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Why bonds?
At Raymond James, we believe bonds can play an important role in a well-diversified portfolio. Bonds can provide predictable income and, most important, principal protection.* Also bonds may help minimize overall volatility.
Who invests in bonds?
Bonds can benefit an investor’s portfolio in a variety of ways. For retirees, bonds may provide a predictable income stream and safety of capital. For other investors, bonds can help meet future wants or needs, such as vacations, college funding or the purchase of a house.
How much to allocate to bonds?
Bond allocation depends on many factors, including an investor’s time horizon, risk tolerance, need for income and future goals. In most cases, as investors age, they grow more dependent on income from their portfolios and become more risk averse. Bonds can help ease specific concerns that arise when investors move from one stage of their financial journey to the next. Consult your financial advisor to determine what portion of your portfolio should be devoted to bonds based on your specific investment objectives.
*If held to maturity, subject to issuer credit risk.
Bond prices and yields are subject to change based upon market conditions and availability. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
Bond Basics
What are bonds?
Bonds are debt securities issued by corporations, governments and municipalities. Bonds are similar to IOUs: investors lend money to an organization and in return receive interest payments. In addition, the organization is obligated to return the principal to investors on a predetermined date in the future. When purchasing bonds, investors become creditors of the issuer and, therefore, have a priority claim on the issuer’s assets in the event of bankruptcy.
Bond Characteristics
– Par or face value is the bond’s denomination and the amount returned to the investor upon maturity. Par is not the price of a bond, as the price fluctuates throughout the lifetime of a bond. If the price is above par, the bond is selling at a premium, and if the price is below par, the bond is selling at a discount. Price is generally quoted as a percentage of face value. For example, a price of 98 means 98% of the bond’s $1,000 par value, or $980.
– Coupon rate (or just coupon) is the annual interest rate paid to investors as compensation for the loan. Coupon payments typically are made semiannually unless otherwise stated. For example, a 4% coupon bond will pay 2% twice a year based on the par value of the bond. Learn more about types of income.
– Maturity is the term of the bond’s life. Bonds range in maturity from three months to 100 years. On the maturity date, the bond’s face value is repaid to the investor and the interest payments stop.
– Call provisions give an issuer the option, at its discretion, to redeem bonds (pay back the principal) prior to maturity after an initial non-call period. Bonds are generally called when the situation is most beneficial for the issuer. In general, bonds are called when market interest rates fall, allowing the company to issue new bonds with lower coupon rates. To compensate investors for the reinvestment risk and unknown final term of investment, callable bonds generally offer higher yields than non-callable alternatives. Learn more about callable bonds.
– Credit rating is usually a reflection of an issuer’s ability to pay interest and principal but may not fully represent its creditworthiness. Independent rating agencies assign ratings based on their analysis of the issuer’s financial condition, economic and debt characteristics, and specific revenue sources securing the bond. Issuers with lower credit ratings generally offer investors higher yields to compensate for the additional credit risk. At times, bonds with comparable ratings may trade at different yields, which may further indicate the market’s perception of risk. A change in either the issuer’s credit rating or the market’s perception of the issuer’s business prospects will affect the value of its outstanding securities. Ratings are not a recommendation to buy, sell or hold, and may be subject to review, revision, suspension or reduction, and may be withdrawn at any time. More details about credit ratings can be found at Factors That Affect Prices of Fixed Income Securities.
Price/Yield Relationship
Yield is the annual rate of return investors earn based on a bond’s coupon rate relative to its current market price. When interest rates rise, the price of an existing bond falls because its coupon becomes less attractive to potential investors. The opposite happens when interest rates fall. Hence, there’s an inverse relationship between a bond’s price and its yield. Bond yields should be evaluated on a worst-case-scenario basis. The two most frequently referenced yields are:
–Yield-to-maturity (YTM) is especially important when bonds are purchased at a discount. Investors should compare YTM to the current yield of comparable new-issue bonds to make sure the discount is big enough to result in the same return or higher. Generally, YTM for a new-issue security is equal to its coupon rate.
–Yield-to-call (YTC), or yield-to-worst case (YWC), must be considered when a bond has call features and is purchased at a premium. An issuer is more likely to call a bond prior to maturity when interest rates decline, giving the company an opportunity to offer new bonds at lower rates. The prices of callable bonds will not rise as much as those of non-callable securities because investors are not willing to pay more due to the increased chance of a call.
What you need to know about the risks of bond investing.
