Recently, we completed a comprehensive financial plan for new clients in their early 60's. They are near retirement, have been great savers and have accumulated a sizeable nest- egg that should be sufficient to help them meet their retirement goals for the next 30+ years. It is probable they will leave a sizeable inheritance for their children, although that isn't their primary goal.
Since their income has been sufficient to meet their lifestyle income needs, stock market volatility hasn't been a big concern, but now that they are approaching retirement they are concerned about another downturn in the markets. In the past, their investment portfolio has been mostly invested in stocks. Recently, they have started to increase their bond allocation, but they are concerned about bonds and don't really appreciate how and why they could be used in a portfolio. Like most of our clients, they have a lot of preconceived notions about bonds and really don't understand the "basics".
This article, the first in a two-part series, will outline 5 important basic concepts that will help you understand how bonds work. The second article will discuss how bonds fit into an overall investment portfolio.
What are Bonds?
When a corporation or a government entity (like the U.S. government, the Commonwealth of Massachusetts or the City of Boston) needs to borrow money, the entity will try and raise money through the sale of a bond. Purchasers of the bond will expect a specified interest payment for a pre-determined number of years and then the lender expects repayment of the original amount borrowed.
The interest rate must be high enough to attract an investor to lend money to a borrower for a predetermined amount of time. Entities from around the world issue bonds so the competition is intense. The interest rate is based on a variety of factors at the time the bond is issued:
- The current interest rate environment.
- The entity's creditworthiness or financial strength - the U.S. government can borrow at a lower interest rate than countries like Brazil or Russia or a highly- leveraged company where there is a greater chance of default.
- The maturity date of the bond is when the lender is repaid, usually 1 to 30 years.
The tax status of the bond will affect the interest rate. U.S. government bonds are taxable at the federal level and tax-free at the state level. Corporate bonds are taxable at the federal and state levels. Municipal bonds are tax-free at the federal level and tax-free at the state level if the investor is a taxable resident in the state the bond is issued. Taxable bonds typically offer higher interest rates than tax-free bonds.
The par value or face value of the bond is usually the amount the issuing entity initially borrowed and is the amount that will be repaid when the bond matures. The coupon rate is the rate of interest the bond will pay. The coupon rate multiplied by the face value of the bond gives you the annual dollar amount of interest the bond pays.
- Call provisions allow the borrower to repay the note earlier than the maturity period. If interest rates go down, the borrower can refinance the notes at a lower cost. This may not be advantageous for the investor.
The current market value of a bond is typically different than the face value of the bond.
Bond values will fluctuate based on similar factors to those that determine interest rates at the time the bond is issued (see above). The current market value of a bond will fluctuate when market interest rates go up or down. When interest rates go down, bond values will increase and when interest rates increase, bond values will decrease. Longer maturity bonds are more susceptible to changes in interest rates than shorter maturity bonds.
Bonds can be bought and sold and their market values are primarily based on mathematically derived calculations. The most important factors to consider are fluctuations in market interest rates and the maturity date of the bond. Two important concepts are "yield to maturity" and "duration":
Yield to Maturity is a calculation that considers the bond's annual interest payments, the number of years to maturity, the bond's value at purchase and its value at maturity. Think of it as the bond's internal rate of return.
The Duration of a bond is a calculation that helps quantify a bond's price sensitivity. It is a better indicator of interest-rate-risk than just the maturity of the bond because it takes into account the timing of the bond's maturity and the interest payments. For example, a bond might have a 6-year maturity and a 5-year duration. In this instance, a 1% rise or fall in interest rates would cause the bond value to rise or fall by 5%.
While most of our clients own bonds, they aren't seen as an exciting or interesting investment. Especially when compared to stocks. At first blush, bonds appear simple, but they can be sophisticated financial instruments that have a variety of attributes, risks and benefits. Our next article will describe how this asset class can fit into an overall investment strategy and how you can avoid the pitfalls of bond investing. In the meantime, please call the Raskin Planning Group if you have questions.
Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC). Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors, a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Raskin Planning Group is not an affiliate of Lincoln Financial Advisors. Lincoln Financial Advisors does not provide legal or tax advice. CRN-1196757-051115