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Investing with Bonds


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The volatility in today’s financial markets is making it impossible to know where to invest and grow your money without the fear of losing your lifetime savings. Historic low interest rates are making …

The volatility in today’s financial markets is making it impossible to know where to invest and grow your money without the fear of losing your lifetime savings. Historic low interest rates are making is difficult to provide the income needed by investing in safer investments such as CDs and annuities. Investing a portion of your overall portfolio in fixed income investments should be considered as a solution to reducing volatility and providing needed income.

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  • 1. Presented by: Russell D. Francis, CPA, CFP® 503-684-6116 April 19, 2012
  • 2. Disclaimer Portland Financial Advisors, Inc. is registered as an Investment Advisor with the State of Oregon. All information contained in these slides concerning investments is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. All statistics/prices/quotes have been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed.
  • 3. Objectives • Are bonds appropriate for your portfolio? • Learn about the various risks associated with bond investments • Learn how different types of bonds help you reach different goals • Learn about various bond trading strategies • Understand the difference between individual bonds and bond funds • Learn about the various methods to invest in bonds • How much should I invest in bonds? • Where do equities fit in?
  • 4. Why Bonds? There's an old saying, "You make your money in stocks but keep your money in bonds." The volatility in today’s financial markets is making it impossible to know where to invest and grow your money without the fear of losing your lifetime savings. Historic low interest rates are making is difficult to provide the income needed by investing in safer investments such as CDs and annuities. Investing a portion of your overall portfolio in fixed income investments should be considered as a solution to reducing volatility and providing needed income.
  • 5. Benefits of Investing in Bonds • You can align your investments with your financial goals, rather than speculating in the markets. Individual bonds can provide a steady stream of income regardless of the value of the bond, and you get all of your money back at maturity. • Bonds provide diversification, smoothing out the higher volatility connected with equities. • A bond portfolio can be “immunized” so that you receive a specific rate of return over a given time period regardless of what happens to interest rates during that time.
  • 6. Benefits of Investing in Bonds • Historical evidence shows that investment grade bonds with Aaa/AAA ratings are very safe investments. If held to maturity, there is less than a 1% probability of default based on statistics back to 1920, which includes the Great Depression. Since 1970, the record has been even better. The only investments with lower expected default rates are Treasuries, CDs and Agencies, which also offer investors lower yields. • To further reduce risk, there are several “bond strategies “that help preserve your principal while minimizing taxes and the impact of inflation. • Some bonds have distinct tax advantages for high income earners.
  • 7. Benefits of Investing in Bonds It is important to realize that bonds can and do decline in value, but historically bonds show much less volatility than stocks, as you can see in the following table: Bond portfolios serve a number of objectives, but their main goals are principal preservation and income generation. The proportion of bonds vs. stocks in a portfolio depends on the investor’s risk tolerance, time horizon, and income needs. Bonds should be a larger portion of a portfolio if an investor is risk averse, or needs a steady stream of income. Name Ticker Inception Date Worst 1 Year Return 10 Year Avg. Return (as of 3/31/12). Vanguard Total Bond Market Index VBMFX 1986 -00.76 in 1999 5.51% Vanguard Total Stock Market Index VTSMX 1992 -37.04 in 2008 4.92%
  • 8. How Bonds Work In simple terms, a bond is just a loan. If you lend out $1,000 for 10 years in return for a yearly payment of 3.75% interest, you could just as well have purchased a bond. •The $1,000 of principal is the face value of the bond. •The yearly interest payment is its coupon. •The length of the loan, 10 years, is the bond’s maturity. A bond is a loan that can be bought like any other security - it is an investment.
  • 9. The Price of a Bond Bond prices move in the opposite direction of interest rates. When interest rates rise, bond prices will fall. This is because the interest you are earning on a bond is fixed. Let’s say you purchase a new bond for $1,000 with a coupon rate of 4.0%. •If interest rates go up to 4.5%, no one would want your bond paying 4.0%, so the price of your bond would be adjusted downward. •If interest rates go down to 3.5%, everyone would want your bond paying 4.0%, so the price of your bond would be adjusted upward. Regardless of the price, you would still receive coupon payments of $400 annually and you would get back your $1,000 investment at maturity.
