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Finance: There is always a risk
Michael Chevy Castranova
Jan. 5, 2012 5:17 pm
Should bonds be part of your portfolio?
Bonds have a reputation for offering low returns and zero excitement. As a result, many people overlook bonds when considering their portfolio options.
However, bonds - including a concept known as a bond ladder - may be ideal places to put your money, especially if you require a steady source of income.
Let's examine some bond basics to help determine if bonds should be part of your portfolio.
What are bonds?
They're debt instruments - loans you make to the issuing company or municipality.
Unlike stocks, bonds do not give you a piece of ownership in the organization. Instead, they are a debt the business or government entity owes you.
The interest rate is set at the time of purchase and is often based on the amount or risk. That rate is known as the coupon, because, in the past, payments often were redeemed from a coupon book.
Also, depending on a number of factors, a bond may sell for its face value (at par), for more than face value (at premium) or for less than face value (at discount). Regardless, at the end of the term, it is redeemed for face value.
Bonds are issued for specific periods of time - generally for 1, 2, 3, 5 or 10 years. At the maturity date, the principal is repaid in full.
Why invest in bonds?
Bonds typically do not provide the same level of returns as stocks over time. They are known more for safety and income rather than growth.
Assuming the risk of default is low, they can provide stability and a degree of consistency.
Is there risk?
There is always risk. If general market returns rise dramatically, there is “opportunity risk.”
For example, if you are locked into a bond with a 5-year maturity that pays 2 percent while other investments are returning 5 percent, you are missing the opportunity for higher returns.
Similarly bonds are subject to interest-rate risk, which means that as interest rates rise, the value of a currently held bond may fall. Also, if the business declares bankruptcy or the government entity goes into default, there is the risk that investors could lose their entire principal.
Debt obligations are affected by changes in interest rates and the creditworthiness of their issuers. High yield, lower-rated (junk) bonds generally have greater price swings and higher default risks.
That is why it is important to know a bond's rating and match it to your own risk tolerance. Private independent rating services provide evaluations of a bond issuer's financial strength, based on the projected ability to pay interest when due and return the principal investment at the bond's maturity.
This helps investors determine a company's credit risk.
What is a bond ladder?
A bond ladder is not a product. Instead, it is a strategy to help maximize the return while helping minimize the risks and providing cash flow.
The idea is to provide a level of diversification by purchasing bonds with multiple maturity dates, such as 1 year, 5 years and 10 years. Each maturity date represents a different rung on the ladder.
This ideally reduces the reinvestment risk that can come with rolling over maturing bonds into similar fixed-income products all at once during a time when rates may be low.
Diversification does not guarantee against loss - it is a method used to manage risk.
Example: Suppose you had $100,000 to invest. By using the bond ladder approach, you might buy 5 different bonds, each with a face value of $20,000 or even 10 different bonds each with a face value of $10,000.
Either way, you would select different maturity dates. One bond might mature in 1 year, another in 2 years and the remaining ones in 5-plus years.
What are the advantages of using bond ladders? By having different maturity dates, you are not locked into one bond rate for a long duration for all your assets.
So, if rates bottom out at one maturity date, there are still other bonds earning higher rates. By using a bond ladder, you may smooth out the fluctuations in the market because you have bonds maturing over time rather than all at once.
In addition, a bond ladder helps you adjust cash flows to reflect your financial situation and needs. You can stagger maturity dates to reflect future needs and anticipate changing responsibilities.