Useful Financial Links Useful Financial Tools

Articles Tagged with "Bonds"

Investing in Fixed-Income Securities

As a money management firm, our client’s are looking for income and cash flow from their investments. There are many ways to accomplish that and one way is investing in bonds. Some investors may believe that bonds are not exciting investments  and do not believe bonds are appropriate for their portfolios. These investors may be wrong on both counts. The variety of debt instruments with a wide range of features can earn current income and large returns. Some bonds including junk bonds can be exciting however they may not be appropriate for conservative investors seeking income and preservation of capital.

As part of our asset management service, we encourage investors to reduce risk and create income through fixed income securities. Bonds do play an important role in diversifying a portfolio. We usually allocate bonds in the tax deferred accounts in order to minimize the tax. As a CPA who specializes in tax reduction and money management, we use many tax saving strategies along with maximizing returns for our clients..

As an asset management firm we analyze our clients income needs and risk tolerance. We are well versed in fixed income securities and we would like to share some basics when it comes to investing in fixed income securities.

What is a bond or fixed-income security?

All bonds have similar characteristics. They represent the indebtedness (liability) of their issuers in return for a specific sum, which is called principal.  All debt has a maturity date, which is the date by which your principal must be paid back. When debt is issued, the length of time to maturity is set, and it may range from one day to thirty years or more. Long-term debt matures more than a year after it has been issued. Debt that matures between one to ten years is sometimes referred to as intermediate debt. The interest rate or sometimes called the coupon rate is paid to the borrower. The interest rate on most securities are fixed rates however there are fluctuating rates such as TIPS. You can buy bonds at par, a discount or at a premium.  This will determine the effective rate which may be different then the stated rate. The potential return offered by a bond is referred as the yield.  There is a relationship between yield and the length of time to maturity for debt securities.  The longer the length of time to maturity, the more risk an investor take on with regards to getting paid back or fluctuations in the interest rate. That is why long-term debt typically has a higher rate to compensate the investor for the additional risk over short term.

What is the yield curve?

The difference in long-term and short-term yields is demonstrated by what is referred to as the yield curve in economics. Although such relationship between time and yield does usually exist, there have been periods when the opposite has occurred (ie., when short-term interest rates exceed long-term interest rates). This happened from 1978 to 1979, and again in 1981. This can be explained by the high rate of inflation, which exceeded 10 percent at that time. In order to contain inflation and slow down the economy the Federal Reserve will raise short term rates. In recessions, like the one we are having now in 2009 and 2010 the Federal Reserve is keeping short term interest rates at 50 year lows to create inflation and spur the economy.

As part of our asset management services, we make sure our clients are well diversified and protected from inflation as well as all the other inherent risks to the best of our abilities.  With asset management, we analyze our client’s portfolio to match income and risk.

What type of Bonds should I invest in?

There are a variety of fixed-income securities available with a variety of terms and risks. As part of our asset management we will allocate your income portfolio according to your short-term and long-term goals and risk tolerance. Here is a summary:

Corporate Bonds- Corporations issue many types of bonds: mortgage bonds, equipment trust certificates, debenture bonds, income bonds, convertible bonds, variable interest rate bonds, and zero coupon bonds. These corporate debt instruments are either secured or unsecured. A secured debt means that the debtor is entitled to some type of security or asset of the company as collateral.

Money market instruments- Short-term, highly marketable loans tied to financial and non-financial corporations. These securities are usually less than 12 months in duration and are generally considered safe investments. They consist of commercial paper, repurchase agreements, bankers acceptances, negotiable CDs, Treasury bills, and tax anticipation notes. Money Market Mutual Funds are what most investors use and it is important to note these instruments are not protected under FDIC insurance.

U.S Government Securities- US Securities are considered direct obligations of the U.S. government. These marketable securities include Treasury Bills, Treasury Notes, and Treasury Bonds. U.S. Treasuries are considered to be the safest fixed-income securities, they are highly sought after in the U.S. and throughout the world. T-Bills, notes and bonds are broken up by the maturity duration of the securities.

Federal Agency Bonds- These instruments are issued by federal agencies to provide funds to support activities such as : postal service, housing, insurance, credit guarantees, etc. Agency bonds that are backed 100% by the U.S. government are defense dept, export –import bank, FHA and Tennessee Valley Authority.  Federally sponsored agencies would be FNMA, student loans, farm credits, Federal Home loans banks, etc.

Mortgage-Backed Securities & asset-backed securities- These are securities that are backed by pools of mortgage loans. Because the underlying mortgages can be prepaid, prepayment risk is a major concern. Additional and more current in headline news is the default risk when there isn’t sufficient collateral or home equity upon default.  There are mortgage pass through securities tied to certain pools of Ginnie Mae, Fannie Mae and Freddie Mac loans. Ginnie Mae obligations are the safest of the three due to the fact they are 100% guaranteed by the U.S Government. Collateralized Mortgage Obligations (CMOs) are a means to pool mortgages principal and interest payments among investors in accordance with their preferences for prepayment risk.

Municipal Bonds- State and local governments borrow money to finance their operations. These bonds are like any other government type bonds except they have additional tax break  incentives.

What risks are there when investing in Bonds?

Time to maturity or duration– The length to maturity has a great affect on a bonds exposure to risk as well as the perceived value of the security. The longer the maturity, the greater the amount of time its coupon (interest) payments would be affected by interest rate changes. This is why longer-term fixed-income issues have a higher rate in order to compensate the investor for the additional risk. When interest rates increase your long-term bonds will decrease more in value than your short-term bonds. Additional risks to longer term bonds are inflation risk and reinvestment risk. The added exposure to risks would again be compensated through higher coupon rates. As a security approaches maturity, its risk exposure is less and its sensitivity to interest movements is also less.

Default or credit risk- This is the likelihood the issuer may default on the payment of interest and principal of the loan. Any security backed by the full faith and power of the U.S. government is considered the highest quality (or lowest default risk). For all other fixed-income securities, there are rating systems.

Currency Risk- Foreign bonds pay in their countries currency denomination. When that currency converts into U.S. dollars there is a currency fluctuation risk.

Other Risks- There are many aspects and risks associated with investing in fixed securities. Other risks not discussed above can be extension risk, liquidity risks, political risks, courts, disclosure, exchange, etc  To explain all of these risks would be too cumbersome for the purpose of this article.  Prudent investing to match our clients financial goals is what our asset management or money management firm provides.