  • 10. The Price of a Bond Unless bonds are new issues, they rarely sell for exactly face value or par. Take a $1,000 bond with a 4% coupon that matures in the year 2014. If you manage to buy it for $800, you’ve effectively bought a bond with a 5% coupon, since the $40 coupon is 5% of your $800 purchase price. The current yield of the bond is 5% (the coupon rate adjusted for the current bond price). Better yet, even though you paid $800, in 2014 you will receive the full $1,000 face value. The total return, taking into account the $200 capital gain is called the yield to maturity.
  • 11. Bond Maturity A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Generally, bond terms range from 1 year to 30 years. Shorter-term bonds, which generally offer lower returns, are considered comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term bonds provide greater overall returns to compensate investors for greater pricing fluctuations and other market risks.
  • 12. Bond Yield Curve Rising Yield Curve - Buy longer-term bonds to capture the additional yield. Flat Yield Curve - Buy short-term bonds because there is no compensation for taking on the risk of longer-term bonds. Inverted Yield Curve - Buy short and intermediate term bonds.
  • 13. Fixed Income Risk • Market Price risk - The risk of bond prices going down due to rising interest rates. • Interest Rate risk – Fixed bond coupons not keeping up with inflation. • Call risk – The risk the loans (bonds) will be paid off early. • Default risk (or Credit risk) – The risk that the bond issuer will not be able to make scheduled payments or pay back the principal. • Liquidity risk – The risk that you may not be able to find a buyer if you need to sell the bond.
  • 14. Market Price Risk The longer a bond’s maturity, the higher the duration. That is, a 30 year bond’s price will fluctuate more than that of a 10 year bond. This potential price volatility is referred to as market price risk. Because longer-term bonds pay higher yields, many investors purchase them without being fully aware of the risks. A 30-year bond has a duration of about 16 years, meaning the bond’s price will drop 16% for every 1% increase in interest rates. Market price risk can be eliminated by holding bonds to full maturity so that you get back the face value of the bond.
  • 15. Interest Rate Risk Bond prices will fall if interest rates rise (Market Risk). But, if rates rise substantially, you would not get the higher coupon yields paid by newer bonds. We already know market price risk can be eliminated by holding bonds to full maturity. Interest rate risk can be minimized by building a bond ladder in which some bonds mature each year so that money can be reinvested at higher coupon rates.
  • 16. Call Risk Your loan may be paid back early, or “called,” forcing you to find another, possibly less lucrative place to put your money. Since a call provision offers protection to the issuer, callable bonds usually offer a higher annual return than comparable non-callable bonds to compensate the investor for the risk that the investor might have to reinvest the proceeds of a called bond at a lower interest rate.
  • 17. Default or Credit Risk Default risk can never be completely eliminated but it is rare for high quality bonds (grade Aa/AA or better) to default, and some bonds can be insured. Diversification among types of bonds, corporate sectors, and geographic locations will also minimize risk. Historically, defaults on investment grade bonds are rare for both municipal and corporate bonds. Portfolios consisting of Aaa/AAA and Aa/AA bonds have a very low probability of default.
  • 18. Bond Rating Grades (Quality) Credit Risk Moody’s Standard & Poor’s Fitch Investment Grade Highest Quality Aaa AAA AAA High Quality Aa AA AA Upper Medium A A A Medium Baa BBB BBB Not Investment Grade Lower Medium Ba BB BB Lower Grade B B B Poor Grade Caa CCC CCC Speculative Ca CC CC No payments/Bankruptcy C D C In Default C D D
  • 19. Bond Default Rates Bond Default Rates—Cumulative Percent (1970–2008) 1 Aaa/AAA indicate top-rated investment grade bonds; Aa/AA bond represent the lower part of the upper tier of investment grade. Moody’s ratings for the full range of investment grade bonds are Aaa, Aa, A, and Baa; Standard & Poor’s and Fitch investment grade ratings are AAA, AA, A, BBB. Non-investment grade ratings are all below Baa and BBB. Source: Municipal Securities Rulemaking Board (MSRB) Rating Categories1 Moody’s Standard & Poor’s Municipal Corporate Municipal Corporate Aaa/AAA Bonds 0.00 0.52 0.00 0.60 Aa/AA Bonds 0.06 0.52 0.00 1.50 Investment Grade 0.07 2.09 0.20 4.14 Non-Investment grade 4.29 31.37 7.37 42.35
  • 20. Types of Bonds • CDs • Treasuries (Bills, Notes, Bonds) • TIPs (inflation Protection) • Agency Bonds (SBA, FHA, FHLB, FRMA, FNMA, GNMA) • Zero Coupon Bonds • Municipal Bonds (Taxable and Non-Taxable, BABs) • Corporate • High Yield (Junk Bonds) • Step-Up Bonds • Index-Linked Bonds • Bond Exchange Traded Funds (ETFs) • Bond Mutual Funds
  • 21. Safety of Principal • CDs are FDIC Insured by the issuing bank for $250,000 per account holder. • Treasuries are backed by the “full faith and credit” of the U.S. government. • Aaa/AAA rated bonds rarely default. • Municipal bonds may be insured. • Diversify among types of bonds, corporate sectors, and geographic locations.
