Bonds – Getting Your Feet Wet
October 17, 2012 7:09 pm in Bond
Investment in Bonds:
Now we have picked up the basics of bonds and understand the risks involved, it’s time to get your feet wet and invest in bonds either directly or through a bond fund.
Here are a few points you should keep in mind before you embark on this new investment journey in the bond market.
Bonds and Research, research, research…
Go through the bond terms with a fine tooth comb and understand all the implications. Examine the kind of bond it is, whether it has any call provisions, rates of interest payment, current yield, YTM (Yield to Maturity) and interest accrued on the bond after the last interest payment date. Like any investment, bonds also need a thorough research before we go for buying those.
Check out the bond issuer, their interest coverage ratios, debt-to-equity ratio and whether there is any past history of default and also the future possibilities for the same.
Assess the likelihood of prompt interest payment and safety of principal by checking out the ratings, if any issued by agencies such as Moody’s and S&P. Understand that these are only rough and ready guides, and may not be entirely current.
Guard Yourself Against Inflation
One great way protect yourself and your capital from the vagaries of inflation is to buy bonds which are protected from inflation risks –TIPS, or, Treasury Inflation Protected Bonds, ensure that the investment is protected against inflation. How do these work?
These are a kind of Treasury bonds of face value $ 1000 to which is added every year an amount representing the percentage rise in the Consumer Price Index (CPI). This way the inflation risk is removed, and because these are bonds issued by the Treasury, so is default risk.
Temptation of Investing in Junk Bonds
If you’re drawn to high yielding bonds, a.k.a. “junk bonds”, these are better bought through the vehicle of a junk bond fund that has a low expense ratio. The expenses you pay are justified by the diversification achieved, something you may not be able to do on your own by buying up individual bonds. The diversification affords protection against the occasional bad apple default.
The Tax Advantage
If you’re paying a lot of taxes, it makes sense to opt for tax-free bonds. The interest earned on these bonds is exempted from tax and to that extent, your yield is improved.
You should calculate, with reference to your tax rate, the net earning on a tax-free bond and that on a normal bond. Compare the two returns and decide accordingly.
What’s Age Got To Do With It?
A lot! Did you know there was a very convenient rule of thumb to calculate how much of your investable funds should go into bonds?
Take your age – that is the percentage of your assets that should go into bonds and the balance into riskier assets such as stocks. So, the higher your age, the more your investments in the comparatively safer bonds.
Bonds and Investment Timing
Ideally, move into bonds when the interest cycle is at its peak. Remember your basics? When interest rates are high, bond prices will be low, and vice versa.
If you buy bonds when interest rates are high, you would be likely buying them at very low prices. If you have timed it correctly, or are even reasonably close, interest rates should be falling off and bond prices will start ticking up. So, apart from your interest earnings, you could also earn some nice capital gains!
This is a technique for investing in bonds which minimizes the interest rate risk borne by the investor.
This is achieved by investing in a bond portfolio a part of which matures every successive year. Thus, an investor could decide to invest 20% of its portfolio in a bond that matures next year, another 20% in the second year, and so on until he is fully invested by the fifth year. As each of these mature, the proceeds of redemption are reinvested in bonds of five-year maturities. In this manner, the investor is always possessing five sets of bonds that are each maturing every year, over the next five years.
By investing in comparatively short-term bonds, which carry the lower interest rate risk, the investor is cushioned against large interest rate impacts. Also, by investing the maturity proceeds every year, the investor stays in step with the interest rate cycle.
Investing in Bonds – Summary
No investment is without risk and that hold true with the bonds also. Bonds may carry less risk than other financial instruments but they do not come risk free. The other factor is that the returns on the bonds may also be less than some other high risk-high gain investment options. One of the thumb rules of investing is to diversify the portfolio. A diversified portfolio would have some high risk and high gainer options and other options which are safer but give less returns. Considering this first thumb rule of investment, check out all the factors mentioned above for a thorough research before investing in the bonds.
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