Expert Guidance: Bonds and beyond With Alexandra Lebenthal, President and Chief Executive Officer of Alexandra & James Inc. Bonds and beyond Investing in bonds isn't likely to produce the level of excitement that accompanied investing in stocks in the bull market of the 1990s. You won't see double-digit returns on the money you put in. But you're not likely to see the double-digit losses that stocks have provided in the past couple of years either.

What bonds can provide in an investment portfolio is the combination of steady income and return of principal that's reassuring for any investor — plus an opportunity for investors who are willing to take a slightly greater risk to achieve a stronger return.

The worst mistake you can make is to think of bonds as one big, monolithic investment category. There are super-safe, insured AAA-rated municipal bonds at one end of the scale and risky issues without ratings teetering on the edge of default on the other. There are bonds that mature in a month and others designed to last 100 years.
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A new look at bonds Whether you're a market optimist or a market skeptic, an enthusiastic investor or a reluctant one, you might want to take a new look at bonds. Bonds probably deserve more attention than most investors give them. And it's not clear why they're sometimes overlooked. It may be because people consider these debt securities dull, or complicated, or both.

But, in fact, bonds have an important part to play in any well-diversified portfolio. Bonds as an asset class have the potential to provide:
Also, depending on the type of bonds you choose, you may benefit from
Of course, there are risks with putting your money into bonds, as there are with all investments. At one extreme, you could lose your principal if an issuer defaulted, or failed to repay. At the other end of the scale, you might not earn enough to stay ahead of inflation. These are some of the reasons why it's so important to diversify your portfolio.
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Strong potential returns Bonds have a reputation as staid investments, in part because they are less volatile than stocks and produce a lower long-term return than stocks. And some investors may have trouble distinguishing them from other income-producing investments, such as certificates of deposit (CDs) or U.S. savings bonds.

It's true that bond prices tend to fluctuate less than stock prices, and that their average long-term returns are lower. But in certain markets you can realize a significant profit by selling bonds for more than you paid for them, and you could have a stronger total return on your bond portfolio than on your stock portfolio.

In fact, if you compare the returns of the Salomon Brothers Long-Term High Grade Corporate Bond Index and the S&P 500 Index of large company stocks between 1990 and 2001, bonds produced stronger returns in five of those years, or almost half the time, despite the 90s reputation as a bull market for stocks.
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Price to yield relationship Bonds' reputation for complexity probably results from two characteristics: the inverse relationship between price and yield — when a bond's price goes up, its yield goes down — and the fact that bonds are debt securities.

When you invest in a debt security, rather than buying something of value, you lend your money. In return, you're promised the return of your principal plus interest, or a percentage of that principal, for the use of your money.

Price and yield

When a bond is issued, it has a stated value, called par value, usually of $1,000, and it pays a specific rate of interest. Both the par value and the rate are fixed for the bond's term. What isn't fixed is the market price, or what investors will pay to own the bond on the secondary market.

One reason the market price changes is that when interest rates rise in the overall U.S. economy, the rates of newly issued bonds rise as well. And when interest rates in the overall economy fall, the rates on new bonds fall as well.

If interest rates drop, bonds that were issued paying the higher, older rate will provide more income than a bond paying the newer, lower rate. For example, a $1,000 bond paying 7% provides $70 of income each year, but one paying 5% provides only $50. So investors will be willing to pay more than $1,000 to get the extra income.

The catch is that when you pay more than par value to get more income, the bond's yield, which is calculated by dividing the income by the price, drops. For example, if you earn $70 on a $1,000 investment, that's a 7% yield, the same as the interest rate. But if you earn $70 on a $1,100 investment, the yield is just 6.36%.
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Bonds & the market Investors also buy and sell bonds in response to political and economic news. For example, when stocks are losing value, more investors tend to buy bonds as a way to protect their principal and collect income. As demand for bonds increases, prices tend to go up. That sends the yield down.

The reverse happens when investors sell bonds, as they might if they expect big gains in the stock market. Then bond prices drop and their yields rise though the interest rates in the economy at large remain fixed.