  • 22. Stable (Predictable) Income • Hold bonds to maturity • Utilize bond ladders • Zero Coupon Bonds • Purchase individual bonds rather than bond funds
  • 23. Inflation Protection • Treasury Inflation Protected Securities (TIPS) • CPI-indexed bonds • Bond ladders
  • 24. Future Income Needs Zero coupon bonds – Zero coupon bonds have no “coupon,” or periodic interest payments. Instead, the investor receives one payment—at maturity —that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds are sold at a substantial discount from the face amount. For example, a bond with a face amount of $20,000, maturing in 20 years with a 5.5% coupon, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. Zero coupon bonds are issued by the U.S. Treasury, corporations, and state and local government jurisdictions. Uses include: Retirement planning, education funding, gifting, avoiding the “Kiddie” tax, and principal erosion.
  • 25. Lower Taxable Income Municipal (Muni) bonds – Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, used to build schools, highways, hospitals, sewer systems, and other projects for the public good. Most municipal bonds are free of federal taxes and often exempt from taxes on interest paid to residents of the state of issuance. Some “Private activity” municipal bonds are subject to the federal alternative minimum tax. Muni bonds are not subject to the proposed additional 3.8% Medicare tax on unearned income in 2013.
  • 26. Taxable Equivalent Yield Taxable Equivalent Yield = Tax-exempt yield (1-Tax bracket) Assumptions: Tax bracket = 28% Tax Free Muni Bond Yield = 3.00% Taxable Equivalent Yield = 3.00/(1-.28) = 4.17%
  • 27. Overall Bond Strategy Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs.
  • 28. Income Matching The Income Matching strategy builds a portfolio based on the timing of your income needs. Income is generated from coupon payments and bond redemptions at the exact time you need it. Any additional capital can be invested in equity investments (stocks and stock mutual funds) that can provide future growth.
  • 29. Building an Income-Matching Portfolio Engineered to match a specific cash flow stream Example: Investible assets = $600,000 Income needs per year starting in 2015 = $20,000 Inflation rate = 3% Time horizon = 8 years Internal rate of return = 3.6% The cost of CDs and bonds in this portfolio is $160,000. The remaining $440,000 will be used to purchase equities using no-load index funds and ETFs for growth and as a hedge against inflation. Year of Maturity Cash flow needed adjusted for inflation Coupon Interest Principal Portfolio cash flows 2015 $20,000 $5,544 $15,000 $20,544 2016 $20,600 $5,004 $16,000 $21,004 2017 $21,218 $4,428 $17,200 $21,628 2018 $21,855 $3,809 $18,500 $22,309 2019 $22,510 $3,143 $19,700 $22,843 2020 $23,185 $2,434 $21,000 $23,434 2021 $23,881 $1,678 $22,500 $24,178 2022 $24,597 $ 868 $24,100 $24,968 $177,847 $26,908 $154,000 $180,908
  • 30. Building an Income-Matching Portfolio •The cost of CDs and bonds in the portfolio is $160,000 . •The remaining $440,000 is be used to purchase equities using no-load index funds and ETFs. •Assuming a 4.0% return over 8 years, the balance of your equity portfolio would be $607,645. •At a 25% tax rate, using munis in the taxable account will save an additional $6,726 in federal taxes. •It may also lower the amount of your Social Security that is taxable.
  • 31. Bond Ladders A bond ladder is a portfolio of bonds with a portion of the portfolio maturing each year. Bond ladders can: •Help protect you against rising interest rates. •Produce a more stable rate of return by providing an average yield over the period of time covered by the ladder. •Match cash flows with the demand for cash. •Diversifies your bond holdings.
