Bond Investing Strategies
Bonds are an important part of a well-balanced portfolio. You should consider what bonds have to offer as well as strategies to build your portfolio. Bonds Deliver Income — If you are looking for a reliable source of income, you should include bonds in your portfolio. Even when interest rates are low, there are a variety of bonds that provide higher returns, such as high-yield bonds and emerging market debt. Bonds Offer Diversification — If you put all of your money into one asset class, such as stocks, your entire portfolio is at greater risk. By investing a portion of your portfolio in bonds, you will reduce your risk. Bonds can help you preserve capital when the stock market is experiencing volatility. Bonds Preserve Principal — When you are getting closer to the time you will need cash from your investments, such as within five years of retirement, you should move more money to fixed-income investments. The stock market can experience huge losses over a short period of time, but your fixed-income investments are less likely to experience large losses over the short term. Many investors increase their allocation to bonds as they move closer to their goals to preserve their principal. Bonds Offer Tax Advantages — If you are trying to reduce your tax liability, certain types of bonds can help you meet this challenge. For example, the interest earned on municipal bonds is free from federal taxes, and if you own a bond issued within the state you live in, it will also be state income tax free. While taxes shouldn’t be the only reason to invest in bonds, consider this as part of your overall financial plan. Bond Risks When investing in bonds, you need to be aware that bonds are subject to several risks, including: Interest rate risk — Interest rates and bond prices move in opposite directions. A bond’s price will rise when interest rates fall and decrease when interest rates rise. This occurs because the existing bond’s price must change to provide the same return as an equivalent, newly issued bond paying prevailing interest rates. The longer the bond’s maturity, the greater the impact of interest rate changes.
Reinvestment risk — You typically know what interest income you will receive from a bond, but you must then take the periodic income and reinvest it, usually at varying interest rates. Your principal may also mature at a time when interest rates are low.
Default and credit risk — Default risk is the risk the issuer will not be able to pay the interest and/or principal. Credit risk is the risk the issuer’s credit rating will be downgraded, which would probably decrease the bond’s value.
Call risk — Call provisions allow bond issuers to replace high-coupon bonds with lower-coupon bonds when interest rates decrease. Since call provisions are generally only exercised when interest rates decrease, you are forced to reinvest principal at lower interest rates.
Building a Bond Portfolio Based on your goals and risk tolerance, there are many strategies for building your bond portfolio. Investors who are looking for income but don’t want to be actively involved in portfolio management may want to employ a buy-and-hold approach. Investors who want more involvement, along with security and predictability, may want to look at index matching and immunization strategies. For investors who want to actively manage portfolios, search for higher returns in exchange for higher risk. Consider the following bond strategies to determine what strategy would be most comfortable for you. The four primary strategies are:
Passive Bond Strategy. With a passive bond strategy known as buy and hold, you are buying individual bonds and holding them until maturity. The bond’s coupon rate is the amount of interest income earned each year based on the face value of the bond, and its yield is the estimated rate of return, assuming it is held until its maturity date. The cash generated by bonds can be used for income needs or be reinvested into other bonds or asset classes. Unlike more active strategies, the buy and hold investor does not actively deal with the future direction of interest rates, nor is he/she focused on the current value of the bonds due to changes in the yield. The assumption is that the bond’s full par value will be received upon maturity. Because of the investor’s minimal involvement, passive bond portfolios provide stability during market volatility. The primary reason for this is that the strategy invests in very high-quality, non-callable bonds, such as government or investment-grade corporate or municipal bonds. Bond laddering is probably the most common form of passive bond investing and provides a steady income stream. The idea of a bond ladder is simple: instead of investing in bonds that mature at roughly the same period of time, or in a haphazard pattern of maturities, you spread your portfolio out in roughly equal amounts over maturities that are evenly separated from one another. Ideally, all of these bonds are from the same issuer or from issuers with the same credit quality. When a bond matures, the principal is reinvested at the bond ladder’s longest maturity date. If interest rates are higher then, your annual bond income will go up; if rates go down across the board, your income will still benefit from the relatively higher rates on the rest of your portfolio. In either case, because most of your portfolio is still throwing off the same cash flow, your annual income won’t change much, which makes your income more predictable than if all of your bonds matured in any single year. 2. Indexing Bond Strategy. An indexing bond strategy is what is known as a quasi-passive strategy. The primary objective is to provide similar return and risk characteristics of a particular index. It is similar to tracking a specific stock market index, as a bond portfolio can be structured to copy a published bond index. Probably one of the most well-known and widely used bond indexes is the Barclays Capital U.S. Aggregate Bond Index. Using this works best with a large bond portfolio due to the number of bonds that need to be purchased to replicate it. While this strategy is comparable to a buy-and-hold strategy, it does offer some flexibility, as the portfolio can be rebalanced to reflect changes in the index. If you invest using an indexing strategy, you need to be aware that there are transaction costs associated with the original investment as well as when the portfolio is periodically rebalanced. 3. Immunization Bond Strategy. With characteristics of both active and passive, the immunization bond strategy invests a portfolio for a defined return for a specific period of time regardless of potential influences, such as changes in interest rates. The immunization strategy is for the investor who is willing to give up potential gains for the assurance that the portfolio will achieve its desired returns. This strategy is often used in institutional investing, when companies need to ensure they have a certain amount of cash flow to meet their liabilities at a certain period of time, but it is also an effective strategy for individuals. The immunization strategy is best used with high-grade bonds that have a remote possibility of default or with zero-coupon bonds. Zero-coupon bonds match the maturity of the bond to the date the funds are needed. 4. Active Bond Strategy. An active bond strategy is about maximizing total returns. Investments are actively managed based on the anticipation of interest rate changes, credit changes, and valuation changes. The premise of active strategies is investors are making investments based on what the future will bring. For example, the active strategy investor would buy bonds with longer maturity durations in anticipation of lower long-term interest rates, buy junk bonds in anticipation of economic growth, or buy Treasuries when the Federal Reserve is expected to increase the money supply.
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