Bonds

A bond is a debt instrument, or simply a loan from the investor to the issuer. In return for the loan, the investor is paid interest on a periodic basis and at maturity the full principal is returned. Bonds have a stated maturity date and a fixed coupon or interest payment. This is why bonds are called fixed income investments. The price of a bond will fluctuate with changes in the interest rate environment. Bond prices move inversely to interest rates; as interest rates rise, bond prices fall and as interest rates fall, bond prices rise. There are many types of fixed income investments and each has unique characteristics depending on the issuer. These characteristics include credit quality of the issuer, coupon payments, final maturity dates, and tax implications to name a few.

In fact, the bond market is considered much larger than the stock market. The bond market can offer investors a lot of choices, so it is important to have a clear picture of your investment objective before selecting appropriate investments for your portfolio.

Why Do Investors Buy Bonds?

The bond market offers investments that can help achieve many different investment objectives - including income generation, portfolio diversification, and even growth.

Income Generation—Traditional interest-bearing bonds pay interest semi-annually, quarterly, or in some cases monthly. These payments on traditional bonds are fixed and generally cannot be changed over the life of the bond. This regular income schedule may benefit investors who rely on the income from their bonds to meet living expenses. At retirement, investors often move a percentage of their portfolios into bonds to meet annual living expenses.

Growth or Total Return—Because bond prices move with fluctuations in interest rates, it is possible to generate growth with bonds. As rates fall, bond prices will move higher. Investors who believe that interest rates will fall or who believe that a certain sector of the fixed income market will outperform can realize growth from their bonds. Investors seeking growth within the bond market should consult with their Financial Advisor to identify appropriate bonds. Bond prices fluctuate just like stock prices, so investors who purchase bonds for growth must be able to withstand that volatility or hold onto their investments until maturity.

Portfolio Diversification

Portfolio diversification is not a new concept. Many investors follow an asset allocation approach to investing. Asset allocation is simply the allocation of investment dollars across asset classes like stocks, bonds and cash. When one sector of the market is faring poorly, another sector may be outperforming. By diversifying across asset classes, portfolio volatility can be reduced. In addition, many investors like the comfort of knowing that on the dates their bonds mature, their principal will be returned to them subject to the claims paying ability of the issuer. Asset allocation does not eliminate the risk of fluctuating prices of uncertain returns.

How much of your portfolio should be in bonds?

Once you have set your overall asset allocation, you and your Financial Advisor can begin to take into account additional factors to identify the types of bonds that suit your investment objectives and risk tolerance.

  • What is your investment time horizon? Is there a funding need, like a child's college tuition, that will need to be met in the future? This can help you determine the appropriate maturity dates of bonds purchased.
  • Do you have specific income needs that must be met? This can help determine the coupon payment dates as well as interest rates required on bonds purchased.
  • What is your tax bracket? Are you purchasing bonds in a tax-advantaged account like an IRA? This can help determine whether you should buy taxable or tax-exempt bonds.
  • What is your risk tolerance in respect to your bond purchases? Are you willing to take some additional risk to secure a higher yield? This can help determine the minimum acceptable credit quality or rating on bond purchases.
  • Do you seek growth from your bond investments? This can help determine which sector of the bond market you should be focused on.

For more information on how bonds may fit into your overall investment objectives, consult with your Financial Advisor. He or she can help you determine how much of your portfolio should be in bonds as well as what types of bonds will best meet your needs.

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