  • 32. 5-Year Bond Ladder 2017 Maturity Bond 2016 Maturity Bond 2015 Maturity Bond 2014 Maturity Bond 2013 Maturity Bond 2012 Maturity Bond $5,000 from maturing bond Reinvest the $5,000
  • 33. Client Name: Portland Fin. AdvisorsAcct Number: Appleby Household Proposal Date: October 21, 2011 Last Updated: October 21, 2011 Completion Date: 1 = Sydney IRA, 2 = Trust, 3 = Marla IRA PORTFOLIO DETAIL State Description Bond Type Quantity Coupon Maturity Calls Rating Insurance Yield TEY* YTC/YTM Price Total $ Amt Income % of PortDuration 3 UT UNIV OF UTAH REV Municipal 20000 5.000% 4/1/2015 NC AA2 NATL 1.45% 1.93% M 111.96 22,425$ 1,000$ 4% 3.2 3 AZ PIMA CNTY AZ GO Municipal 25000 5.000% 7/1/2016 NC AA2 2.00% 2.67% M 113.44 28,713$ 1,250$ 6% 4.2 3 TX BEAUMONT TX WTR & SWR REVMunicipal 20000 4.250% 9/1/2018 9/1/2016 AA3 AGM 2.00% 2.67% C 110.42 22,084$ 850$ 4% 4.4 3 WA SPOKANE WA GO Municipal 15000 5.000% 12/1/2020 6/1/2018 AA2 AGM 2.60% 3.47% C 114.51 17,462$ 750$ 3% 5.6 3 TX AUSTIN ELEC REV Municipal 15000 5.500% 11/15/2021 11/15/2018 A1 2.91% 3.88% C 116.50 17,810$ 825$ 3% 5.8 3 TN MET GOVT NASHVILLE & DAVIDSON GOMunicipal 15000 5.000% 8/1/2022 8/1/2016 AA1 2.30% 3.07% C 112.17 16,986$ 750$ 3% 4.3 3 OH CUYAHOGA OH CMNTY COLL REVMunicipal 15000 5.000% 8/1/2023 2/1/2020 AA2 3.35% 4.47% C 111.85 16,778$ 750$ 3% 6.8 2 CA SAN DIEGO CNTY CA REV Taxable Municipal 20000 5.728% 8/15/2017 NC AA2 CNTY GTD 3.01% 4.01% M 114.48 23,057$ 1,146$ 4% 5.0 2 NY NEW YORK NY GO Taxable Municipal 15000 4.787% 12/1/2018 NC AA2 3.19% 4.25% M 110.11 16,791$ 718$ 3% 6.0 2 OR OREGON ST GO Taxable Municipal 25000 5.420% 8/1/2018 NC AA1 2.60% 3.47% M 117.48 29,634$ 1,355$ 6% 5.7 1 MI MICHIGAN ST GO BAB Taxable Municipal 10000 6.850% 11/1/2019 11/1/2018 AA2 SINKING FUND3.99% 5.32% C 119.58 12,249$ 685$ 2% 5.5 2 WI DANE CNTY GO Taxable Municipal 10000 3.250% 12/1/2019 12/1/2018 AA1 2.80% 3.73% C 102.89 10,407$ 325$ 2% 6.3 1 TX SAN ANTONIO TX GO Taxable Municipal 15000 6.050% 8/1/2021 8/1/2019 AAA 3.00% 4.00% C 121.16 18,320$ 908$ 4% 6.3 3 PA PENNSYLVANNIA ST GO Taxable Municipal 10000 4.750% 7/15/2022 7/15/2020 AA1 3.66% 4.88% C 108.11 10,928$ 475$ 2% 7.1 2 WA KING CNTY WA GO Taxable Municipal 15000 4.900% 12/1/2022 12/1/2019 AA1 CNTY GTD 3.49% 4.65% C 109.87 16,761$ 735$ 3% 6.6 2 TX PLANO TX GO Taxable Municipal 25000 5.110% 2/15/2023 2/15/2019 AAA 3.40% 4.53% C 111.05 27,942$ 1,278$ 5% 6.1 3 MORGAN STANLEY Step-up 15000 4.00% 7/30/2020 7/30/2013 A2 2.80% 3.73% C 102.13 15,418$ 600$ 3% 1.7 3 GOLDMAN SACHS Step-up 10000 3.50% 9/17/2020 9/17/2016 A1 4.65% 6.20% C 96.65 9,694$ 350$ 2% 4.4 3 PROTECTIVE LIFE CPI-Linked Note** 16000 5.620% 10/10/2014 NC A2 CPI + 1.85% 4.74% 6.32% M 102.50 16,439$ 899$ 3% 0.3 3 MORGAN STANLEY CPI-Linked Note** 10000 4.500% 4/1/2021 NC A2 CPI + 2% 5.83% 7.77% M 96.75 9,708$ 450$ 2% 0.3 2 GOLDMAN SACHS Corp 20000 4.750% 7/15/2013 NC A1 3.29% 4.39% M 102.47 20,723$ 950$ 4% 1.6 2 JP MORGAN (BEAR STEARNS) Corp 15000 5.700% 11/15/2014 NC AA3 2.62% 3.49% M 109.10 16,712$ 855$ 3% 2.8 397,042$ 17,903$ *TEY Assumes Fed Bracket = 25% Client Information Maturity: Current Holdings Portfolio Parameters A1 $397,042 Type: Investing: Taxable/Muni Ladder Ratings: Short-Intermediate Special:
  • 34. Barbells & Bullets Barbell strategy - With this strategy, you invest only in short-term and long- term bonds, not intermediates. The long-term holdings will provide higher coupon rates. Having some bonds maturing in the near term creates the opportunity to invest the money elsewhere if the bond market takes a downturn. Bullet strategy - can be used to invest for a date and amount needed in the future. If you are 50 years old and you want to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year bond five years from now, and a five-year bond 10 years from now.
