By Judy Loy
Registered Investment Advisor, ChFC® and CEO of Nestlerode & Loy, Inc.
We often talk about bonds and fixed income but don’t elaborate. People were uncertain about what bonds were all about and how they worked. They just think as they get older, they need more of them in their portfolios, usually through bond mutual funds.
Investing in individual bonds can be a sound way to balance your portfolio and get a predetermined yield on the money invested. Bonds are debt instruments – unlike stocks or equities - and often are called fixed income securities. They are basically IOUs from municipalities or businesses who have issued the bond to borrow money for expansion, acquisitions or other uses. Corporate bonds are considered safer than stocks because they are one of the first to be paid in any liquidation and common stockholders are last.
The advantage to investing in bonds is that they are a safer investment vehicle than stocks, although bond returns are often lower than stocks. Purchasing bonds as part of your overall investment portfolio is a good counter to the return fluctuations common in stocks. Typically, when the stock market is doing poorly, the yield on bonds is steady.
There are several concepts about bonds that will help you understand them better:
Coupon is the interest paid on the bond. (Bonds once came with actual interest coupon books, hence the name.) Bonds are issued for a specific time period, and the bond interest is usually a fixed rate or return, although some bonds do have variable rates. Interest is usually paid twice a year on bonds. So, if you have a $1,000 bond paying 6%, you would get a check for $60 a year, or $30 twice a year.
Maturity is the length of time before the par value of a bond reaches its full value; put another way, at "maturity" the bondholder receives the full value of the bond. Bonds that mature in less than five years are usually classified as short-term bonds; intermediate-term bonds are issued with maturities of 5 to 12 years, and long-term bonds have maturities of 12 years or more.
Par value, often referred to as "face value" or "principal value," is how much the bondholder will receive at bond maturity. For instance, a U.S. savings bond with a value of $100 will be worth $100 on the date it can be redeemed.
Bond rating refers to the quality of the bond, or the ability of the bond issuer to pay its financial obligations. Standard & Poor's is one of the top independent rating agencies that rates bonds. The rating basically asks the question, "Does the bond issuer have the financial strength to pay back the bond and the interest stipulated in the bond indenture?"
It is also important to understand the types of yields on a bond: nominal yield, current yield and yield to maturity.
Nominal yield is the coupon interest rate (see above).
Current yield considers the current market price of the bond, which may be different from par value, and can give you a different return on that basis. For instance, if you bought a $2,000 par value bond with an annual coupon rate of 5% ($2000 x .05 = $100) on the current market for $1,600, your actual yield would be 6.25% because you would be earning the $100 on a value of $1,600 vs. $2,000 ($100/$1,600 = 6.25%).
Yield to maturity is the most complicated calculation. It reflects the coupon rate, current market rate, time to maturity, and presumes the interest on the bond is reinvested at the bond's coupon rate. It is best to work with a financial planner on this calculation since it is quite tricky to calculate.
Bonds can be purchased from a full-service or discount brokerage, or directly from a bond broker who usually requires a $5,000 minimum investment. Mutual funds that invest in only bonds are also a good way to buy bonds since bond funds usually purchase a wide range of bonds from many different types of entities, which diversifies the risk.
In summary, bonds are fixed-income investments that can help diversify risk in your portfolio. They have a predetermined set rate of return and bond ratings help you know which bonds are of better quality than others. However, bonds do have risk, including interest rate risk and default risk.
Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector.
Judy Loy is a Registered Investment Advisor, ChFC®, and CEO, Nestlerode & Loy Investment Advisors, State College. She can be reached at [email protected] or at 814-238-6249.