A curious reaction

Ironically, good news about the economy often means bond markets fall. The reason is that a robust economy can lead to inflation, which leads to higher interest rates, which in turn erodes the value of existing bonds — taking the wind out of the bond market's sails.
Up and down Bonds in the secondary market almost always sell at a premium, with a price above par or at a discount, with a price below par. One sign that the risk of default has increased is a bond selling at several hundred dollars below par.
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The value of bonds With bonds, the word value is used in two different but related ways: As a general rule, bonds can help you weather downturns in the stock market, not only because bonds tend to fluctuate less in price than stocks, but also because they have the potential to provide regular income and strong total returns in periods when stocks are struggling.

Once you're convinced that adding bonds to your portfolio makes sense, the next task is evaluating the potential risks and rewards that individual bonds pose to find those that, either individually or in combination, add the greatest value. The places to start are with the bond's interest rate, its term, and its rating.
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Market cycles To understand how market cycles affect you as an investor, you need to know that:
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Interest rates The interest rate a bond pays is a measure of its value. In one way, the higher the rate a bond pays, the more the bond is worth as an investment since it provides proportionally greater income. And since a bond pays the same rate for its full term, or until it is called, or redeemed by the issuer, buying high-paying bonds locks in long-term income. Additionally, an investor could potentially profit from selling a high-paying bond when rates drop.

At the same time, rates on newly issued bonds that are much higher than the average being offered on other bonds with the same term is a danger sign, since only the riskiest bonds must pay higher than market rates to attract buyers.

Unlike stocks, where share prices of comparable companies can differ dramatically, interest rates on bonds issued by comparable companies at about the same time often vary by only fractions of a percentage point — depending on the type of bond, the length of a bond's term, and its credit rating.
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Term Each bond is issued with a specific maturity date, or time when your principal will be repaid and the investment ends. The time between the date of issue and the maturity date is the bond's term.

When the term is a year or less, the bond is described as a short-term issue. Short-term U.S. Treasury bonds are called bills, and some very short corporate debt securities are called commercial paper. Bonds with terms of two to ten years are described as intermediate-term bonds, and those with terms of 20 or 30 years or more are long-term bonds.One specific term-related approach you may want to consider is buying bonds that mature at a time when you expect to need your investment principal, such as when a child will enroll in college. You won't have to worry if the price fluctuates in the period, and you can anticipate a cash infusion when you need it.

Time is (sometimes) money

In most environments, the longer the term the more the issuer must pay in interest to attract investors. But that's not always the case, since short-term rates can rise or fall quickly in response to changes in the economy or the political situation. If it's possible to earn a higher rate on short-term or intermediate-term bonds, there's less reason to tie up your money for the long term.
From the Expert
If you know you're going to need your money in one or two years, or if you are hedging your bets on what's going to happen to the interest rate, I'd buy short-term bonds that mature in one or two years. That way, you're not subjecting your liquid assets to the vagaries of the market.
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Ratings a worst-case scenario, a bond goes into default. Default occurs when the bond issuer fails to pay interest as it comes due and/or fails to repay the par value of the bond at maturity.

Independent research firms — including Standard & Poor's, Moody's Investors Service, and Fitch — evaluate many types of bonds and assign each new issue a credit rating to indicate its relative risk of default. And they continue to track the financial condition of the bond's issuer until the bond reaches maturity — sometimes changing the rating they've previously assigned.
Investment-grade describes bonds rated Baa or higher by Moody's, or BBB or higher by Standard & Poor's. Junk bonds are the lowest-rated corporate and municipal bonds — meaning there's a greater-than-average chance that the issuer will fail to repay its debt. But you may be willing to take the risk of buying these low-rated bonds because the yields are often much higher than on more highly rated investments. However, the prices are volatile as well, exposing you to additional risk if you have to sell before maturity.

The lower a bond's credit rating, the higher the interest the issuer must pay to attract buyers. And if an issuer's financial condition deteriorates, and the rating services downgrade its bonds, the prices those bonds command in the secondary market drop as well, as investors demand a higher yield for owning the bond. That's one of the risks you take as a bond investor, especially if you anticipate having to sell a bond before maturity. Rating criteria

In deciding how to rate a bond, rating services consider:
Future changes
The large ratings service companies are upgrading their rating practices to correct elements in the existing system that failed to catch serious financial problems in certain companies. The new ratings will encompass closer attention to business practices and accounting procedures to ensure a more accurate and thorough assessment.
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Bonds for special purposes Some bonds pay no interest while the loan is maturing. These bonds, called zero coupon bonds, are popular with some investors. Instead of separate fixed-interest payments, the interest of a zero coupon bond accrues, or builds up, and is paid in a lump sum at maturity. Corporate, municipal, and Treasury bonds are all available as zero coupon bonds.

