually lose value over time.
Tax Considerations: Treasuries are fully taxable at the federal level but are exempt from state and local taxes.
Government Agency Bonds.
These bonds are indirect debt obligations of the U.S. government issued by federal agencies and government-sponsored entities. Examples of such organizations are the Federal National Mortgage Association (FNMA or "Fannie Mae"), the Government National Mortgage Association (GNMA or "Ginnie Mae"), and the Student Loan Marketing Association (SLMA or "Sallie Mae").
Risk Considerations: Next to Treasury bonds, agency and entity bonds are the second safest bonds in terms of credit risk. Because these bonds are not directly issued by the U.S. government, they are not backed by its full faith and credit. In addition to the risks inherent in government bonds, agency bonds run the risk of going into default, although such an occurrence is highly unlikely. Because of this added risk, however, these bonds generally offer the potential for higher yields than government bonds.
Tax Considerations: These bonds are fully taxable at the federal level and, in some cases, at the state and local levels as well.
Municipal Bonds.
Municipal bonds, or "munis," are issued by a U.S. state, county, city, town, village, or local authority to raise funds for general use or particular public works projects.
Risk Considerations: Munis fall somewhere in the middle of the credit risk spectrum. The risk of default can vary depending on the creditworthiness of the issuer and the type of debt obligation.
Tax Considerations: Perhaps the biggest advantage of most munis is their tax-exempt income status. Income accrues tax free at the federal level and, in most cases, at the state and local levels as well. However, investors may be subject to the Alternative Minimum Tax for certain private activity bonds. Capital gains, on the other hand, are fully taxable.
Points To Remember
- A bond is an "IOU" from an issuer to an investor.
- A bond’s issuer agrees to repay the investor the principal amount invested at the bond’s maturity date, along with regular interest payments at the bond’s stated coupon rate.
- Bond risks include market risk, interest-rate risk, credit risk, and inflation risk.
- Most bonds fall into one of four general categories: corporate, government, government agency, and municipal.
- Some investors might best pursue their fixed-income goals through bond mutual funds, although they should remember that while government bonds guarantee principal and interest, the funds that invest in them do not. Also, bond funds do not mature; therefore, risk to principal cannot be avoided by holding the bonds to maturity.
