Investing in Bonds
Fixed income investments have a place in most individuals' investment portfolios. Bonds
or other types of fixed income investments provide diversification and predictable income
and are generally thought of as more conservative investments than stocks.
Different Types of bonds
Certificates of Deposit or Savings Certificates
Issued by banks, thrifts and credit unions, these instruments are probably the easiest to
buy and own. They are often available in maturities ranging from 30 days to over five years.
Since they are insured by the FDIC or NCUA up to $250,000, the risk of default is almost
US Government bonds
The Federal Government also issues bonds of varying maturities. Treasury bills are issued
with maturities of less than a year. Treasury notes have maturities from one to ten years
and Treasury bonds have maturities from ten to thirty years. US Treasury obligations are
considered to be some of the most financially sound investments available. Even though the
risk of default is negligible, the values of these bonds change as interest rates change.
When rates rise, values fall and vice versa. The longer the maturity, the more their values
will change with changing interest rates.
Most obligations issued by states, cities and other non-federal governmental bodies pay
interest that is not subject to federal income tax. As such, the interest rates on those
bonds is usually lower than similar quality and similar maturity taxable bonds. To determine
if tax-free municipal bonds are right for you, compare the after tax yield of a similar
taxable bond with the tax-free yield of a municipal bond.
Not all tax-free bonds are of equal quality. Ratings agencies assign quality ratings to
many bond issues. They look at the credit worthiness of the issuer and other factors.
Usually it is a good idea to stay with high quality bonds - those rated A, AA or AAA. The
market values of municipal bonds also change with changes in interest rates.
Corporations also borrow money by issuing bonds. The interest from these bonds is fully
subject to federal and state income taxes. The ratings agencies also usually assign ratings
to corporate bonds and staying with the high quality bonds makes sense.
Ways of Own Bonds
You can buy individual bonds from many sources. Banks usually offer government bonds and
brokerage firms can sell all types of bonds. The biggest benefit to owning individual bonds
is the ability to choose exactly what bonds you own. Most bonds send interest or you can
have it deposited into your brokerage account.
With a fixed income mutual fund, you buy shares in a fund that owns a portfolio of different
bonds. The bonds are selected by the portfolio manager who also monitors the bonds while
they are in the fund. The portfolio manager has the ability to buy and sell bonds from the
portfolio as he or she thinks the market is changing. For example, if the manager believes
that interest rates are going to rise, he or she may replace longer-term bonds with shorter
maturity bonds so there will be less price deterioration if rates rise.
The disadvantages of bond mutual funds include the costs of the fund and being subject to
poor selections by the portfolio manager.
Unit Investment Trusts
Unit investment trusts (or UITs) are like a mutual fund in that you buy into a portfolio of
bonds, but the portfolio remains static. Once the UIT is formed, the bonds stay in place
until they mature. Usually the costs of a UIT are lower than a mutual fund but you give up
the close monitoring that is part of the portfolio manager's duties with a mutual fund.
Words of Caution
You should also note that the values of bonds, bond mutual funds and UITs change when
interest rates change. When rates go up, the values of bonds fall.
Fixed income investments should be conservative tools used to lower overall portfolio
risk and to produce steady streams of income. There is often a temptation to consider types
of bonds or other fixed income investments that offer returns that seem very high compared
to the alternatives. Stay with high quality issues bought from reputable institutions. When
something seems too good to be true, it often is.