COLUMN:

Bond Investment Strategies

Bonds are an integral part of a well-diversified portfolio, but with over 100,000 different options, how can you pick the ones that best complement your investment strategy? It’s wise to include several bonds in the fixed-income portion of your portfolio, each with different features based on your risk tolerance level. Following are descriptions of the two major categories.

Corporate Bonds

Corporations issue bonds to raise capital for a variety of purposes. These bonds give businesses the ability to purchase new equipment, fund projects, build new offices, reduce outstanding debt obligations and meet other goals. When investors purchase corporate bonds, they are lending money to the corporation with the promise that the company will repay the principal investment at a specified time and date, known as the maturity date.

Corporations also pay interest to bond holders, generally on a semiannual basis. The interest rate is based upon the bond’s credit rating. Bond ratings identify the financial stability and strength of the issuers. Rating agencies apply a series of financial tests that may change a bond’s rating over time as the issuer’s ability to make interest and principal payments changes. Generally, the higher a bond’s rating, the lower its yield. This is because a higher rated bond is more likely to pay interest and principal payments on time than a lower rated bond. Therefore, investors will accept lower returns on their investment if their principal and interest payments are considered safe. Bonds with lower ratings often pay higher interest rates to compensate for their higher risk of default.

Government Bonds

Safety of principal is one of the primary benefits of investing in government bonds, which include treasury bills, notes and municipal bonds. They provide a way for the federal, state or local government to raise capital to pay for certain projects.

If the bonds are issued at the federal level, they are backed by the “full faith and credit” of the United States of America, and are therefore debt obligations of the U.S. government. Issuance of U.S. government bonds is determined by the U.S. Treasury Department, and the quantity and type of government securities issued reflect federal budget needs. In general, the marketplace determines the interest rates these securities pay. The interest government securities pay is exempt from state and local taxes, but is subject to federal taxation.

When investors purchase municipal bonds, they are loaning money to fund projects that often impact their daily lives. For example, the proceeds of municipal bonds frequently are used to improve schools, highways, housing, sewer systems and other major public projects. State and local bonds are issued by municipalities and backed by the specific city or town’s financial stability; therefore, they are secondary to U.S. government bonds with regard to safety of principal.

What makes government bonds different from corporate bonds are the tax advantages. Unlike corporate bonds whose interest payments are taxable at ordinary income tax levels, government bonds provide favorable tax advantages. Interest on municipal bonds is often free from federal and state income taxes if the investor resides in the state of issuance. Interest on issues of the federal government (treasury bills, notes and bonds) is taxed by the federal government, but is exempt from taxation at the state and local levels. Because of their tax advantages, U.S. government and municipal bonds usually pay lower interest rates than corporate issuers.

Investors should be aware of the tax equivalent yield when assessing the merits of U.S. government and municipal bond investments. In general, tax-free investments are more suitable for investors in high tax brackets and are not as advantageous for investors in low tax brackets.

Risk Factors

As with most investments, bonds carry certain risks. Therefore, it is prudent for you to carefully analyze your choices before making a decision.

Credit risk and default risk take into account the likelihood that the bond issuer will meet its financial obligations. You can evaluate issuers by examining their bond rating. These ratings are done by private, professional agencies that review issuers’ financial health and assess their ability to make the promised principal and interest payments. The ratings help you make educated decisions by determining which bonds fall within your level of risk tolerance.

Purchasing power risk, also known as inflationary risk, considers how inflation affects the value of bonds. Inflation reduces the purchasing power of your money. Because it can decrease the future value of dollars, it is advantageous for you to purchase bonds that are likely to outpace inflationary rates.

Call risk refers to the likelihood that a bond will be called back before maturity. Not all bonds have a call feature, and it’s a good thing to know before you make a purchase. A call feature usually is executed when interest rates are falling. When it is exercised, the issuer pays the investor the face value of the bond and reissues another bond with a lower interest rate.

Interest rate risk applies if you were to sell a bond before it matures. When you buy and hold the bond until it matures, aside from the return of your principal payment, you also should receive the interest rate that’s stamped on the face of the bond. If you sell the bond before it matures, however, current interest rates may be higher, thus lowering the attractiveness of your bond to new investors.

Buying bonds from different issuers with different maturity dates can help manage interest rate risk and protect the fixed-income portion of your portfolio. Also, having a mix of corporate, government and municipal bonds may reduce the possibility of losses in a particular market sector.

When considering which bonds to purchase, investors will have to weigh the features, benefits and risk factors, and take the time to decide which bond best complements their investment strategy.

Travis Lee Kikuchi is a wealth manager at Lee Financial Group, 2756 Woodlawn Drive, Suite 6-201, in Manoa. His phone number is 988-8088. This column provides general information only; it is not intended to replace recommendations you would receive from your financial advisor, who is most familiar with your portfolio and investment philosophy.

back to top

© Copyright Generations Hawaii. Designed by Trade Publishing