Bonds have long been a stable-return strategy for long-term investors. They offer an annual yield, similar to interest, which can be fixed or variable (floating rate notes), in which case the yield will rise with interest rates.
Bonds are the most common hedge against equity volatility, but it is difficult for individual investors to benefit from the stable returns bonds can offer. This is because most bonds are offered in denominations of $1000 or higher. As with all investments, bond investments should be well-diversified, ranging across a wide array of issuers, countries and types. So, a diversified bond portfolio can cost well above $50,000.
Mutual funds offer small investors a way to invest smaller amounts into this essential asset class.
There are two main types of bonds available to investors: Government Bonds and Corporate Bonds.
Government bonds are issued by a government agency in order for the agency to finance its operations.
Treasury Notes (T-Notes) and T-Bills are intermediate- and short-term bonds issued by the United States Treasury. Because they carry with them the good faith and credit of the United States Treasury they are a very low-risk, low-return investment. Just about every Fixed Income Fund will invest a portion of its assets in U.S. Treasuries.
Municipal bonds are issued by individual municipalities throughout the United States and, as such, carry a higher risk of default. As a result, they often carry a higher yield than Treasury bonds. Municipal bonds are also very tax-efficient, as interest earned is usually not taxed by state and local governments.
Corporate bonds are issued by corporations and carry a higher risk of default than most government bonds. The higher the risk of default, the higher the yield.
Corporations are issued a credit rating by Standard and Poors and Moodys, two credit reporting agencies not very different from the consumer credit reporting agencies, Experian, TransUnion and Equifax. S&P and Moodys have different rating scales, but both will consider the financial health of a company, its history of borrowing, and its outlook. These factors help to determine a companys credit-worthiness.
The higher the rating, the lower the interest rate a company will have to pay in order to issue bonds.
There are two main risks involved in Bond investments: Credit Risk and Interest Rate Risk.
Credit Risk is the risk that the bonds value will decline because the issuers credit rating has declined. This has recently happened to many North American airline companies and two of the largest auto manufacturers as the companies financial health declined.
While it is more likely for corporate bonds to experience credit risk, many emerging markets that issue government bonds are also a risk. Current Iraqi bonds, for instance, decline in price with every bit of news of an insurgent attack, because investors fear that the country will default on its obligations. Brazil defaulted as recently as 1990 and Argentina defaulted in 2002.
This is a well-known but little-understood risk of bond investments: bond values decrease when interest rates rise, and bond prices increase when interest rates fall.
To illustrate this point, I will use an absurd example: lets say I bought a 10-year bond issued by company A for $1,000 in January that paid a 5% yield. The interest rate on a 10-year Treasury (issued by the U.S. Treasury) was 4%. So, since Company A carried a slightly higher risk of defaulting than the U.S. Treasury, my bond carried an extra 1% yield.
Well, lets say that in August, interest rates went through the roof, and the T-Note yield had doubled to 8%. My corporate bond, which only yields 5%, actually has a higher risk of default than current Treasuries, which pay 8%. Put another way, why would anyone buy a higher-risk corporate bond at 5% when they could buy a superior T-Note that yields 8%? As a result, I will not be able to sell my bond for $1,000. Its price drops.
Now, I think 8% is a good yield for T-notes, so I buy one in August for $1,000. The following spring, as the economy stabilizes and interest rates fall. The T-Note yield is back down to 4%. Now, that original corporate bond I bought (assuming the companys credit rating has remained stable through all of this) is worth $1,000 again. More importantly, my T-Note which pays 8% is now worth twice what I paid for it and I can sell it for a healthy gain.
These are largely factors which individual investors have little control over, so it is best to hire a professional when entering the bond market. This is where mutual funds come in.
The best fixed-income funds will be open-ended, allowing the fund to invest in a wide array of issuers and types of bonds. The fund management should be able to assess the bond market and determine which bond issues are likely to perform best.
There are times when short-term low-yield government bonds will fare better than corporate issues. Sometimes convertible bonds (bonds which can be exchanged for stocks at a fixed price in the future) will be the best investment. In the eighties and nineties, high yield bonds (also called junk bonds), bonds issued by companies with low credit ratings, performed best.
For this reason, you should consider diversified bond funds, which can benefit from all issuers and all types. PIMCOs Total Return and Diversified Income as well as the Dodge and Cox Income Fund are very good choices.
For a tax-efficient income stream, specialty municipal bond offerings are a good option. Oppenheimers Rochester Munis are among the best, but nearly all fund families include tax-exempt bond funds.