Types of Taxable Bonds
U.S. Treasury Securities are issued by the United States government and generally are considered the safest of all investments because the timely payments of interest and principal are guaranteed by the U.S. government. Because of the safety advantage, government bonds pay relatively lower interest rates than other fixed income securities. Treasury bonds are issued in a wide range of maturities, from four weeks to 30 years. Generally they are non-callable, and interest payments are exempt from state and local taxes. Treasury bonds can be purchased through your financial advisor or directly from the U.S. Treasury.
Government Agency Bonds are bonds issued by Federal Government Agencies.
Major issuers include:
- Government National Mortgage Association (GNMA), whose securities are backed by the full faith and credit of the U.S. government; subject to market risk
- Tennessee Valley Authority (TVA), whose bonds are not guaranteed by the U.S. government, but are secured by the power revenue generated by the Authority
Government-Sponsored Enterprise securities (GSEs) are issued by government-created corporations and most carry “AAA” ratings.
Major issuers are:
- Fannie Mae (Federal National Mortgage Association)
- Freddie Mac (Federal Home Loan Mortgage Corporation)
Both Fannie Mae and Freddie Mac are government-sponsored entities and operate as public companies. Although both were created by congressional charters, neither is a government agency. Timely payments of interest and principal are sole obligations of the issuers. Their securities do not constitute debt of the United States and are not guaranteed by the federal government.
Brokered certificates of deposit (CDs) are issued by financial institutions, such as banks, and are sold directly through brokerage firms like Raymond James. Brokered CDs have characteristics similar to bonds, but offer the protection of FDIC insurance, which covers up to $250,000 per issuer (including principal and interest) for deposits held in different ownership categories, including single accounts, joint accounts, trust accounts, IRAs, and certain other retirement accounts. FDIC insurance does not protect against principal losses due to sale prior to maturity. Prices of brokered CDs fluctuate during their lifetimes due to changes in interest rates. Upon maturity, CDs are redeemed at par. Consult your financial advisor for more information about the difference between regular bank CDs and brokered CDs. To learn more about brokered certificates of deposit, please read our Disclosure Document (PDF)
Corporate bonds are debt obligations issued by U.S. and foreign companies to raise capital for business growth and general corporate purposes. Most are unsecured promises to repay the principal at a predetermined future date, although some bonds may be secured by a first mortgage or other assets. Since corporate bonds are considered riskier than some other fixed income investments, such as U.S. Treasury bonds, they generally offer higher yields. Corporate bond prices are affected by changes in interest rates, issuers’ credit ratings and other factors. Please consult with your financial advisor about various bond features before investing.
Foreign currency bonds are issued by corporations and governments. In addition to offering bonds in domestic markets and local currencies, governments and companies also can issue bonds in other markets and different currencies. Foreign currency bonds carry additional risks that domestic bonds are not subject to, including currency risk, political instability and local market risk. As with any investment, foreign securities should fit within the investor’s stated objectives and risk tolerance, and should be allocated accordingly.
Preferred securities offer certain benefits of both stocks and bonds. They are most suitable for investors with a long-term time horizon who are interested in a fixed rate of return. Unlike common stocks, most preferred securities are issued with a fixed dividend or interest rate which is typically paid quarterly, and most have a par value of $25 per share. Since most preferred securities are considered debt and are senior to common stock, they enjoy a priority claim over common stock on assets of a corporation in case of a liquidation; however, they are often junior to bond holders. They generally have a much longer term maturity than bonds, and in a number of cases they are perpetual. Some preferred securities are subject to unique risks which include the fact that the issuer may defer interest payments for up to 10 years. However, the investor will be liable for income tax on accrued but unpaid “phantom income.” Further, dividend payments are not guaranteed and will only be paid if interest payments on the underlying obligations are made, which are dependent on the financial condition of the issuer. In addition, most preferred securities are callable at the option of the issuer, just like bonds, and may be subject to tax event or special event calls. The market value is sensitive to changes in interest rates. Unlike common stocks, preferred stocks do not have voting rights.
Mortgage-Backed Securities and Collateralized Mortgage Obligations
(MBS) traditionally have been referred to as relatively high quality, high cash flow generating investment vehicles. However, turmoil associated with mortgage loan originations reveals the need to understand these investments and the factors that drive their performance. Many potential investors shy away from MBS, while others consider this an opportune time to invest.
Pass-through securities represent an ownership interest in mortgage loans made by financial institutions (savings and loans, commercial banks or mortgage companies) to finance the borrower’s purchase of a home or other real estate. Pass–through securities are created when these loans are packaged, or “pooled,” by issuers or servicers for sale to investors. As the underlying mortgage loans are paid off by the homeowners, the investors receive payments of interest and principal.
