BONDS REVISITED Ten things you should know

As the equity market continues to do well, investors think less and less about bonds, and often forget some small but significant details. Here are ten things you probably knew, but may have forgotten. Happy Investing

BONDS REVISITED
Ten Things You Should Know
 
Because bonds are not usually actively traded by your average investor, it is easy to forget some important things about them.
 
1.       Bonds are a glorified IOU. When companies need to finance growth and development they often borrow from you by selling bonds. They not only promise to pay you back at maturity but they also pay interest, usually twice a year.
 
2.       Contrary to popular belief, stocks to not always outperform bonds in terms of total yield. Bonds actually provided a greater return on investment in 2000, 2001, and 2002. In 2003 stocks took over once again and proceeded to outperform bonds.
3.       You can lose money in bonds. They are not supercharged CD’s, and while their interest payment is fixed, the returns are not. They will fluctuate in value over time and that causes changes in their actual yield. Should you need to access your money prior to maturity you can easily take a loss. If interest rates have gone up since you purchased your bonds, their value will drop as they cannot compete with newer debt that has a higher interest rate. Conversely, if rates drop after your purchase, you can actually sell your bonds for a profit as they will have a higher yield than new bonds coming to the market.
4.       Once again, bond prices move opposite direction of interest rates. If interest rates fall, prices rise, and vice versa. However, if you hold a bond until maturity price fluctuations will not matter. Because the interest rate is fixed you will receive the same interest payment regardless of the value of your particular bond issues.
5.       Bonds and bond funds are vastly different. With a single bond issue you will get your interest and principal upon maturity, assuming the company does not go belly up. With a bond fund, the bonds inside the fund are frequently traded so your fund will change in price and may be at a loss when you decide to make a withdrawal.
6.       Don’t invest all your retirement money in bonds. Inflation erodes the value of your bonds while stocks stand a better chance in outpacing it. Despite the volatility of the stock market, young and middle aged persons should have a large portion of their money in stocks as they do outperform any investment vehicle, given time. Even retirees should have a portion of their investments in stocks.
7.       Think about tax free bonds, especially if your tax bracket is 28% or higher. Your real yield will be much higher. As you age and retire, your tax bracket may drop low enough that your net return may be higher with taxable bonds. Consult your tax professional before committing either way.
8.       This one is important. Pay attention to total return, not just yield. If a broker sells you an issue with a coupon of 8%, but charges you a premium of 101 for example, your actual yield will not be 8%. To get a return of 8% you would have had to purchase that bond at par, or 100 (1000 per bond). On the other hand, if the coupon is 8% but you purchase it at a discount, 99 for example, your actual yield is slightly higher that 8%.
9.       If you want capital gains and think that rates are headed lower, purchase long bonds. Consider zero coupon bonds as they will react the most as rates head down, and you stand to have the greatest gain. Keep in mind that the longer the bond the greater the volatility, so you are going to see some fluctuations along the way.
10.   If it’s steady income you desire, stick to a laddered portfolio so you are able to take advantage of changes in interest rates. You will also be able to structure the interest payments so you have a steady and predictable income stream.
So there you have it, a brief overview of bonds. Be sure to consult your tax professional to determine which is better for you, taxable or tax free bonds. Generally in your younger years, the real return on tax free bonds is highest, and as you grow older and your tax bracket is likely to be lower, you may want to buy higher yielding taxable bonds.
Good luck, and happy investing.
 

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