The strategies used for bond investing will depend on the financial objectives you are pursuing. You need to consider a list of facts in order to receive a good return.
This is the most typical role for bonds and is usually accomplished with a buy-and-hold strategy. With this strategy, you purchase a bond and hold it to maturity, looking for the highest return potential for a given time frame within a comfortable risk level. By holding the bond to maturity, you don't have to worry about interest rate changes impacting your bond's price.
Since bonds with longer maturities typically have higher interest rates, this strategy typically involves investing in longer-term bonds. Interest rate changes will typically affect a longer-term bond's price more because long-term bonds have a longer stream of interest payments that don't match current interest rates. Someone looking to maximize income will also be more likely to sell a bond before maturity to lock in capital gains. Another strategy to help achieve this objective is to invest in high-yield bonds, which are bonds with lower credit ratings. Due to the lower credit rating, these bonds often have to offer higher interest rates to obtain investor interest.
One of the most significant bond risks is interest rate risk, or the risk that increases in interest rates will cause a decrease in your bond's price. Bond ladders can help manage this risk. A bond ladder is a portfolio of bonds of similar amounts maturing in several different years. When one of the bonds matures, the principal is reinvested in another bond at the bond ladder's longest maturity. By spreading out maturity dates, you lessen the impact of interest rate changes. Holding the bond to maturity prevents interest rate changes from resulting in a loss when you sell the bond. Since your bonds mature every year or so, your principal is reinvested over a period of time instead of in one lump sum. If interest rates rise, you have principal maturing every year or so to reinvest at higher rates. In a declining interest rate environment, you have some funds in longer-term bonds with higher interest rates. But the main advantage is you won't continue to hold only short-term bonds while you wait for interest rates to peak, an event that is difficult to predict.
The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully help offset this decline. For instance, in 2002, the S&P 500 returned 22.1%, while long-term government bonds returned 17.8% and intermediate-term bonds returned 12.9%.* One way to assess the percentage of bonds to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.
Because bonds have a definite maturity date, you can select maturity dates to coincide with when you need your principal. You might want to consider zero-coupon bonds for this purpose. Zero-coupon bonds are issued with a deep discount from face value and do not pay interest during the bond's life. The return results from the bond's price increasing gradually from the discounted value to face value, which is reached at maturity. The longer a zero-coupon bond has until maturity, the greater its price discount will be. Like other fixed-income investments, a zero-coupon bond's price moves up when interest rates fall and down when rates rise. However, since zeros lock in a fixed reinvestment rate of interest, they are affected more drastically by interest rate changes. One important factor to consider is taxation. Even though you do not receive any interest income until the zero-coupon bond matures, you are taxed on the yearly growth in the zero's value (called accretion).
A bond swap, which is simply the sale of one bond and the purchase of another, can help achieve this objective without changing the basic composition of your bond portfolio. In essence, you sell a bond with a current market value less than your purchase price to realize a loss and deduct it on your tax return. You then use the proceeds to purchase similar bonds. The end result is that you still own a comparable bond, but you also have a tax loss. Review the cost of the swap before executing the transactions to ensure costs don't offset most of your expected tax savings. Make sure to comply with the wash sale rules or your loss won't be deductible. A wash sale occurs when an investor sells a security and 30 days before or after the sale purchases a substantially similar security. Bonds purchased within the 30-day window must differ from the bonds sold in a material way, which includes different issuers, coupon rates, or maturity dates.
One strategy would be to invest in municipal securities. See the article "Are Muni Bonds Appropriate for You?" for more details.
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