What About Bonds?
An often overlooked, yet essential component of Your Investment Portfolio

By Joyce Cassidy O’Reilly

First, the ‘What’: Simply stated, a bond is a promise to repay the principal mount loaned to the issuer, along with interest (coupons) on a specified date (the maturity). Stocks and bonds are both securities. Unlike with equities, a bond investor does not have any ownership rights in the underlying entity, and is therefore a creditor of the issuer. There is a wide range of entities or borrowers, including public corporations, municipal entities, various state authorities (e.g., Housing Authority and the Municipal Bond Bank in Maine) and the US Treasury. The issuer determines whether the interest paid to investors is taxable or tax-exempt.
  
Key elements of a bond are:
Face, principal, or nominal amount – the amount that must be paid back by the issuer of the bond, and the amount on which interest is calculated.
Issue price – the price paid when first issued to investors.
Maturity date – the date when the full principal amount is repaid, typically ranging from one to 30 years. (U.S. Treasuries are called bills if less than one year, notes if between one and 10 years, and bonds if greater than 10 years).
Quality, or credit risk of the issuer. This often-overlooked aspect of bond investing has received much focus in the current economic climate. Obligations of the U.S. Treasury, considered to carry the least risk of any bonds, are backed by the full faith of the U.S. Government, which has the ultimate power to “create” money as issuer of the world’s reserve currency.
Several agencies rate issuers, with Moody’s and Standard and Poor being the most frequently used. Bonds are generally classified into two groups – “investment grade” bonds and “junk” bonds. The term “junk” refers to bonds with Standard & Poor’s ratings below BBB and/or Moody’s ratings below Baa. The ratings of several Fortune 500 firms went from investment grade to “junk” in a matter of days last fall.

Coupon – the interest rate paid. While commonly fixed until maturity, some bonds have rates that float or are indexed to a specified interest rate that reflects the overall market for bonds of a certain maturity and credit rating. Other zero-coupon bonds are issued at a discount, or below their par value, with the interest effectively being rolled up and paid at maturity. Inflation-linked bonds, like the popular Treasury Inflation-Protected Securities (TIPS), issued by the U.S. Government, have both the principal and interest amounts linked to the inflation rate.
  Market Price – the amount paid to purchase a bond. This is influenced by many factors, including current interest rates compared to the rate at issuance, the time until maturity, and the issuer’s creditworthiness. For instance, a 10-year 5.0% bond issued three years ago must be priced at a level today to compensate the investor for holding that bond if interest rates have moved up or down after issuance.

Bonds are traded in decentralized, over the counter markets rather than on an exchange, with dealers charging a spread (based on the difference between the “bid” or purchase price paid by one investor, and the “ask” or sale price paid to the seller) rather than a commission. Dealers also charge spreads because they assume the risk for holding bonds. (Ask how bonds are priced – spreads are not regulated and can vary widely. A 1% to 2% markup is generally acceptable for a retail buyer.)

Why buy bonds? There are five primary reasons. When held to maturity, bonds are effective in preserving principal. They can be used to save for a specific need, such as a college education (savings bonds). Expense matching (immunization) is achieved when a future expected cash need is matched in amount and timing with the purchase of zero coupon bonds. Both individuals and business entities use bonds’ predictable income stream to fund future expenses in their long range planning.

Bonds play a key role in achieving portfolio diversification because of their generally negative or inverse correlation to stocks. For example, during periods of inflation, stock prices of companies, which can increase prices on their products or services, may rise, however the ongoing value of a fixed coupon rate from a previously issued bond may fall. In addition, the predictable and steady income produced from a bond will smooth price fluctuations in stock prices; again, lowering the portfolio’s volatility or year-to-year price movement.
 
Who should invest in bonds? Most investors will benefit from exposure to bonds, whether held directly or through a bond index or bond mutual fund. Consult your financial advisor to determine how much of your portfolio should be allocated to this essential yet often overlooked investment class.

For additional information, visit www.mainebank.com.

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