Most investors understand the basics of bond investing. However, when evaluating individual bonds for a personal portfolio, a more specific understanding of the unique bond terminology can help an investor make the best decision. Here is what you should know about your bond portfolio.
What is bond insurance and will it protect me? Bond insurance is protection purchased by the bond issuer to insulate investors against a potential default. It is most prevalent in the municipal bond market. Bond insurance guarantees the scheduled payments of interest and principal, and is thought of as credit enhancement. This translates into a higher credit rating and often better liquidity for the specific issue. Municipal bond defaults are rare, estimated by Moody’s at less than 0.05%. This has caused many investors to question if buying insured bonds, which often “cost” more in the form of a lower yield, is worth it. Take a look at Detroit, where general obligation bondholders received on average 74% of their principal in the bankruptcy agreement. Those who held insured Detroit debt generally recovered 100% of their principal. The situation in Puerto Rico is still fluid, but insured obligations have enjoyed better price stability than the uninsured issues.
Why would anyone buy a premium bond? Bonds are generally issued at par, or the amount you expect to receive at maturity. So why do bonds trade above par? Premium bonds often pay a higher coupon rate than par or discounted offerings, so that the total return resembles that of a bond paying lower interest and trading at face value. Since investors find the higher coupon payments so attractive, they bid up the price of the bond. Premium bonds also tend to be less interest rate sensitive, as the high coupon provides a cushion to price movements that come along with interest rate swings.
Why a loss on your statement may not really be a loss. If you buy a bond at $1050 but only receive $1000 at maturity, have you suffered a loss? Here the concept of total return comes in to play. On a price basis, you have paid more than what you will receive. However, from an investment perspective, when the coupon payments received over the life of the bond are factored in, your total return is likely to be positive. You brokerage statement may not reflect that. We encourage investors to focus on the total return concept. Similarly when purchasing a bond, focus on the “yield to worst” calculation. This will take into account the price paid for the bond and coupons received either over the remaining life of the bond or the time until it is called, whichever reflects the lowest total return.
What is a zero coupon bond? Zero coupon bonds do not make any interest payments until maturity, when the investor gets back the full face value of the bond. Zero coupons are purchased at a discount to that face value. If you are retired or looking for a steady stream of income, zero coupon bonds are likely not for you. However, this instrument may be ideal if you are looking for a fixed amount of money to fund a future need or long-term goal. College tuition and a retirement buffer are perfect examples. Zeros are ideal if you are planning to hold the bond until maturity as they then have minimal reinvestment risk and predictability in the return. Negatives of zeros include the need to pay tax on accreted interest; these bonds are best held in a tax-deferred account.
The bond market is the largest securities market in the world, and investors have many options in terms of sectors, maturity dates, credit profiles and structural nuances. Being an informed consumer can help an individual make a solid investment choice. As always, stay diversified and do not let any one position become too large a piece of your investment pie.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
For nearly 25 years, Point View Wealth Management, Inc. has been working with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals. Click here to contact David Dietze, John Petrides, Claire Toth, Donna St.Amant, and Elaine Phipps, or call 908-598-1717 to learn more about Point View Wealth Management, Inc. and how we can help you and your family meet your financial objectives. To sign up for our complementary commentaries and newsletters, e-mail us at firstname.lastname@example.org.
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