As with any investment, successful investing in bonds requires following a simple routine or discipline. While experienced bond investors will follow this routine automatically, those who are newer to bonds should follow a checklist before committing themselves in this area.
This checklist is arguably even more important for bonds than it is for equities, since bonds are portrayed, often correctly, as being more conservative investments. The checklist, therefore, is intended to get to the bottom of this issue: Are bonds really as riskless as your advisor paints them?
1) When do the bonds mature? All things being equal, longer-term bonds are much more risky than shorter-term bonds. A 20-year bond with a 7% coupon trading at par would fall in price by about -10% if interest rates were to go up by +1%, whereas a 5-year bond with similar characteristics would only drop by about -4%. There is nothing intrinsically wrong, of course, in taking the more risky approach, but it is useful to have the risk quantified. One of the attractions of high-quality bonds as compared with stocks is that their risk is easily quantifiable.
2) Are the bonds good quality? By definition, good-quality bonds are less risky than lower-quality bonds. The main point here is that with junk fixed-income securities the risks are multiple. A number of different factors can adversely affect weaker bonds – changes in credit ratings, industry trends, politics, internal corporate matters, among many others. For the best quality bonds, however, namely U.S. government securities, the only risk lies in which direction interest rates go.
3) What are the prices of the bonds? To some degree, the price of all bonds is determined by interest rates, but with lesser bonds it is also determined by a number of other factors, one of which is liquidity. One of the major attractions of the Treasury market is its high liquidity. There are over $3.5 trillion in government bonds outstanding, whereas in the entire corporate bond market there is little more than half of that. The net result is that many bonds have issue sizes of only a few million dollars. The effect on pricing here is that spreads are generally wider, as such bonds trade very infrequently.
4) What is the coupon? A bond’s coupon, established at the time the bond is issued, is the (usually) fixed rate of interest that is paid by the issuer, either annually or semi-annually. The significance of the coupon is that it is one of the most important determinants of a bond’s sensitivity to changes in interest rates. All things being equal, a bond with a higher coupon will hold its value better as interest rates rise. In short, higher coupon bonds tend to be less risky investments.
5) What is the yield? The “YTM” (yield to maturity) of a bond is a very rough-and-ready measure of the return that the bond will deliver over its life. A high YTM is better than a lower one (again assuming “all things are equal”). It is a theoretical calculation that assumes that all interest payments received will be reinvested at the same rate. While this never happens, it’s still the best single measure available for most bonds. Sometimes, however, it’s dead wrong. For the answer to this problem, read on.
6) Any special features? Sometimes bonds are flat-out complicated with an entire alphabet soup of features attached to them. One larger feature, which gives rise to an entirely separate class of bonds, is convertibility. Bonds of this type are convertible into another security, usually common shares, and how to value them is an entirely separate subject. A less significant feature, but one that’s still important, is “callability”. This means that the issuer can, under certain circumstances, pay off the bonds before they come due. In such a case, the important calculation for any aspiring investor becomes “yield to call” versus the “yield to maturity”, and it is important to note that the YTC of a bond is often less, sometimes by a good deal, than the YTM.
7) What about taxes? This is a voluminous subject all by itself. Here we can do little more than say that, without at least some grasp of the general tax ramifications of investing in all types of bonds (municipal, corporate, Treasuries, discount, zero coupon, etc.), you are assuming an unknown risk. While we believe that bonds belong in most investor portfolios, at least to some degree, going in “blind” is a sure recipe for poor returns and frustration. If you are uncertain about how taxes may impact you and your bonds, you should talk with your accountant rather than your financial consultant, who may not be qualified to provide you with this type of guidance.
LEGAL: Investing in securities denominated in currencies other than the U.S. dollar involves certain considerations comprising both risk and opportunity not typically associated with investing in U.S. securities. The Security may be affected either favorably or unfavorably by fluctuation in relative rates of exchange between the currencies, by exchange control regulations, or by indigenous economic and political developments.
Source: http://www.iaac.com
