Find the right bond at the right time

Every investment portfolio should consider allocating a certain percentage of funds to bonds at a certain point in the investor’s life. This is because bonds provide a stable and relatively safe cash flow (income), which is essential for investors who are in the asset withdrawal or capital preservation phase of an investment plan and investors approaching this phase. In short, if you rely on investment income to pay bills and daily living expenses (or in the near future), then you should invest in bonds.

In this article, we will discuss several different types of bonds and determine how to use each bond to achieve investor goals.

Key points

  • A diversified portfolio should include bond investments, but if you look at the bond market as a whole, it can be complicated and overwhelming.
  • Depending on your investment objectives, tax risk, risk tolerance, and time frame, different types of bonds will be best for you.
  • Understanding the risks and characteristics of each type of bond can help you understand when and how many asset classes to add to your portfolio.

Build your income portfolio

Unlike stock investment, the structure of the bond portfolio can meet the exact income needs of investors, because for stocks, investors may rely on uncertain and unpredictable capital gains to pay their bills. In addition, if investors liquidate stocks to obtain current income, they may have to do so at the wrong time-when the volatile stock market falls.

A well-structured bond portfolio does not have this problem. Income can come from coupon payment, or a combination of coupon payment and principal return at maturity of the bond. Any income that is not required at the maturity of the bond is strategically reinvested in another bond to meet future demand-so that income requirements are met while keeping capital to the maximum. Most importantly, compared with stocks, bonds provide a historically less volatile, less risky and more predictable source of income.

There are US Treasury bonds, corporate bonds, mortgage bonds, high-yield bonds, municipal bonds, foreign bonds, and emerging market bonds—just to name a few. Each type has a different duration (from short-term to long-term). Let’s take a closer look at these different bond types.

U.S. Treasuries

U.S. Treasury bonds are considered one of the safest investments in the world, if not the safest. For all intents and purposes, they are considered risk-free. (Note: They have no credit risk, but no interest rate risk.)

U.S. Treasury bonds are often used as a benchmark for other bond prices or yields. It is best to understand the price of any bond by looking at its yield. As a measure of relative value, the yields of most bonds are cited as the difference between the yields of comparable U.S. Treasury bonds.

Example: Difference in Yield

The spread on a certain corporate bond may be 200 basis points higher than the current 10-year Treasury bond. This means that the yield on corporate bonds is 2% higher than the current 10-year Treasury bond. Therefore, if we assume that this corporate bond is not redeemable (meaning that the principal cannot be bought out in advance) and the maturity date of the U.S. Treasury bond is the same, we can interpret the additional 2% yield as a measure of credit risk Standards. This credit risk or spread measurement standard will vary according to the company’s specific circumstances and market conditions.

If you are willing to give up some gains in exchange for a risk-free investment portfolio, you can use treasury bonds to build a portfolio with coupon payments and maturities that meet your income needs. The key is to minimize your reinvestment risk by matching these coupon payments and maturity dates as closely as possible to your income needs. You can even buy U.S. Treasury bonds directly from the U.S. Department of the Treasury at the same price (yield) as Treasury Direct’s large financial companies.

Corporate bonds

Although not all listed companies raise funds through bond issuance, there are still corporate bonds from thousands of different issuers. Corporate bonds have credit risks, so they must be analyzed based on the company’s business prospects and cash flow. Business prospects and cash flow are different-a company may have a bright future, but it may not have current cash flow to pay off debt. Credit rating agencies such as Moody’s and Standard & Poor’s rate corporate bonds to help investors assess the issuer’s ability to pay interest and principal in a timely manner.

Yield provides a useful measure of the relative value of corporate bonds and U.S. Treasury bonds. When comparing two or more corporate bonds based on yield, it is important to recognize the importance of maturity.

Example: bond yield and credit risk

A five-year corporate bond with a yield of 7% may have a different credit risk than a 10-year corporate bond with a yield of 7%. If the 5-year U.S. Treasury bond yields 4% and the 10-year U.S. Treasury bond yields 6%, we might conclude that the 10-year corporate bond has less credit risk because it is in line with the Treasury benchmark. Generally speaking, the longer the maturity of the bond, the higher the yield required by investors.

The most important thing is not to try to compare the relative value of bonds with different maturities without recognizing these differences. Also, be aware of and identify any bullish characteristics (or other option characteristics) that corporate bonds may have, as they will also affect yields.

Diversification is the key to minimizing risks and maximizing returns in a stock portfolio, which is equally important in a corporate bond portfolio. Corporate bonds can be purchased through retail brokers, and the minimum face value is usually $1,000 (but it can usually be higher).

Mortgage bond

Mortgage bonds are similar to corporate bonds in that they carry some credit risk and are therefore traded at the difference in yields with U.S. Treasury bonds. Mortgage bonds also have risks of early repayment and rollover. These types of interest rate risk are related to the possibility that potential borrowers will refinance their mortgages as current interest rates change. In other words, mortgage bonds have an embedded call option that the borrower can exercise at any time. The valuation of the call option greatly affects the yield of mortgage securities. Any investor who compares relative values ​​between mortgage bonds and/or other types of bonds must understand this well.

Mortgage bonds are divided into three general types: Ginnie Mae, agency bonds and private label bonds.

  • Ginnie Mae bonds are fully trusted and credit-backed by the U.S. government-loans that support Ginnie Mae bonds are guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs, or other federal housing agencies.
  • Institutional mortgage bonds are bonds issued by government-sponsored housing finance companies (GSE): Fannie Mae, Freddie Mac, and the Federal Housing Loan Bank. Although these bonds do not have all the trust and credit of the US government, they are guaranteed by GSE, and the market generally believes that these companies have implicit guarantees backed by the federal government.
  • Private label bonds are issued by large mortgage promoters or financial institutions such as Wall Street companies.

Ginnie Mae bonds do not carry credit risk (similar to U.S. Treasury bonds), institutional mortgage bonds carry certain credit risks, and private label mortgage bonds can carry great credit risks.

Mortgage bonds can be an important part of a diversified bond portfolio, but investors must understand their unique risks. Credit rating agencies can provide guidance for assessing credit risk, but be aware-rating agencies sometimes make mistakes. Mortgage bonds can be bought and sold through retail brokers.

High-yield bonds, municipal bonds and other bonds

In addition to the aforementioned treasury bonds, corporate bonds, and mortgage bonds, there are many other bonds that can be strategically used in diversified, income-generating investment portfolios. Analyzing the yields of these bonds relative to U.S. Treasury bonds and relative to comparable bonds of the same type and maturity is the key to understanding their risks.

Just like the price changes of stocks, bond yields are not consistent from one sector to another. For example, as the political risks of developing countries change, the yields of high-yield bonds and emerging market bonds may change. Only when you understand the source of yield differences can you effectively use yield comparisons between bonds and industries for relative value analysis. Make sure you understand how the bond’s maturity date affects its yield-this includes embedded call options or prepayment options that can change the maturity date.

Bottom line

Bonds have a place in every long-term investment strategy. Don’t let your life savings disappear in the volatility of the stock market. If you rely on investment for income or will invest in the near future, you should invest in bonds. When investing in bonds, compare relative values ​​based on yields, but make sure you understand how the maturity and characteristics of the bonds affect their yields. The most important thing is to study and understand the relevant benchmark interest rates such as 10-year Treasury bonds in order to correctly view each potential investment.

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