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Buying Bonds – Follow Up

February 27, 2014

My previous blog suggested buying very long-term bonds instead of shorter-term bonds and worked out numbers to show the reasons why.  However, there is a lot of additional information you need to know about bonds before investing in them.  Here is a checklist of some of what you need to be aware of.  Also, I posted previous blogs on bonds on Feb 26, 2013, Sep 13, 2012, Aug 16, 2012, Aug 14, 2012, May 3, 2012 and Feb 24, 2012.  If you email me, I’ll send these to you in one file.  Also, before doing anything, consult with your investment advisor.

Basic reasons, facts and principles:

  • Bonds are purchased to provide a fixed cash flow for a fixed period of time at the end of which you get back your investment
  • The typical investor should not buy bonds to trade in or to get a profit on changes in market value.  That should be restricted to sophisticated traders or those with managers experienced in such maneuvers
  • Bonds should not be purchased for a long period or term if there is a distinct possibility that they might need to be sold before maturity.  Then, there is a great possibility of loss when they are sold
  • Longer-term bonds have a higher risk than shorter-term bonds and because of this, pay higher interest rate
  • Every corporate and muni bond carries a default risk.  Some are greater than others and rating services categorize these risks
  • Irrespective of what bonds you buy (including default risk-free Treasuries), market values will continuously fluctuate.  However, if your purpose in buying the bond is to hold it until maturity, the changing value will be meaningless.  It will be a paper notation upward or downward that will eventually vanish on the maturity date at which time you will get the bond’s face value
  • One way to reduce risk of default is to buy a range of individual bonds, and I suggest at least ten different companies spread over at least five sectors
  • To increase overall yield, you might want to consider some lower rated bonds for about 20% of your bond portfolio
  • Another way to reduce risk is to create a bond ladder.  This is where you stagger maturities so a certain percentage of the bonds mature at fixed intervals – such as every two years for the next twenty years
  • Bond funds are an easy way to buy bonds and spread risk, but they lack a key element of the reason for bonds – there is no fixed maturity date, ever.  You are NEVER guaranteed to get your investment back.   You can only get what the market says the funds are worth when you decide to cash out.  In the case of funds, the fluctuations become reality!  I do not recommend bond funds

Here are steps to follow:

  • Decide on the percentage of bonds you want in your portfolio
  • Decide on the type of default risk you want to assume
  • Decide on yields you are willing to accept and for what terms you are willing to lock in those rates
  • Buy the longest maturing bonds you are able to get to provide the cash flow you want

Here are my reasons:

  • Bonds create a layer of safety to your portfolio, are an anchor that protects some of your assets and reduce overall portfolio risk
  • Longer-term bonds provide a higher cash flow than shorter-term bonds
  • No matter how you feel, at least some portion of your bond portfolio will be a locked in, a sunk investment, that will never be liquidated (baring terribly unimagined circumstances)
  • Whatever that portion is, invest as long as you can to get the highest reasonable yield
  • A frequent objection to longer-term bonds from older investors is that they don’t want to buy bonds that will outlive them.  This is not a valid concern.  The purpose of bonds is to provide cash flow.  When the owners die, their heirs will have a choice whether to sell the bonds at a possible loss, or retain them for the cash flow.  If the concern is the loss of value to the heirs, then buy life insurance to assure a legacy, but don’t use this excuse to buy lower yielding bonds

How to defending what I am suggesting:

  • Show this blog to your investment manager and ask them to either do what I say or explain where I am crazy
  • If they tell you I am wrong, get their reasons and compare what they say to what I wrote and decide who is making more sense.  You can even ask them to prepare a little calculation for the “30 year” period

Other issues with bonds to consider or be aware of:

  • There is more than one rating service and investors should be aware of the differences between them and how they base their ratings
  • High yield or “junk” bonds should not be entirely ignored, but also need caution and understanding when considering them for a portion of your allocation
  • 30 years is a long time to give up the opportunity for alternatives
  • Bonds purchased at a premium, that are held to maturity, will see that premium vanish.  They should be made up as an offset to the higher coupon payments
  • Bonds purchased at discounts will receive the full face at maturity and will have a capital gain.  The offset here is lower interest payments each year
  • Many bond issues are callable even when specified as not being callable, have sinking fund or prefunding provisions, are subject to special provisions involving maturity date changes and step up or downs of rates
  • Many times when buying bonds, the brokers’ markups are not disclosed and excessive mark ups would reduce the eventual yield
  • Always find out the yield to maturity when buying a bond – that is what you will get, annually, assuming the bond is held to maturity
  • If a bond has an earlier call date, also find out the yield to call
  • People trade bonds with the same volume and frequency as stocks, but for much higher amounts and possibly greater risk.  This is not covered here and is not recommended except for very highly knowledgeable investors who understand the full risks
  • Those with larger size portfolios should consider an investment manager for their bonds, but, like any other financial endeavor, should determine the investment objectives, style, value and fees beforehand

Buying bonds is somewhat confusing and I tried to explain it as clearly as possible.  If you question anything or want greater clarification, write a comment and I will respond to it.  Or, email me directly and I’ll post your question anonymously with my response.

Buying bonds requites the effort to understand bond ownership.  Also, do not lose sight of the purpose of bonds which is to be part of a cohesive plan to provide for you and your family’s long-term financial security.

2 Comments leave one →
  1. Robert Nagler permalink
    February 27, 2014 12:21 pm

    HI Ed good advice

  2. February 28, 2014 3:43 am

    Reblogged this on 50963182600013.

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