To achieve your financial goals, it's important to allocate your assets in a way that creates a diversified portfolio. Many investors use bonds as the foundation of their balanced portfolios because bonds offer a wide range of maturities (duration periods), interest payment terms and credit quality that fits most investors' needs.

Back to Basics: What is a Bond?

In its simplest terms, a bond is an IOU. It represents a loan by you (as one the bondholders) to an issuer (a corporation, municipality of government agency). Bondholders lend money to the issuer in return for the promise of fixed periodic payments of interest and the repayment of the loan's principal amount at maturity. However, if you need to sell a bond before its maturity date, the price you receive may be more or less than your original price or the bond's maturity value.

Since a bond's interest rate is fixed when you buy it, a change in interest rate will affect the value of your bond if you were to sell it prior to its maturity For example, if you bought a $10,000 bond with an 8% coupon and interest rates dropped from 8% to 4%, your bond would become more valuable than those subsequently issued at lower interest rates. Therefore, prior to maturity you could sell your bond at a premium to its face value. On the other hand, if rates rose to 12%, investors would want to own new issues that pay more interest, and your bond would lose some of its resale value. If you sold it under this scenario, it would be at a discount.

Evaluating Bond Risks and Returns

In assessing the level of risk and return of any fixed income investment, the following two factors are important.

Maturity. Your bond's maturity is the date on which the principal amount becomes due and payable to you. The number of years until the bond matures will dictate the bond's sensitivity to changes in interest rates. Generally, you are compensated with higher yields for longer-term securities because the longer a bond has until it matures, the longer its principal value is exposed to interest rate fluctuations. Bonds with short-term maturities (overnight to one year) normally experience relatively minimal change in price as interest rates fluctuate, but they also typically provide relatively lower yields. Intermedia bonds (2 to 10 years) typically have greater yields and price fluctuations. Long-term bonds, which typically mature in 20 to 40 years, usually have higher yields but can also experience greater price fluctuations.

Quality. The credit quality rating of a bond provides an indication at a particular point in time of an issuer's ability to make timely payments of interest and principal to bondholders. Two nationally recognized rating agencies, Standard & Poor's corporation and Moody's Investors Service, measure a bond's credit quality by assigning it a letter grade, ranging from AAA for the highest quality to D for a bond in default. Bonds rated at least BBB by S&P or Baa by Moody's are considered "investment grade." Lower-quality bonds generally have higher yields but also have a greater potential for default. Ratings are constantly revised based on related industry or company changes and can have a distinct effect on a bond's market price.

Your challenge as a bond investor is to obtain the highest possible return with the least risk, in line with your investment objectives. Many fixed income investors "ladder" their bond investments by structuring a portfolio of bonds with staggered maturities. By diversifying investments in short-term, intermediate and long-term bonds in a ladder portfolio, you can take advantage of the liquid aspects of the shorter-term bonds while attaining the higher yields typically available through longer-term bonds.

This article does not constitute tax or legal advice. Consult your tax or legal advisors before making any tax-related or legally related investment decisions. This article is published for general information purposes and is not an offer or solicitation to sell or buy any securities or commodities. Any particular investment should be analyzed based on its terms and risks as they relate to your circumstances and objectives.

[ Learn More About William J. Berrall | Check Out Our Message Boards |
Back to Experts' Advice | Ask A Question ]