Bond Strategies

Investing in stocks can be exciting since they have the possibility of big rewards (as well as the accompanying risks). Bonds (also called fixed-income securities) generally appeal to those who are less adventurous.

Bond Basics

In a balanced investment portfolio bonds can provide stability. Bond prices generally are less volatile than stock prices and bond interest payments are generally higher than stock dividend payout rates. People who need to live on their portfolio income like the predictability of bonds and many people who feel burned by the stock market focus more and more on fixed-income securities.

Bonds are not without their own risks. In particular, bond investors need to be concerned about interest rate risk. When interest rates are rising, as they have been, the prices of issued bonds must fall, and, conversely, as interest rates fall, bond prices go up. What’s more, bonds with longer maturities generally respond more sharply to interest rate changes. That’s why longer term bonds typically offer higher interest rates than shorter term obligations.

Purposeful Diversification

In times of economic uncertainty there is a strong temptation to park assets in the relative safety of money market funds and wait for a better time to invest. That’s not often the best approach. One problem is successfully identifying that “better” time and another is the relatively low income paid by money market funds. Bond investors can use three strategies to increase their income while managing interest rate risk:

• Bullets. Let’s say you have $100,000 that will be needed in ten years to fund a college education. A ten year bond will lock in today’s interest rates but you won’t be able to take advantage of future interest rate increases. The alternative is to spread the bond investment over time, choosing the same target maturity. The strategy is to buy some ten year maturities in the first year with a portion of your funds, nine year maturities in the second year, eight year maturities in the third year, and so on.

• Barbells. To increase the yield from a bond portfolio, buy bonds with long and short term maturities and avoid bonds with intermediate maturities. If the long term bonds can be held to maturity, the investor need not worry about paper losses that occur, if interest rates rise. Meanwhile, the short term bonds can be reinvested at higher rates as they mature.

• Ladders. Building a laddered portfolio involves buying an assortment of bonds with maturities that vary over time. For example, you might invest equal amounts in bonds maturing in two, four, six, eight and ten years. In two years, when the first bonds mature, you reinvest the principal in a ten year bond, maintaining the ladder. This approach provides better protection against interest rate risk than investing in a bond with a single maturity. The ladder structure generally provides a greater yield than investing only in short term issues.