Archive for May, 2011
Buying Bonds?
Sunday, May 1st, 2011
Your choices range from conservative to speculative
Along with stocks and cash, bonds are one of the key building blocks of a diversified portfolio. While historically bonds have offered lower total returns than stocks, they can provide a reliable, steady income stream. What’s more, bond prices have often increased when stock prices have fallen, making them potentially useful for diversification purposes. Let’s review the main categories of bonds and briefly discuss the pros and cons of each.
Talking Treasuries
Bonds are available with a variety of risk/reward characteristics. At the low end of the risk spectrum are Treasury and government agency bonds. These securities are backed by the “full faith and credit” of our federal government. Consequently, they’re thought to have virtually no risk of default. Because of their relative safety, Treasuries offer lower yields than most other bonds.
Treasuries are perhaps the most sensitive bonds to swings in interest rates. Rates and bond prices move in opposite directions, and interest rates are near all-time lows. That means if rates rise appreciably — for example, in response to rising inflation — Treasury prices could fall significantly.
However, Treasuries can be an effective hedge against financial upheaval. This point was driven home in 2008, when Treasuries stood virtually alone — even among bonds — as investments that delivered positive returns. Although profits are never guaranteed, this “flight to safety” feature is worth considering when structuring your portfolio.
Mentioning munis
Municipal bonds (munis) are issued by state and local governments, as well as their agencies and authorities. These bonds generally are exempt from federal income taxes and in some cases state income taxes. Because of their tax-exempt status, munis tend to offer lower yields than even U.S. Treasuries. That said, for investors in high tax brackets, munis can produce better returns than comparable taxable securities after the tax benefits are factored in.
While municipal bonds are debt obligations of cities and towns, they don’t have the full faith and credit of the U.S. government behind them. Moreover, the recession has pushed many state and local government budgets nearly to the breaking point. Consequently, munis are a market where you should carefully assess the quality and risk of any potential purchases.
Concentrating on corporates
Corporate bonds are debt securities issued by corporations. As you might expect, corporate debt runs the gamut from the very highest-rated securities, issued by financially solid firms, such as Exxon Mobil and Microsoft, to low-rated bonds floated by companies that are struggling to stave off bankruptcy. Corporate bonds rated BBB or higher are considered investment-grade; those below that level are high yield or “junk” bonds.
As their name implies, high yield bonds offer significantly higher levels of income than investment-grade debt. The prices of junk bonds can be extremely volatile, though, as investors discovered in 2008. Moreover, there is significant risk of default, especially as you move down into lower-rated issues.
Investigating international bonds
This category includes foreign sovereign bonds in developed markets (the foreign equivalent of U.S. Treasuries), international corporate bonds and emerging market bonds. Investing in foreign bonds introduces some new risks and opportunities, including currency risk. For example, if you purchased a German government bond that carries a 5% yield but the euro depreciates by 5% against the dollar, you’re back to a break-even return. By the same token, currency movements can sometimes provide a tail wind.
Investors in foreign bonds also are subject to the credit risk of the countries issuing the bonds. Greece and other eurozone countries made news in early 2011 because of their shaky finances, which drove the yields on their bonds up and the prices down.
It used to be a rule of thumb that emerging market bonds carried significantly higher risk than those issued by developed markets. However, recent events have blurred this distinction, as many emerging markets have become more financially and politically stable, and some developed economies have deteriorated.
The right bond portfolio for you
What’s evident from this brief survey is that bonds are a multi-faceted market. You should approach bonds the same way you would stocks, matching exposure to the various categories according to your risk tolerance, time horizon and other criteria.
SIDEBAR: Bond funds vs. individual bonds
For practical purposes, two primary avenues exist for investing in bonds. You can buy individual bonds or purchase a product that pools the capital of a group of investors, such as a bond fund or an exchange-traded fund (ETF).
Bond funds and ETFs have the advantages of being easy to buy and sell, offering more diversification in a single portfolio and having low investment minimums. They also offer a way to buy bonds that would be difficult for individual investors to purchase on their own, such as bonds from emerging market issuers.
That said, individual bonds offer one key advantage: They have a specific maturity date on which your principal must be returned. Even if interest rates have risen and the price of the bond has fallen since it was purchased, your principal is repaid in full at maturity —barring a default, of course.
By contrast, bond funds and ETFs have no particular maturity date on which you’re entitled to a return of your principal.
Courtesy of PDI Global. © 2011