Understanding the Bond Market

As markets become volatile, many investors turn to bonds as an alternative to stocks. While bonds can play an integral role in a well-diversified portfolio, investors should fully understand their characteristics before investing. Bonds are often deemed a "safe" investment. However, investors need to be aware that bonds, like all investments, do carry some risk, and those risks need to be considered carefully.

Bond Fundamentals

If you are considering purchasing, or have already purchased, bonds for your portfolio, you should understand that not all bonds are created equal. While they are all considered debt instruments, bonds are created by different entities for very different purposes and carry varying risks and tax-related liabilities. Simply put, bonds are issued by companies and government bodies to fund their day-to-day operations or to finance specific projects. When an investor buys a bond, he or she is, in fact, loaning money for a certain period of time to the issuer of the bond. In return for loaning funds, investors receive the principal amount back, with interest, at the time the bond comes due or "matures."

A bond's face value, or the price at issue, is known as its "par value," and the interest payment is known as its "coupon." The price of bonds will fluctuate, similar to stocks, throughout the trading day. However, with most bonds, the coupon payment will stay the same (some floating-rate securities do exist). If an investor purchases a bond in the secondary market at the face value, the bond is considered to be sold at "par." If a bond's price is above its face value, it is sold at a premium. If a bond's price is below face value, it is sold at a discount.

Understanding Yields

As previously mentioned, the coupon rate is the interest rate paid on a bond. This amount is expressed as a percent of par value (normally $1,000). For example, a 4% coupon would indicate that the annual interest paid on the bond is $40. The current yield rate indicates the current rate of return an investor will receive on each dollar invested, without any adjustments for differences between the purchase price and the maturity value. The current yield rate is useful when comparing current yields on various income investments. The yield to maturity rate indicates the overall rate an investor will earn, including adjustments for any differences between the purchase price and the $1,000 maturity value.

The yield to call rate indicates the overall rate an investor will earn, including adjustments for any differences between the purchase price and the call price, in the event the bonds are called by the issuer. It is important that investors make note of the yield to maturity and yield to call on any bonds they are considering purchasing.

Laddering

Investors can never be completely certain as to where yields on bonds are headed. A popular way for investors to help balance risk and return in a bond portfolio is to utilize a technique called laddering. To build a laddered portfolio, investors purchase a collection of bonds with different maturities spread out over their investment time frame. By staggering maturities, investors may be able to reduce the impact that changes in interest rates can have on their portfolio.

For example, an individual who wishes to create a laddered portfolio could purchase bonds that mature each year during a span of ten years. By using a rollover strategy as well, when the first bond matures, the investor could reinvest those funds in a bond that matures in ten years. As each bond matures, the investor would continue this process. After ten years, the investor would own all ten-year bonds, with one maturing every year. By laddering the bond portfolio, an investor can worry less about fluctuations in interest rates. If interest rates rise, he or she will soon have money available, from a maturing bond, to take advantage of a new bond. If interest rates should fall, then the investor has at least managed to secure higher rates for a portion of the portfolio. This strategy can also be used with certificates of deposit (CDs).

The Effect of Taxes

Many investors find municipal bonds attractive because of their tax advantages. However, it is important for investors to compare the tax-advantaged bonds to taxable investments in order to determine the best investment for their situation.

In order to compare rates of return on investments, it is helpful to adjust the tax-free rates to their "taxable equivalent" rates. This is the taxable rate that would have to be earned in order to net the same tax-free rate, after paying federal income taxes. To calculate the taxable equivalent rate, simply divide the tax-free rate by one minus your federal tax bracket rate. For example: Assuming an investor's federal marginal tax bracket is 28% and an investment offers a tax-free rate of 4%, the taxable equivalent rate would be 5.56% (4% /1-.28 = 5.56%).

Based on this calculation, the investor would have to earn 5.56% on an investment that was subject to federal income taxes to net the same 4% that the tax-free investment offered.

Knowing the Risks

While the income generated by bonds is generally "fixed," the same is not true for a bond's return. There are many risks that may affect a bond's return.