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| The Basics | Why every portfolio needs bonds
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There are plenty of reasons to buy bonds: Preserving capital, a modest rate of return, a means of income, and with municipal bonds, no taxes.
By Dan Akst
Everybody knows that in the long run, nothing beats stocks. So why on earth would anyone buy a bond?
Plenty of reasons. A Treasury bond, to cite the safest of the breed, means absolute capital preservation and a predictable, if modest, rate of return. A portfolio of bonds means income on which to live. Municipal bonds, when you take taxes into account, can sometimes compete nicely with stocks. And if interest rates go down, you might even get some capital gains out of your bonds.
What is a bond?
A bond is simply an IOU that investors can buy and sell. Purists will say its a long-term loan, meaning at least five years, but for purposes of our discussion well lump bills, notes and other shorter-term debt securities together. All of them have a fixed maturity date and pay interest until the principal comes due or the bond is called by the issuer.
Taken together, these fixed income securities make up a surprisingly large marketplace. In most years, corporate debt issuance far exceeds new stock sales. The federal, state and local governments issue billions of dollars in additional debt annually. The Treasury alone has created more than $4 trillion of direct U.S. government debt. Foreign governments and corporations also issue bonds, with the result that the global fixed-income market is gigantic.
Why bonds are a good buy
The main reasons for buying a bond are relative safety of principal and the yield. The yield is a function of the coupon, or the dollar amount of interest to be paid at preset times, and the price of the bond. Since the coupon is fixed -- at, say, $50 a year -- the yield would be fixed, too, if the price of the bond did not fluctuate. But then who would buy a bond with a yield of 5% when interest rates in general are at 10%? No one, which is why the price of that bond goes down when interest rates go up. By selling for a lower price, the yield becomes attractive to new buyers. Note that the market price in this case is different than the face amount, which is the amount of the initial borrowing.
Normally, the longer a bonds term, the higher its yield. Bond mavens often speak of the shape of the markets yield curve. This is simply shorthand for the relationship of short-term and long-term rates as expressed by plotting yields on the y-axis of a graph and maturities on the x-axis. Usually, this curve is rising, but an inverted yield curve moves downward.
The zero coupon
Another kind of bond worth noting here is a zero coupon. This is a bond that sells at a deep discount to face value; the catch is that the bond pays nothing until it comes due. The bond does rise in price as the time to maturity gets shorter, and Uncle Sam considers this interest for tax purposes. Zeros can be useful if youre planning for some predictable future event, such as your childs education. You can buy zeros that mature when your kids enter college and know that the right amount will be there when you need it.
Finally, there are convertible bonds. These act like regular bonds but can be converted into shares of the issuing company when the stock hits a certain price. Thus, they offer the advantages of a bond and the chance to profit from the stock. The down side is that you usually must accept a lower yield in exchange for convertibility.
The matter of safety
Unlike stock, which represents an ownership share of a company, bonds are simply IOUs, and you are a creditor -- one who has priority over stockholders in the event things go sour. Thus, people are often attracted to bonds for safety, but its important to understand the risks. These are of two basic kinds: credit risk and market risk.
Credit risk is easy to understand. It refers to the possibility that the bond issuer fails to pay what is owed. Needless to say, this is bad news, but you can minimize this risk in several ways. Treasury securities, for instance, are considered to be without credit risk. As for other bonds, look for the ratings given most issues by Moodys Investors Service, Standard & Poors, or another major rating firm. Triple A is the highest rating, and it goes down from there through single A, various Bs, Cs and even, from some services, Ds. Bonds with ratings through BBB (this is Baa from Moodys) are considered investment grade, while lower rated debt is known as junk bonds.
Always diversify
Diversification is another way to reduce credit risk. Holding bonds from more issuers across many industries or governments adds safety. Diversification is what makes junk bonds less scary; a diversified portfolio of low-grade debt means that even if one or two bond issuers fail to pay, the high yields offered by the others can more than compensate.
Another layer of safety for municipal bonds comes in the form of insurance provided by such firms as Ambac Inc. The issuer pays a premium, which is factored into the bonds price, and the insurer promises to pay bondholders if the issuer doesnt. Some people consider insurance to be overkill in a diversified municipal bond portfolio or mutual fund, and insured bonds usually yield slightly less than comparable uninsured debt.
Market risk is the chance that interest rates could soar, driving down the value of your bond. If you hold the bond to maturity, this might not bother you, since you get all your money back then, but in the interim you will have to make do with, say, 3% when newer bonds of comparable quality and duration offer perhaps 6%.
You can reduce market risk by owning a series of bonds of staggered durations, a practice known as laddering. Lets say youre ready to retire and, seeking income, want to invest $100,000 in bonds. Sticking to Treasuries for simplicitys sake, you would divide your money into 10 equal parts and buy 10 separate issues, each maturing a year later than the last, so that in every year for the next decade youd have $10,000 coming due and ready for reinvestment at current rates. Each time, youd buy a 10-year bond.
Another risk for bondholders is inflation, which erodes the buying power of that fixed yield youre stuck with, and also reduces the value of the fixed sum you get back when the bond matures. If you think inflation is about to come roaring back, stick to short-term debt securities or the new inflation-adjusted Treasury securities.
What about taxes?
Taxes are an especially important consideration with bonds. If your stocks go up, you pay no taxes until you sell. But bonds produce income that may be taxable as you collect it. Municipal bonds are attractive because they are free of federal taxes, and if you buy bonds issued by your own state, theyre free of state income taxes as well. (Treasury securities are only free of state taxes.) Thus, people in high tax brackets find municipals attractive. Are they good for you? Figure out your marginal tax rate -- the rate you pay on the next dollar of income -- and subtract this number from 1. Then divide a given municipal yield by the result to determine the taxable equivalent. For someone in the 30% bracket in 2002 and 2003 who is considering a 6% muni, the calculation looks something like this:In other words, that 6% muni gives you the same bang as a taxable issue paying about 8.6%, very possibly with less risk. Same-state investors with a 40% marginal rate would get the equivalent of 10% -- roughly the average historical return on stocks.
How to buy bonds
The basic choice here is between owning individual bonds and investing in a mutual fund consisting of many bonds.
Owning individual bonds can reduce market risk, since you can always hold on until maturity and (one hopes) get your money back. Owning a bond fund can reduce credit risk, because a good fund is diversified and careful about the bonds it picks. On the other hand, a rise in interest rates can reduce the value of your holdings, and there is no fixed maturity date for the entire fund. (Unit investment trusts do have a fixed maturity date.) As with stocks, bond funds offer convenience, professional management and instant diversification. They come in all flavors, including investment grade, junk, municipal and global.
You can buy Treasury bonds directly through the Federal Reserve or through a bank. Corporate and municipal bonds are usually purchased through brokerage firms or bond dealers.
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