With the future direction of interest rates uncertain, you may wonder whether now is a good time to invest in bonds. If you are reassessing your bond investments, consider the following:
Decide how much of your portfolio to allocate to bonds. Whether you're shifting funds between stocks and bonds, rebalancing your portfolio, or setting up an investment strategy, decide how much of your total portfolio to invest in bonds. Your allocation to the bond portion of your portfolio will depend on your personal situation, but over time your percentage of bonds is likely to change. In general, the percentage of bonds you own should increase as you become more averse to putting your capital at risk.
Understand your objectives for your bond investments. Many investors purchase bonds for a dependable income stream and to protect their principal. These investors will typically buy and hold bonds until maturity. They are looking to maximize yield for a given time frame with a comfortable risk level. Other investors prefer to use bonds to reduce risks in a portfolio heavily weighted with stocks or to actively trade bonds for capital gains. These investors will assess the likely future direction of interest rates in conjunction with other factors. Each type of investor will use different strategies for bond investments.
Determine maturity dates you are interested in. Your best approach may be to select a maturity date that coincides with when you need your principal. Otherwise, if you have to sell before maturity, fluctuating interest rates and transaction costs may leave you with less than you expected. Before deciding on a maturity, review the yield curve to see if there are advantages to selecting a slightly longer or shorter maturity. You may find that increasing the maturity date by a couple of years will increase your return or that committing your funds for a long time does not bring much additional return.
Evaluate different types of bonds. Consider your personal situation and risk tolerance. Treasury securities are the safest type of bond, since they are guaranteed by the U.S. government. However, they also typically have the lowest yields. Interest income is usually exempt from state and local income taxes, but is subject to federal income taxes. Government issued inflation-indexed bonds may be of interest to long-term investors who are concerned that inflation will erode their investments' purchasing power. Investors in higher tax brackets should review municipal bonds, since the interest income is typically exempt from state and local income taxes. However, municipal bond income may be subject to the federal alternative minimum tax (AMT) and capital gains from sales of municipal bonds may be subject to taxes. Keep in mind that municipal bonds are subject to market risk, interest rate risk, and credit risk. Corporate bonds usually carry more risk, but also typically offer higher returns. Interest income from corporate bonds is subject to federal and state income taxes. Interest rates can vary significantly among different types of bonds and among bonds with different maturities or credit ratings. However, different types of bonds do not always respond to interest rate changes with the same magnitude. Before purchasing a bond, review the historical spread in yields between two different types of bonds. This can reveal whether the bond's yield is attractive compared to another type of bond.
Diversify your bond portfolio in several ways. You can select different bond types, issuers, maturity dates, coupon yields, or credit ratings. All of these factors add diversification to your bond portfolio.
Consider laddering your bond portfolio. A bond ladder is a portfolio of similar accounts and types of bonds, which mature at several different dates. For instance, a $30,000 portfolio might consist of six issues of $5,000 each, maturing in six consecutive years. Since the bonds mature every year or so, you reinvest the proceeds over a period of time rather than in one lump sum. If rates increase, you have money every year or so to reinvest at the higher rates. With declining rates, you have some funds invested in longer-term bonds.
Review the use of bond swaps, where appropriate. A bond swap is simply the sale of one bond issue and the purchase of another. Swaps take advantage of inefficiencies in the bond markets and between different bonds. One of the more popular bond swaps is the tax swap, which realizes losses on a bond for tax purposes. In essence, you sell a bond with a current market value less than your purchase price to realize the loss and deduct it on your tax return. You then use the proceeds to purchase similar bonds. The end result is you still own a comparable bond, but you also have a tax loss. Review the cost of the swap before executing the transactions to ensure the costs don't offset most of your expected tax savings. Make sure to comply with the wash sale rules or your loss won't be tax deductible. A wash sale occurs when an investor sells a bond, and 30 days before or after the sale, purchases substantially the same security. Bonds purchased within the 30-day window must differ from the bonds sold in a material way, which may include different issuers, coupon rates, or maturity dates.
Use duration to help manage interest rate risk. Interest rates and bond prices move in opposite directions, which can significantly affect a bond's market value. However, it is often difficult to determine what impact a given interest rate change will have on a specific bond, since maturity date, credit ratings, coupon rate, and current interest rates all affect the result. Duration can be a helpful tool in estimating the expected impact of interest rate changes on your bond portfolio. Duration calculates how much a bond's price will move for every 1% change in interest rates. A bond's duration is typically shorter than its maturity. You can set an overall target duration for your portfolio, so you'll have a reasonable estimate of how your bond portfolio will fluctuate with interest rate changes.
Remember the basics. In general, rates of return reward you for the risks you assume. If prevailing interest rates are 4%, a bond paying 7% probably carries some additional risk. Make sure you understand that risk before purchasing the bond. Evaluate your entire portfolio periodically to ensure your bonds still meet your investment objectives. Changes in credit ratings or other events can significantly affect your bonds' values.
Various strategies can be used with your bond investments. Please call if you'd like help deciding which are appropriate for your circumstances.