Joey: “So, Ross. If you had a million dollars, what’s the first thing you’d buy?”
Ross: “I’d probably get some municipal bonds, and then put the rest of the money in the bank and live off the interest.”
Joey: “Well, we’ve heard from Dr. Fun.”
– From Friends, Season 3 Episode 18: “The One with the Hypnosis Tape”
A bond is an investment to receive the repayment of a “loan” at a certain interest rate. The way you invest in bonds matters now more than ever because of low interest rates.
Bond mutual funds are attractive for ease of use, but purchasing individual bonds insulates you from swings in their market price. Following are some key points for investing in individual bonds.
Create a laddered portfolio
The beauty of this strategy is that it can achieve several goals. First, it provides a predictable income source. Second, it gives a bond portfolio a shorter average maturity, but with almost the same yield as a longer maturity one.
To create a ladder, determine how much you have to invest and what time period you would like to invest it over. Divide the total investment into relatively equal parts and choose investments with different maturities equally weighted over your time horizon. For example, $100,000 invested in a five year ladder would have $20,000 invested each in bonds with maturities of one, two, three, four, and five years. As each bond matures, you replace it by purchasing the longest maturity bond in the ladder – in this case five years. The average maturity works out to be about three years.
The rationale behind laddering isn’t complicated. When you buy bonds with short-term maturities, you have stability – but you have to accept a lower yield. When you buy bonds with long-term maturities, you receive a higher yield, but you must also accept the risk that the prices of the bonds might change. With a laddered portfolio, you would realize greater returns than from holding only short-term bonds, but with lower risk than holding only long-term bonds.
Laddering like this gives you the flexibility to redirect funds if needed for withdrawals, and reduce interest-rate risk because if rates rise, you are reinvesting at the higher rates.
Armed with this knowledge, you can begin building yourself a bond portfolio that, while hardly immune to rising rates, at least won’t get pummeled by them.
Understand Interest Rate Risk or Market Risk
Bond prices move inversely with interest rates. So when rates rise, your bonds drop in value. The longer the maturity, the greater the degree of price volatility. This isn’t a problem if you buy individual bonds and hold them until maturity. But it’s a major risk for investors in bond mutual funds, which price their shares according to the market each day. By way of example, the price of a bond fund with a duration of five years would be expected to fall approximately 5% if interest rates rose by only 1% point!
By having individual bonds, you receive the par, or face, value of your bond at maturity.
- When interest rates rise, new bonds come to market with higher yields than older securities, making the older ones worth less. Hence, their prices go down.
- When interest rates fall, new bonds come to market with lower yields than older one. Hence, their prices go up.
As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
When interest rates increase, take steps to minimize the negative effect it will have on your bonds. Longer maturity bonds get hit more by rising rates than shorter maturity bonds. Also, bonds with higher coupon rates tend to do a bit better than bonds with lower coupon rates in periods of rising rates. During times of rising interest rates invest in individual bonds and not mutual fund bonds for better return, protection against interest rate risk, and liquidity.
The rating of individual bonds is very important.
A bond is unsafe when it defaults its interest or principal payments. Interest coverage ratio must be solid. Investment grade bonds have the highest quality possible A-AAA. Maintain investment-grade whenever possible.
Look at the yield-to-maturity not coupon. Hold the bonds to maturity; this way fluctuation in interest rates doesn’t affect your bonds. Buy premium bonds. Never buy long-term bonds, too much risk for not much more return. You seldom earn much extra income from tying up your money for longer than 10 years.
Only interest on certain private purpose (private activity) municipals may trigger something ugly, the alternative minimum tax (AMT), yuck.
Bond ladders are usually better than CD ladders because:
- They are more liquid
- There is no penalty for early withdrawal
- You receive a better rate further out
Because bond values move in the opposite direction of interest rates, the value of most bonds or bond funds will go down (you will lose principal) when interest rates rise. But it still makes sense to hold bonds as rates rise.
Well, we’ve heard from Dr. Fun.