You buy zero coupon bonds — called zeros — at a deep discount, far lower than par value. When the zero matures, the accrued interest and the original investment add up to the bond's par value.

The pros and cons

Bond issuers like zeros because there's an extended period to use the money they have raised without paying periodic interest. Investors like zeros because the discounted price means you can buy more bonds with the money you have to invest, and you can buy bonds of different maturities, timed to coincide with anticipated expenses.

Zeros have two potential drawbacks. They are extremely volatile in the secondary market, so you risk losing money if you need to sell before maturity. And, unless you buy tax-exempt municipal zeros, or buy zeros in a tax-free account, you have to pay taxes every year on the interest you would have received had the interest, in fact, been paid.
From the Expert
If you're in your 20s and 30s and want to diversify your portfolio, zero coupon bonds can be great investments. The smaller amounts that are required for buying zero coupons let you get into the bond market more easily. And if you're investing for your child's education, zero coupons can be a real plus, in part because they offer tailor-made maturities.
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Buying and trading bonds While all bonds share basic characteristics such as terms, rates, and par values, all bonds are not alike. One of the major differences is that they're issued, or sold, by four distinct entities in the U.S. and by comparable issuers around the world.

Corporations issue bonds to raise money for expansion, research and development, and other expenses of doing business. While corporations can also raise money by selling new stocks, they may prefer bonds because the existing stocks lose value when new stocks are issued.

Municipal governments, such as states and cities, sell bonds to fund special projects and pay for regular expenses.

The U.S. Treasury issues bonds to meet its regular and unusual obligations.

Government agencies issue bonds to raise capital to do their work, such as provide mortgage money or student loans.

You can buy some of these bonds when they are issued and most already-issued bonds in what's known as the secondary market. That means they're traded over the counter (OTC) and in the bond trading rooms of stock exchanges and brokerage firms around the country.

For example, if you want to keep a certain percentage of your assets in bonds and one of your bonds is called, you'll have the principal to invest. If interest rates on new bonds are low, you might prefer to buy an older, higher-paying bond in the secondary market.
From the Expert
A municipal bond is evidence of the collective debt a community takes on to pay for the public necessities that underpin commerce, society, and the quality of life. You can't get up in the morning, flick on a light, take a shower, a subway, a bus, go over the bridge or under the river without a municipal bond touching your life.
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Primary markets Newly issued corporate and municipal bonds are sold at par value without commission, in the primary market. The investment bank or banks that underwrite the issue absorb the costs of getting the bonds into the market. Most of these sales are to institutional investors that buy large quantities, but some municipalities try to make it easier for individual investors to buy.

New Treasury bills and notes are auctioned, also without commission. Competitive bids from large-scale investors offering to accept the lowest interest (which means they offer to pay the highest price) are accepted first, and then incrementally lower bids are accepted until the quota is filled. The final bid becomes the auction rate, and all successful bidders have their orders filled at that rate. Individual investors, who make noncompetitive bids, or tenders, also get the auction rate.
Dutch auction
Treasury auctions are actually Dutch auctions, which means the action begins the highest price and continues at gradually lower prices until all the items — in this case bonds — have been sold. In a conventional auction, such as on the floor of a stock exchange, bidders offer increasingly higher prices until no more bidders will participate. The item goes to the highest bidder.
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Secondary market When you buy bonds and hold them until they mature, you know from the start how much you'll earn in interest and when the principal will be repaid. Only two things can interfere with your expectations: If the issuer defaults, and fails to pay the interest or return the principal, or if the bond is called, which means the issuer redeems the bond early by paying back the principal.

That happens, most often, if the interest rate you're earning is higher than current market rates, and the issuer can save money by paying you off and issuing new, lower-paying bonds.
From the Expert
While some experts recommend more, in my experience, $25,000 is enough to build a portfolio of individual bonds. With less, you may not be able to achieve adequate diversification in your bond portfolio, and you might be better off investing in a bond fund.
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Buy and hold When you buy bonds and hold them until they mature, you know from the start how much you'll earn in interest and when the principal will be repaid. Only two things can interfere with your expectations: If the issuer defaults, and fails to pay the interest or return the principal, or if the bond is called, which means the issuer redeems the bond early by paying back the principal.

