Bonds are a crucial part of any investment portfolio and can provide stability of principle and regular interest payments. Investors who are interested in using bonds in their portfolio need to understand the risk associated with the fixed-income market.
Interest Rate Risk
Bonds have become a concern for investors who do not understand the relationship to interest rates. The price of a bond and interest rates work in an inverse manner. When interest rates rise, bond prices decline. When interest rates drop, bond prices increase. Investors who are unaware of this relationship need to understand that individual bonds should be held to maturity in a rising interest rate environment.
The term duration is also becoming important to bond buyers. Duration is the measure of sensitivity a bond or a bond portfolio has to interest rates. The lower the duration is, the lower the sensitivity. Bonds that have a shorter maturity have a lower sensitivity to interest rates. Bonds with a longer maturity have a higher duration and are more affected when interest rates fluctuate. Investors holding longer-term bonds should hold the issue until maturity. Investors who buy bond mutual funds need to be aware of the fund duration. When interest rates rise, the underlying bond prices may fall, along with the mutual fund value.
Individual bonds have a credit rating associated with the issuer's financial strength. Bonds that are investment grade are of higher quality and are therefore the most stable. Bonds that are below investment grade, also known as junk bonds, are rated lower in quality. To attract investors, junk bonds issue a higher interest payment in exchange for the risk of investing in a lower quality bond. Bond buyers who are interested in chasing yield need to understand the credit quality of the bond issuer. If the bond issuer misses an interest payment, the credit rating will go down. This will also reduce the value of the bond price. For example, Puerto Rico was having difficulty making interest payments to its municipal bondholders and therefore was downgraded. The price of Puerto Rican bonds dropped significantly in value, and many bondholders were having difficulty selling their bonds on the open market.
Buying Complex Bonds
Many different types of bonds are available in the fixed-income market. The basic premise of a bond is to provide interest payments and pay its par value to the investor upon maturity. However, there are many complexities that investors may not understand about bonds. Many bond buyers do not understand call features, defeasance and accrued interest. Floating rate, convertible and catastrophe bonds are overly complex for the typical bond investor. Bonds can also be purchased through an exchange-traded note that can be leveraged or inversed. Before investors purchase a fixed-income security, they should fully understand how the investment works and the associated risks.
Bond Price Markups
Individual bonds are purchased on a secondary market and include a markup for commissions or transaction fees. Depending on the quantity and type of bond purchased, broker commissions can range from 0.5% to 2%. These fees and commissions are built into the bond's price when relayed to the consumer. For example, if an underlying bond price were $1,030 per bond, with a 1% commission, the price would be $1,040 to the buyer. It is important for investors to understand whether they are getting a reasonable price when purchasing bonds. Bond buyers can use the Trade Reporting and Compliance Engine (TRACE), which shows all transactions for the secondary bond market. If the average transaction price was significantly lower than the bond purchase price, the commission could have been excessive.
Inflation and Taxes
Investors who have too high a percentage of their portfolio in bonds might not be able to keep pace with inflation. Bonds may reduce volatility in portfolios, but over the long term, they have considerably less returns than stocks. Bond interest payments do not increase with inflation. Therefore, a 20-year bond that is paying a 5% coupon today provides more purchasing power than it will in 20 years. Investors who wish to keep pace with inflation need to have an allocation of stock in their portfolios.
Taxation is also important for bond buyers to understand. Municipal bond interest is tax-free on both a state and federal level. However, to be tax-free on a state level, the bond needs to be issued from the same state as the investor. Otherwise, it will be taxed on a state level. Even though the interest from municipal bonds is tax-free, capital gains are taxed. A bond that is bought and sold for a profit is taxed as a capital gain.