  • 35. Bond Funds vs. Individual Bonds A bond “fund” is a pooled portfolio of bonds but without the predictable characteristics offered by individual bonds. When interest rates are low, individual bonds have a distinct advantage over bond funds. The price of a bond fund is based on the appreciation or depreciation of the underlying bonds, represented by net asset value (NAV). When interest rates are rising, the NAV will fall. Because bond funds generally do not hold bonds to maturity, the total return for a bond fund will be lower than the underlying bonds if they were held to maturity. A portfolio of individual bonds held to maturity, on the other hand, is unaffected by the intervening price loss and simply collects the coupon payments and principal when the bonds mature. Bond funds can expose investors to significant risks when compared to individual bonds in a rising rate environment.
  • 36. Impact of Interest Rates on Total Return Bond Funds Individual Bonds Falling Rates Price Return Price Return Income Return Income Return Total Return > Income Return Total Return > Income Return Flat Rates Price Return Price Return Income Return Income Return Total Return = Income Return Total Return = Income Return Rising Rates Price Return Price Return Income Return Income Return Total Return < Income Return Total Return = Income Return
  • 37. BOND ETFs Bond Exchange Traded Funds (ETFs) are a hybrid that have similarities to bond funds but also have some unique features. ETFs can be bought and sold like stocks. ETFs can be purchased with underlying bonds that all mature in the same year. These can be used to build a short to intermediate term bond ladder. •Corporate bond ETFs - Guggenheim Funds (Ticker: BSCB – BSCH) •Muni bond ETFs - iShares (Ticker: MUAA – MUAF)
  • 38. Buying Bonds Treasury bills, notes, bonds and TIPs can be purchased directly from the Treasury at Bond funds, Exchange Traded Funds (ETFs), Municipal bonds, and corporate bonds can be purchased through stock/bond brokers.
  • 39. Bonds Costs Bond funds may have sales charges or may be no-load. They also have annual management and expense (M&E) fees from .2% to 1.5%. There may additional costs when sold. Bond ETFs will have trading commissions when bought and sold. They have lower M&E fees than most bond funds. New individual bonds costs are paid by the issuer. You purchase them at par. There may be a commission on the purchase and/or if sold before maturity. Individual bonds on the secondary market are purchased through a bond broker who makes money from the “spread”, or difference between the broker bid and ask price. There may be additional commissions or trade-away fees. There may also be commissions or trade-away fees if the bonds are sold before maturity. Treasuries purchased through are acquired by bidding in an online auction.
  • 40. How Much Should You Invest in Bonds? Enough to: •Provide the necessary income stream. •Protect your portfolio against defaults. •Diversify your fixed income portfolio among type, corporate sectors, and geography. If you’re using an individual bond ladder, you also have to diversify by maturity. There is no minimum for bond funds or ETFs. They are inherently diversified. We typically recommend a minimum of $200,000 for individual bonds and bond ladders.
  • 41. Questions?