That happens, most often, if the interest rate you're earning is higher than current market rates, and the issuer can save money by paying you off and issuing new, lower-paying bonds.
Words to the wise
If you’re considering a buy-and-hold approach, you should:

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Buying strategies When you buy bonds for the long term, you're often looking for regular income. But what happens when a long-term bond that's paying 7% matures, and the best you can find to replace it is one paying 5%?

One way to forestall that problem is to use a technique known as laddering. When you ladder your bond portfolio, you divide your investment among intermediate-term bonds that mature in a rolling sequence every one or two years instead of putting all of your money into a single issue.

Each time bonds mature, you reinvest the principal in new bonds to extend the pattern of maturation dates you've established. That way, if you have to settle for a lower rate for a third or a quarter of the money you have committed to bonds, the rest is still invested at the older rate. And when the next bonds mature, the rates may be up again. What's more, if you need the principal for another investment or to meet certain expenses, you don't have to liquidate your entire portfolio.

With a similar technique, known as barbells, you spread your interest-rate risk by putting half of your principal into long-term bonds (20 to 30 year terms) and the other half into short-term bonds (a term less than one year), ignoring intermediate-term bonds altogether. That way, you can lock in higher long-term rates for part of your investment, while staying agile with the rest.
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Trading bonds Another approach to bond investing is buying and selling systematically to take advantage of changing prices.

Fluctuating interest rates, shifting credit quality, and ups and downs in the economy all affect the short-term prices of bonds in the secondary market. That means that if you sell your bonds before their maturity dates, you have the potential to make money on your investment.

For example, if you own high-interest bonds as rates drop, you could sell the bonds for more than you paid and use the money to make a different investment. And since, in the interim, you've been collecting interest, the bonds could yield a tidy profit. Of course, you also have to consider the costs of buying and selling as you calculate your total return.

The risk you take is that rates will rise, reducing the market value of your bonds. If you can afford to wait until the next phase of the cycle, you won't have a loss. But if you must sell at a discount, your loss could wipe out your interest income and more.

Of course, trading bonds isn't suitable for all investors, and your brokerage firm may impose certain requirements to allow you to trade bonds.
Swap your bonds
If you're interested in exchanging one of your bonds for a different bond, you can make a bond swap. When you swap, you simultaneously sell one bond and purchase another one to replace it in your portfolio.

Swaps are a good way to change maturities, change your level of income, and even upgrade in credit ratings. What's more, making a bond swap can help you save on capital gains taxes if you're selling for a loss.
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Choosing bonds You may look at the enormous variety of bonds as a world of choice. Or you may be overwhelmed by having to make an appropriate selection. Whether you're looking to invest for the first time or you want to add bonds to an established portfolio, you follow a two-step process. First you decide among the major subclasses, or categories: corporates, Treasury, municipal, and agency bonds. Next, you must identify specific issues within the subclasses you have chosen.

No easy task

As you diversify the assets you have allocated to bonds, your goal is to put together the right mix of risk and return. That involves looking at the interest rates various bonds are paying and the yields they're providing, as well as their terms, their ratings (if they are rated), and their tax status.

What complicates your task is that despite the similarities among bonds of the same type, each issue differs — sometimes slightly and sometimes dramatically — from the others.
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Treasury bonds U.S. Treasury bills and notes are often the first bonds that investors buy, and they make up the bulk of many bond portfolios. One appeal of Treasurys is that they're extremely safe, since they're backed by the U.S. government. Another attraction is that it's easy to buy Treasurys, either online or over the telephone.

All you have to do is open a Treasury Direct account, link the account to your bank, and place your order. The minimum is one bill or note, with a $1,000 par value, though you may invest more. The trade-off for the convenience, safety, and flexibility is that Treasurys pay interest at a lower rate than even the highest-rated corporate bonds.

Treasury notes, with intermediate terms of 2, 5, or 10 years, are popular with investors who want to earn a reasonable rate without making a long-term commitment. Treasury bills, or T-bills, with 4, 13, or 26 week terms, appeal primarily as a place to hold cash reserves.

