Investments

Before you add bonds to your portfolio, you should understand how they work and what variations exist among them. Just as importantly, you need to identify the risks that come with owning bonds and how you can protect yourself from them.

Bond Basics

Bonds are essentially IOUs, issued by federal, state, and municipal governments as well as by corporations and governmental agencies. They are intended to raise revenue for a wide variety of activities. For example, governments issue bonds to finance the construction of infrastructure projects, such as roads, bridges, airports, public housing, and schools. Corporations may use the proceeds of bonds to pay for the construction of new manufacturing facilities, research and development, or to expand into new markets.

Bond investors essentially loan money to the bond’s issuer. In return, they receive interest payments at specified intervals plus a promise that the issuer will return the bond principal to investors when the bond’s term ends on its maturity date.1

Interest Rate Risk

Bonds are not a risk-free investment. Rising interest rates may reduce the desirability of the bonds you own because there is an inverse relationship between bond prices and yield. If you opt to sell a bond before it matures because interest rates on newly issued bonds have gone up, you will most likely have to accept a lower price than you paid for it.

The Importance of Credit Quality

Credit risk — or the risk that a bond issuer will fail to make promised interest and principal payments — is another important consideration. Bonds issued by companies or entities that are financially healthy are not as risky as bonds from issuers that are less financially sound. Bonds with low credit ratings offer higher yields to compensate for added risk to your portfolio.

Rating Agencies

Rating services assess municipal bonds, all types of corporate bonds, and international bonds. U.S. Treasury bonds are not rated. Before rating a bond, analysts assess various factors that could affect the issuer’s willingness and ability to meet its obligations to bondholders. For example, they examine other debt the company carries and how fast the company’s revenues and profits are growing. They take a holistic approach in that they also review the state of the economy and the financial health of other companies in the same business. In the case of municipal bond issuers, they examine and compare municipalities of a similar size and similar budget.

Credit ratings influence the interest rate an issuer must pay in order to sell its bonds. However, credit ratings are opinions about credit risk. Even though credit ratings are forward looking in that they assess the impact of foreseeable future events and can be useful to investors, they are not a guarantee that an investment will pay out or that an issuer will not default. While investors may use credit ratings in making investment decisions, they are not indicators of investment worth nor are they buy, sell, or hold recommendations. You can learn more about the rating systems of the two major services, Standard & Poor’s and Moody’s, on their websites.

This information is not meant as tailored investment or tax advice. Before building a portfolio that includes bonds, you may find it helpful to discuss your strategy with a financial professional.

1Bonds can gain or lose value based on economic conditions and market events. Principal is not guaranteed.

If you are investing in bonds for income, you most likely want to minimize any risk of loss to your portfolio. Since no investment is entirely risk free, you need to understand where the risks with bonds lie. One risk is the possibility that the issuer won’t pay the interest or repay the principal at maturity. There’s also reinvestment risk, or the risk that your bonds will mature while interest rates are falling. When that happens and you buy new bonds with a lower interest rate, you reduce the income stream that you are depending on.

Laddering is a strategy that minimizes the risk of being locked in at a single interest rate and provides added liquidity to your portfolio. It involves buying a series of bonds (perhaps from different issuers) with a range of maturities. The staggered maturities of the “laddered” bonds can reduce the likelihood of you dealing with reinvestment shock if interest rates happen to be lower when some of your bonds mature. Creating a laddered portfolio can help even out volatility in your income stream while allowing you to estimate how much your portfolio will yield from year to year.

Another benefit of a diverse,* laddered portfolio of bonds is that it can reduce your exposure to default risk. The default of one issuer in a portfolio that holds bonds from multiple issuers is less damaging than it would be in a portfolio concentrated in bonds from just one or two issuers.

The Mechanics of Laddering

As an example, assume that you divide up your portfolio by buying equal dollar amounts of bonds with two-, four-, six-, eight-, and 10-year maturities. So, the average maturity in your portfolio is six years. As each bond matures, you replace that bond with one equal to the longest maturity in your portfolio. For example, when your two-year bond matures, replace it with a 10-year bond. The 10-year bond you initially purchased now has eight years until it matures. And the eight-year bond has six years to maturity and so on. Despite these changes, the average weighted maturity of your portfolio does not change — it remains at six years.

When interest rates fall, your laddered portfolio protects you since the longer maturity bonds at the top of the ladder are still paying above-market rates. And when interest rates start climbing, you reinvest maturing bonds at the bottom of the ladder in higher yielding, longer maturity bonds.

You can also use laddering as a strategy if you are investing in certificates of deposit (CDs) for income. The principle is the same except you are buying bank-issued CDs instead of bonds.

As an income investor, ensuring a steady, predictable stream of income is critically important. Your investment professional can help you determine if laddering bonds or CDs is a smart strategy for achieving your goals.