Whether you read financial magazines and newspapers, listen to all of the talking heads on the financial channels or talk to your Great Uncle Charlie, you have probably heard the investment advisors singing the praises of investing in bonds. Depending on whom you talk to or what your age is or even your risk tolerance, you will hear a different opinion on this mystifying subject. Before you jump online or call your broker to make your next big purchase you may want to arm yourself with a few basic bullets in your holster.
According to the Bond Market Association there are seven key questions that you will want to ask (and get thorough answers to) before you invest in bonds. With these key questions in mind you may better be able to determine the value of your bond investment and the degree to which it matches your financial objectives.
What is the maturity of the bond? Another way to ask this question is How long will you need to hold the bond before you can get your money back? It is very important that you consider how soon you will need the money whether it will be used for a vacation, a new home or to fund your retirement. Another important factor to consider on this subject concerns liquidity. Is there a ready market for the bond if you need to sell it prior to the maturity date? Or will you need to find another means to fund that unforeseen opportunity?
Does it have early redemption features such as a call date? Many investors have either been unaware of or have overlooked the call features on their bonds and other callable fixed income products. Many investors purchased bonds paying very attractive yields when rates were higher only to have them called away during the recent low interest rate environment. If you are counting on a high yield bond to provide the income that you need to buy your groceries you may be a bit surprised when your bonds are called away and you are looking at reinvesting in new yields that will barely cover a trip through the drive thru window at your local fast food restaurant.
What is the credit quality? What is the rating? Is it insured? Don't get too excited about that 7% yield until you find out whether the bond is investment grade or if it is junk! Credit quality is very important. If you can find a bond that is triple-A rated with insurance guarantying that you will receive all of your interest payments and all of your money back at maturity you might be happy. But, if you just blindly jumped on a bond that was paying 7% because it had a great yield you may be surprised to find out that the company might be on the verge of bankruptcy and you may never see your money again.
Investors should keep in mind that credit ratings may change after you purchase a bond or most other investments. Does Enron ring a bell? Many brokerage firms had buy ratings on Enron's common stock and Standard & Poor's even showed an A- rating on Enron's Common stock as late as October 2001. Unless you have been living under a rock you have probably heard what has happened to investments in Enron.
Credit quality of the insurer is important too! While having an insured bond often lends us great comfort, the insurance on the bond is only as good as the quality of the company that is insuring it.
What is the interest rate? How much am I receiving to lend my money to the issuer? Remember that you are actually loaning your money to someone else and you should be properly compensated. Is the interest rate appropriate for your time horizon? If you are receiving 3% on a two year bond you may be satisfied with the yield but you probably would not be satisfied with the same yield on a thirty year bond.
What is the price? Many investors get so excited when they see a high yield bond that they forget to consider the price! A bond may originally have cost $1000 to purchase but with the changes in interest rates (as well as other factors) over time; the bond may be worth more or less than when originally issued. If a bond pays 7% interest but you pay $1120.00 to purchase it, the yield is not so attractive. This leads us to our next question;
What is the yield to maturity? What is the yield to call? If the bond is priced over par, or over the original issue price, your yield will be less than the stated interest rate. You will receive the payments at the stated interest rates, but because you paid a premium for your bonds, the actual return that you will receive will be less than the seven percent that you may have expected. On the flip side, if you see a high rated bond selling at a discount you may want to consider buying it because the actual return may be higher than the stated interest rate.
What is the tax status? Are you purchasing a taxable bond or a tax free bond? Which type of bond is better? Is it subject to alternative minimum tax (AMT)? What does my tax bracket have to do with it?
Most municipal bonds are federally and even state and local tax free. If you buy a 7% bond that is taxable and you are in the 15% tax bracket your actual return is about 5.95%. The same bond purchased by someone in the 35% tax bracket has an equivalent return of about 4.55%. The investor in the higher tax bracket might want to consider a tax free bond. Tax free bonds are not usually as attractive for investors in the lower tax brackets as they tend to enjoy better overall returns in taxable bonds. A tax free bond paying 5% has an equivalent yield of 5.88% for investors in the 15% tax bracket and 7.69% for investors in the 35% tax bracket. In the previous example the investor in the lower tax bracket might be better off buying the taxable bond at 7%. The above examples do not consider state and local taxes and are for illustrative purposes only.
Some tax-free municipal bonds are subject to Alternative Minimum Tax (AMT). When considering an investment of this type, investors who are subject to AMT will want to pay special attention to tax implications, as this tax will reduce their overall anticipated rate of return. Please consult your tax advisor to learn more about your personal situation prior to investing.
While these key variables should always be reviewed, every investor should consider their own circumstances and consult their tax and or legal advisor prior to investing.
The topics covered in this article are for discussion and information purposes only. Clients should take special care in understanding all of the risks involved prior to investing in Fixed Income products as they are not suitable for all investors. Nothing contained herein should be considered as an offer to buy or sell any security or securities product. Place Trade Financial, Inc. is a registered broker dealer. Member FINRA, SIPC. This article may be linked to other websites. Place Trade is not responsible for the content of these sites. For more information please contact Place Trade Financial at 919-719-7200.
Sarah M. Place, MBA is the President and CEO of Place Trade Financial, Inc., Member FINRA, SIPC, http://www.placetrade.com She has over eighteen years experience in the financial services industry. She has vast experience working with stocks, bonds, mutual funds, 401(k)s and other investment vehicles. She is a member of the National Association for Business Economics (NABE) and the Finance Roundtable, serves as a member of the North Carolina Council on Economic Education (NCCEE) Board of Directors as well as several other boards and committees that are dear to her heart.
She has presented topics including economic issues, investments and retirement planning to numerous groups over the years including the Tufts University Alumni Association and the Cary Jaycees. She is a contributing writer for several publications including Balance Magazine, the Carolina Newswire, the NC Journal for Women, NC Career Networking Magazine and Women in the Triangle.
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