Treasury inflation-protected securities — also known as TIPS — are inflation-indexed notes. Like traditional Treasurys, TIPS pay a fixed rate of interest for the term. But what makes TIPS different is that the principal value of the bond, to which the interest rate is applied, is pegged to the current rate of inflation. So if inflation rises throughout the term of the bond, the principal grows proportionately — and so does your interest income.

While traditional bonds pay slightly higher rates of interest, the real rate of return on TIPS generally outpaces traditional bonds. Another advantage of allocating some of your bond portfolio to TIPS is that they can lower its overall volatility. That's because TIPS have a low correlation to other types of bonds, since their value isn't eroded by inflation.
  Treasury bills Treasury notes TIPS
bonds
Par value $1,000 - $1 million $1,000 - $1 million $1,000 - $1 million
Terms 4, 13 & 26 weeks 2, 5 & 10 years 5 & 10 years
Trading details New: through Treasury Direct Existing: through brokers New: through Treasury Direct Existing: through brokers New: through Treasury Direct Existing: through brokers
Risk Very safe Very safe Very safe
Interest Federally taxable Federally taxable Federally taxable
Call provisions Not callable Some are callable Sometimes callable
Rated
 No No No


The long bond is back again
The Treasury issued 30-year long bonds regularly between 1977 and 2001, then stopped selling them. But in February 2006, the Treasury began auctioning them again, to finance the growing U.S. deficit and meet investor demand for a low-risk, long-term investment vehicle.
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Municipal bonds The higher your federal tax bracket, the more attractive municipal bonds, popularly known as munis, may be to you — even though they typically pay interest at a lower rate than similarly rated taxable bonds. And if you live in a high-tax state, these bonds may be even more appealing. That's because muni interest is exempt from federal income tax, and from state tax if you're a resident of the state where the bond was issued.

In most cases, you buy munis in $5,000 increments, though there may be exceptions if certain issuers want to make their offering available to a larger number of investors.

While all munis share their tax-exempt status, they're not all alike. Some pose more risk of default than others because the state and local governments that issue them aren't on firm financial ground. Some, called general obligation (GO) bonds, are backed by the full faith and credit of the issuer, which means residents' taxes pay the interest. In contrast, interest on revenue bonds is paid by the income generated by the particular project being financed. Generally speaking, revenue bonds are riskier than GOs.

  Municipal bonds
Par value $5,000 and up
Terms 1 month to 40 years
Trading details Through brokers
Risk Variable
Interest Federally tax-exempt, sometimes locally tax-exempt
Call provisions Sometimes callable
Rated
 Moody's, S&P, Fitch

Munis, while a smart choice for many investors, may not work as well for others. Experts advise against buying them for tax-deferred retirement accounts because all withdrawals from those accounts are taxed — even muni bond interest. And investors in the lower tax brackets may find they actually put more in their pockets with taxable bonds.
From the Expert
AMT bonds are clearly identified as subject to the alternative minimum tax, so if you have enough tax write-offs and preferential income to trigger a potential AMT liability, avoid them. But if you don't have AMT liability, AMT bonds may be windfalls. That's because to compensate for the potential tax liability they could trigger, they have to pay higher interest.
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Corporate bonds You may consider buying corporate bonds for the income they provide, as well as the potential price gains, though fewer individuals own these securities directly than own municipals or Treasurys. That's true in part on account of the cost of buying, since you pay higher commissions on purchases smaller than $100,000.

All corporate bonds are rated by independent research firms, and those with the highest ratings typically pay the lowest interest rates — though the interest rates are still higher than comparably rated munis. Debentures, the most common type of corporate bond, are backed by the general credit of the corporation, while asset-backed bonds are backed by specific corporate assets, such as property or equipment.

  Corporate bonds
Par value $1,000 (though sometimes less)
Terms 1 to 100 years
Trading details Through brokers
Risk Variable
Interest Taxable
Call provisions Callable
Rated
 Rated by Moody’s, S&P, Fitch


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Convertible bonds Some corporations issue convertible bonds that give you the option — but not the obligation — to convert your investment principal into company stock. The conversion terms are set when the bond is issued, including the date, price, and amount of stock into which the bond can be converted.

