Whether your portfolio is large or small, you must put your money somewhere. You can choose from mutual funds, individual stocks and bonds, or simply stash away your cash in bank accounts, money-market accounts and other cash equivalents.
In a volatile economy, experts say, diversification is essential. By spreading investments among various categories, you minimize the chance of a major loss. For example, when stocks fall in price, bonds usually rise, and vice-versa. That’s one reason bonds have a place in almost every portfolio.
While bonds of all types — government, municipal and corporate — are considered safer than securities, they are not entirely risk-free. With the exception of U.S. Treasury bonds, there is the possibility (though rare) that an issuer will be unable to meet its obligations to pay the interest and principal.
By choosing bonds of different types (government, agency, corporate, municipal, etc.), you can further minimize risk. Another option for the investor is to stick with mutual funds made up of bonds to guarantee diversification.
Since the price of bonds is tied inversely to interest rates, the market value of bonds falls when interest rates rise. This isn’t a problem for the long-term investor, since interest payments will remain the same regardless of market price, and the full face value of the bond will be paid when it matures.
If preserving principal and earning interest is your goal, a buy-and-hold strategy is best. When you hold a bond to maturity, you receive interest payments (usually twice a year) and get the face value of the bond at maturity.
If you want to maximize interest income, longer-term bonds typically offer higher interest rates. With more time to mature, long-term bonds are more vulnerable to interest-rate ups and downs, but the fluctuations won’t affect you unless you sell them.
Sometimes, you may need to sell bonds you bought as part of a buy-and-hold strategy, since things don’t always work out as planned. If you need to sell a bond before maturity, you’ll get more or less than you originally paid, depending on whether interest rates have gone up or down since you bought it.
Among the lesser-known considerations in purchasing individual bonds is the markup (a commission-like fee) buyers pay to brokers. Bond brokers aren’t required to reveal their markup; the National Association of Securities Dealers (NASD) only says it should be “fair” — a rather vague requirement.
In a typical transaction, a broker buys a bond at one price and sells it to the buyer at a higher price; the difference is the broker’s profit. When brokers buy bonds back, they employ the opposite technique, charging a “markdown,” or paying the buyer less than they receive from the sale.
Because most bonds aren’t traded on an exchange, bond buyers have no way of knowing what the market price for a given bond is without shopping around. If you buy bonds from a broker, find someone you trust to charge a “fair” markup.
Another aspect is the “call” feature. “Callable” bonds can be redeemed — paid off — by their issuers before their maturity date. There’s no loss of principal, but since calls are seldom invoked unless interest rates are falling, the bondholder will suddenly be in possession of cash he or she needs to invest elsewhere, likely at a lower interest rate than the bond had been paying.
Bonds and bond funds can be held in taxable or tax-deferred retirement accounts, and there are reasons to choose one account over another. Tax-free municipal bonds, for example, are best held in a taxable account, where they can help reduce taxable income. Since the maximum tax on capital gains was reduced to 15% in 2003, those in high-income tax brackets may find it advantageous to hold bonds in taxable accounts.
The best choice for you depends on your circumstances and tax status. Your accountant or investment advisor can help you examine the choices and work out a solution that best fits your needs.
Have a question or comment? E-mail our editor Dave Davis at [email protected].