Investments in bonds should be tailored to your investment objectives, risk tolerance, and other personal circumstances. Answering some fundamental questions will help you determine the role bonds should have in your portfolio:
What are your overall investment objectives?
Investors committed to growth are looking for appreciation of capital, with little concern for income, so bonds will have a minimal role in their portfolios. Total return investors want a balance of income and capital appreciation, so bonds will be more important in their portfolios. Income investors are looking for interest or dividend income, with capital appreciation a secondary concern, so bonds will have a significant role in their portfolios.
What's your investment time frame?
When selecting bonds, you should consider when you need the principal. Typically, yield increases as the maturity date lengthens, since you assume more risk by holding the bond for a longer time. Investors are often tempted to purchase bonds with long maturity dates to lock in higher yields. However, use that strategy with care. If you purchase a long-term bond and sell it before maturity, interest rate changes can significantly affect the bond's market value. Although you can't control interest rate changes, you can limit the effects of those changes by selecting bonds with maturity dates close to when you need your principal.
What is your risk tolerance?
Typically, the higher a bond's return, the greater its risk. Thus, U.S. Treasury securities, which are considered one of the safest bonds, typically carry lower rates than municipal or corporate bonds. Make sure you understand the risks involved before purchasing a specific bond.
Are you concerned with minimizing income taxes?
Interest income from U.S. Treasury securities is exempt from state and local income taxes, but is subject to federal income taxes. Interest income from municipal bonds is exempt from federal income taxes, and typically is exempt from state and local income taxes for residents in the issuing state. Interest income from corporate bonds is subject to federal and state income taxes. Investors in higher tax brackets typically find tax exemption of interest income more valuable. Be aware that any exemption from income taxes applies only to interest income. Capital gains from the sale of a bond are still subject to income taxes.
What variables should you consider before purchasing a bond? Before you purchase a specific bond, make sure you fully understand its features and can answer the following questions:
- What is the bond's maturity?
- What is the bond's credit rating and is it insured?
- Does the bond have call provisions?
- What is the coupon rate?
- What is the bond's price?
- What is the yield to maturity?
- How is the bond's interest income taxed?
The role of bonds in your portfolio will depend on your answers to these questions.