Because of this flexibility, convertibles pay a lower interest rate than other bonds the company offers. But they are less sensitive to interest rate changes than most conventional bonds. As a result, their prices tend to be less volatile than other company bonds, as well as less volatile than the company's stock. If you would consider owning the company's stock, but you're reluctant to buy it outright, you might want to look into convertible bonds.
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Agency bonds Certain federal government agencies, including Ginnie Mae — the Government National Mortgage Association — and Tennessee Valley Authority, issue bonds to raise funds either to make loan money available to consumers or to pay for new projects.

The best known of these bonds, Ginnie Mae, are self-amortizing pass-through mortgage-back securities. That means that, as homeowners repay the underlying mortgage loans, their payments are passed through to you. You wil receive some of your principal back with each interest payment.

Public perception is that these issues are less risky than corporate bonds because they are linked to the government, even though most are not federally insured or backed by any taxing powers. Minimum purchases are typically in the $25,000 range, which may further limit their appeal for individual investors.

Interest on most government agency bonds is federally taxable, and is paid at rates higher than Treasurys but lower than corporate bonds. Interest on certain agency bonds is tax-exempt, as it is on municipal bonds.

  Agency bonds
Par value $1,000
Terms 1 to 50 years
Trading details Through brokers or banks
Risk Variable
Interest Sometimes tax-exempt
Call provisions Sometimes callable
Rated
Some issues rated by some services

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Bond funds If you don't have a lot of money to invest, but want to allocate some of your portfolio to bonds, you might want to look into bond mutual funds. You can buy shares in a bond fund with an initial investment of between $1,000 and $2,500 dollars and add assets gradually, sometimes as little as $50 a time if you arrange for direct transfer into the fund. That gives you much more flexibility than buying individual bonds.

What's more, your dividends can be reinvested to buy additional shares, providing compounding that's not possible with individual bonds. And you get the benefit of professional management. That expertise can be a particular advantage in diversifying into riskier high-yield bonds, which can provide welcome added income but also expose you to greater risk of default.

On the other hand, while bond funds invest in individual bonds, they're quite different investments from individual bonds themselves. Bond funds have no maturity date, don't pay a fixed rate of interest, and make no promise that you'll get your original investment back.

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Fund basics When you buy shares in a bond fund, the manager pools your money with money from other investors and buys bonds for the fund's portfolio. The price you pay is the net asset value (NAV), computed by dividing the total value of the bonds in the fund by the number of existing shares, plus whatever sales charge may apply. Some, but not all, funds impose these charges.

At the same time that your money is being invested, the manager authorizes the sale of bonds in the portfolio to take advantage of changes in the marketplace. Because the fund isn't holding the bonds it buys to maturity, its value fluctuates all the time. If you sold your shares when the fund value represented by the NAV was lower than it was at the time you bought, you'd sell at a loss.

In addition, bond funds — like all mutual funds — charge annual management fees. You should evaluate these costs as part of the process of choosing a bond fund.

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What funds buy Bond funds typically buy bonds from one of the major categories (such as corporates, Treasurys, municipals, or agencies), and may specialize in bonds of a particular term, such as short-term corporates or long-term municipals.

One strategy may be to combine individual bonds and bond funds in your portfolio, using the funds to fill the gaps in your diversification efforts. For example, you might select a Ginnie Mae fund, which may be more affordable than an individual Ginnie Mae bond, as a source of regular revenue. Or, you might seek diversification by buying an international bond fund or a high yield fund.

Smart bond investing

If you decide to invest in tax-exempt municipal bond funds, you'll want to be careful about which bond fund you choose. Some funds buy only the issues of a single state while others buy bonds from several states. If this is the case, you may owe state taxes on the income from a portion of your fund's investments, even though you still wouldn't owe federal taxes. The good news is that the fund will report the taxable amount. You don't have to figure it out on your own.
From the Expert
Bond funds make tremendous sense for an investor who has small sums to invest over time. And let's not forget — bond funds provide easy diversification.

Diversification has proven critical over the last few years — whether in stocks or bonds. A good way to diversify with bonds if you don't have the funds to put together a large amount to invest is in a bond mutual fund so you have different maturities, different names, and different ratings all with as little as a $1,000 purchase.
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A well-rounded portfolio Investing doesn't mean choosing between stocks and bonds. Your portfolio needs bonds for dependable, spendable income. And it needs stocks for their potential to provide profit and gain. Equally important, when you invest in bonds and stocks that tend to move up and down in value at different times in the economic cycle, you're in a much better position to manage risk without having to sacrifice return.
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