Financial Empowerment cont. - The World of Fixed Income

Financial Empowerment cont. - The World of Fixed Income

Continuing our Financial Empowerment series, this blog article introduces our readers to the world of fixed income.

What is a bond? To keep things simple, a bond is a loan between two parties: the bondholder (lender) and the borrower. The lender gives the borrower a sum of money up-front, and in exchange the borrower promises to make regular interest payments plus repay the original loan value at an agreed upon future date. For those of you who may have borrowed money to buy a house or a car or to pay for college, this may sound familiar. Mortgages, car loans, and student loans are indeed all subsectors of the bond market.

But the bond market is much larger in scope than just mortgages and cars. Governments around the world borrow money for all sorts of reasons. The US Government began issuing Treasury bonds in the early 1900s to fund World War I, and by World War II US Treasuries were some of the most popular investment vehicles in history. Today, the United States owes its bondholders about $16.4 trillion. Treasuries are considered some of the safest investments because it is assumed the US Government can and will fulfill its obligations no matter what. Also, Treasuries are exempt from Federal tax.

State and local governments issue bonds to fund roads, public works projects, airports, and schools. These types of bonds are referred to as “municipal bonds,” and are generally considered to be very safe investments because many municipal bonds are backed by the taxing authority of the municipality. If an investor purchases bonds issued by his state or municipality, they are typically exempt from both Federal and State taxes.

Corporations issue bonds to fund equipment, manufacturing facilities, land development, and a whole host of other things. These bonds are called “corporates,” and are fully taxable at both the State and Federal levels. The term “credit quality” is used to describe a company’s ability to satisfy its outstanding obligations, and there are currently three rating agencies that evaluate a corporation’s outstanding debt: Moody’s, Fitch, and Standard & Poor’s. Each agency uses a unique rating scheme, but all three roughly follow the academic grading system. Bonds rated in the A’s typically have a high likelihood of being repaid (deemed “investment grade”), while bonds rated below the B’s are much less likely to be repaid (sometimes called “junk”).

Loans to individuals like mortgages and cars are often bundled together and sold to investors as “mortgaged-backed securities” or “asset-backed securities.” The theoretical benefit to a loan like this is that the debt is secured by some kind of hard asset (in this case, a car or a house). If the borrower decides to stop making payments (i.e., he defaults), the lender can take this physical asset as repayment. By bundling hundreds or thousands of individual mortgages together, bondholders are somewhat insulated from risk because it is unlikely that all or most of the mortgages will default.

Bonds are typically priced with a “par value” (i.e. initial value on the issuing date) of $1,000 or $5,000 per bond. After issuance, depending on the coupon rate, credit rating, and several other key factors, the bond may change hands above par (at a premium) or below par (at a discount). However, bondholders should expect to receive par value back at the maturity (expiration) of the loan.

 

There are a number of reasons why investors want to own bonds. First, bonds tend to be relatively safe investments, especially municipals, treasuries, and bonds of established blue-chip companies. In the event of a bankruptcy, bondholders are some of the first investors to be repaid while stockholders are at the bottom of the list. Second, bonds tend to be steadier, more stable investments than stocks because interest and principal repayments are based on the initial contract terms of the bond. Investors know when repayments will be made. Third, being more stable investments, bonds tend to move in a somewhat opposite direction to stocks. Case in point, in 2008 when the S&P 500 index was down as much as 50%, some bonds actually increased in value.

It’s also important to note here that, although they are traditionally safer than stocks, bonds do carry risk. The most significant risk is interest rate risk, the risk that prevailing interest rates rise and the value of you lower-interest bond will fall because it will not be as appealing to investors. If you plan to hold your bond from issuance to maturity dates, this should not impact you because you will receive par value back at maturity. However, for investors that may trade bonds in the interim between issue and maturity dates, it is a critical risk to consider. Other risks include default risk (the risk that the borrowing company can’t make interest or principal payments), and inflation risk (the risk that the rate of inflation outpaces your coupon payments, meaning you effectively lose purchasing power over time). We recommend you research these risks as well as the other risks associated with bonds, and/or ask your financial advisor to educate you on the subject.

What percentage of your portfolio should be invested in bonds versus stocks? The answer depends on a number of factors including age, time horizon, risk tolerance, and investment objectives. There are some old “rules of thumb” about having the same percentage invested in bonds as your age (i.e., a 60-year old should be 60% invested in bonds), but we believe these rules are far too simplistic.

For our next blogs, we’ll discuss other types of investments including commodities, real estate, and hedge funds.

The most significant risk is interest rate risk, the possibility that prevailing interest rates rise and the value of your lower-interest bond is less appealing to investors, thus causing the price to fall.

Securities offered through Level Four Financial, LLC, a registered broker dealer and member of FINRA/SIPC. Advisory services are offered through Level Four Advisory Services, LLC, an SEC-registered investment advisor. Accounts carried by Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC. Neither Level Four Financial, LLC nor Level Four Advisory Services, LLC offer tax or legal advice. Please contact your tax or legal professional for specific information regarding your individual situation.
 
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