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Many people believe they won't need bond investments until they retire and want steady income. However, bonds can play an important role in almost any investment portfolio.
Not only can they provide high, current income potential, but they may provide investment diversification*, helping to reduce a portfolio's overall volatility. Here are some of the basics you'll need to know about bonds before you invest.
What are bonds?
A bond is essentially a negotiable IOU, or debt security, issued by governments and government agencies, corporations and municipalities. When you buy a bond, you are lending money (principal) to that entity (issuer) for a certain period of time (term).
In exchange, the issuer promises to repay the principal on the maturity date and you receive a series of fixed interest payments. Usually the rate cannot change, which is why bonds are called "fixed-income" securities.
A bond is not designed to appreciate in value; however, its market value may rise or fall depending on economic conditions.
The Impact of Interest Rates on Bonds
If you hold a bond until maturity, you will receive its full face value (principal). Until then, the market value of the bond may fluctuate, usually because of the rise and fall of interest rates. The quality rating of the bond and availability in the marketplace play lesser roles in determining its value.
Bonds generally become more valuable when interest rates fall and less valuable when interest rates rise. Here's why:
- If you sell a bond before its maturity date and interest rates have fallen since your initial purchase, investors are interested in buying your bond because it has a higher interest rate than currently available in the marketplace. So the value of your bond has gone up.
- If you sell a bond before its maturity date and interest rates have risen since your initial purchase, your bond now has a lower interest rate than what is currently available in marketplace. Consequently, other investors know they won't make as much money with your bond, so they are not willing to pay as much for it. Thus, your bond has declined in value.
This effect is usually more pronounced for longer-term securities. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
The maturity — the length of time that the issuer has before repaying the principal — also affects the interest rate of the bond. Bond maturities can range from:
- Short-term: Less than one year
- Intermediate-term: Between 1 and 10 years
- Long-term: Greater than 10 years
In general, longer-term bonds offer higher interest rates to compensate investors for the added uncertainty of tying up their money for a long time at a fixed interest rate that may or may not be competitive as time goes by.
Types of Bonds
Bonds are characterized by type of issuer, as well as credit quality (the assessment of the bond issuer's financial condition) and length of maturity.
U.S. Government Bonds
Bonds issued by the U.S. Treasury are considered lower risk debt instruments because they are guaranteed by the full faith and credit of the U.S. government as to timely payment of principal and interest if held to maturity. Guarantee only applies to the timely payment of principal and interest and does not pertain to the portfolio, mutual fund, or variable annuity holding such securities. Values will fluctuate, and upon redemption, share values may be worth more or less than the original investment.They include Treasury bills, notes and bonds (characterized by their length to maturity).
In addition, federal agencies issue bonds with lesser guarantees, such as mortgage-backed Ginnie or Fannie Maes. Because government bonds are considered lower risk investments, their yields and total returns tend to be slightly lower than those of other bonds.
Bonds issued by corporations, both U.S. and international, are rated according to the quality of their credit rating. The most highly rated bonds will carry designations between AAA and BBB. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.
Bond credit ratings also affect the level of interest they are willing to pay investors. Lower rated bonds, called high-yield bonds, are willing to pay higher interest rates because they carry a higher degree of risk.
Corporate bonds are subject to both interest rate and credit risk. International corporate bonds carry an added degree of risk because they are affected by currency changes and foreign economic conditions in addition to interest rate and credit risk.
Municipal bonds are debt securities issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if the investor lives in the state in which the bond is issued. The municipal market can be adversely affected by tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax advisor regarding your specific situation.
Investing in Bond Mutual Funds
Bonds can be purchased individually or through bond mutual funds. Although bond funds may pay higher yields than other fixed income investments (sometimes due to the fact that it may contain a high proportion of less-than-investment grade bonds [so called "junk bonds"]), it does not negate the fact that the market value of all bonds fluctuate. Their net asset values are sensitive to interest rate movements (a rise in interest rates can result in a decline in value of the investment) and other factors. Therefore, upon redemption your share value may be worth more or less than your original investment. However, mutual funds may also provide many benefits including:
A professional money manager determines which bonds to buy and sell based on extensive research and analysis of economic and market conditions. With their experience, these professionals may provide a level of return that would be hard to match on your own.
By pooling your money with others, you may be able to achieve a degree of diversification among many types of bonds, maturities and risk levels that would be difficult to achieve on your own. Diversification also may help reduce the risk that one bond's poor performance may have on your investment portfolio.
A bond fund typically distributes almost all of its interest income as monthly dividends (individual bonds typically pay interest at six-month intervals). Unlike individual bonds, you can receive these dividends in cash or have them automatically reinvested.
You can easily buy and sell shares of mutual funds at any time and receive their current net asset value, which may be more or less than their original cost. Finding someone to buy your individual bond at a fair price may be more difficult.
Your bond funds can be easily transferred from one fund to another within the same "fund family" as market conditions or your investment objectives dictate.
*There is no assurance that a diversified portfolio will perform better than an undiversified portfolio, nor does it assure against market loss.
In general, the bond market is volatile. Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
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