A more complex type of MBS is a collateralized mortgage obligation. CMOs were developed to meet investor demand for more predictable cash flows and specific maturity ranges. These securities can be backed by a pool of mortgages or existing pass-throughs. CMOs are broken down into classes called “tranches.” Monthly mortgage payments received from home owners are directed to different classes according to a principal pay-down priority schedule. To learn about different CMO structures, visit the Securities Industry and Financial Markets Association at investinginbonds.com.
What you need to know about the risks of bond investing.
Municipal Bonds
Also known as “munis,” municipal bonds are debt obligations issued by state and local governments and other governmental entities to fund the building of highways, hospitals, schools, sewer systems and many other public projects. Munis are attractive to investors in high tax brackets because, in most cases, the interest income is excluded from federal income tax calculations. If investors own municipal bonds issued within their states of residence, interest income may also be excluded from state and local taxes.
Taxable municipal bonds are an entirely separate market within the municipal sector where interest income is included in federal income tax calculations. However, these issues still offer a state – and often local – tax exemption to investors residing within the state of issuance. Taxable municipal bonds exist because the federal government will not subsidize the financing of certain activities that do not provide a significant benefit to the public. Investor-led housing projects, local sports facilities, and borrowing to replenish a municipality’s under-funded pension plan are three types of bond issues that are federally taxable. Yields on taxable munis are typically comparable to those of other taxable issues, such as agencies and corporate bonds.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment.
What you need to know about the risks of bond investing.
Fixed Income Advantage
Working with your Raymond James financial advisor, you have a Fixed Income Advantage, as your advisor has the freedom to offer objective, unbiased advice with access to client-focused resources. Once your advisor understands your personal circumstances, a meticulously tailored long-term plan will be based solely on your specific goals.
Over time, bonds can provide excellent risk-adjusted returns. Fixed income investments diversify your portfolio, helping to stabilize your over-all return and create a predictable income stream to support your desired lifestyle, all while safeguarding your net worth. Your advisor will create a portfolio with the potential to preserve capital and minimize risk while maximizing returns. And as your needs evolve, your advisor will integrate Raymond James Fixed Income resources to monitor, manage and adapt your portfolio as needed.
Understanding that one solution does not fit all, your advisor will strive to earn and maintain your trust by delivering five important elements: personalized service, reliable performance, significant experience, innovative solutions and industry leadership. The Raymond James fixed income department offers resources that your advisor can use to help determine the suitability of each investment. Education efforts and market perspective are complemented by independent third party research, supported by Moody’s Investors Service Credit research, available to you from your Raymond James financial advisor.
Innovative Solutions
In addition to being familiar with your specific situations and financial goals, your advisor has direct access to fixed income professionals who can suggest appropriate actions and develop custom strategies. This gives you an opportunity to follow a long-term approach that uses passive investing overlaid with active monitoring, and make adjustments as warranted.
Fixed income tools available to you through your Raymond James financial advisor include:
- Timely market information and commentary
- Input from trading desk professionals for guidance
- Evaluation and advice on specific transactions
- Assistance in bond portfolio creation
- Investment evaluation and portfolio analysis tools
- Home office visits to meet fixed income professionals
Competitive Execution
Critical components of fixed income investing include price transparency, liquidity and execution. Through your Raymond James financial advisor, you’ll have access to both primary and secondary markets. This means you are not limited to bonds owned by Raymond James, since we co-mingle our offerings with those of many other dealers. Raymond James participates in the selling and/or underwriting of agency offerings, FDIC-insured brokered CDs, corporate notes and preferred securities. The result is that your financial advisor can choose the offerings best suited for your individual needs. Expect to receive superior service through a wide array of tools and offerings available to your Raymond James financial advisor, including:
- Suite of market transparency tools, including price improvement logic, and MarketView, giving your advisor the ability to select the best bonds at the best prices.
- Bond inventories from more than 100 broker/dealers, showing the lowest priced offerings. This platform displays in excess of 12,000 different taxable fixed income offerings.
- Access to alternative trading platforms such as TradeWeb, MuniCenter, Knight Bondpoint and Bondtrac.
- Bid wanted requests automatically routed to more than 100 dealers with which the Raymond James fixed income traders compete, helping to ensure that you receive competitive price executions if you sell bonds from your portfolio.
- Integrated real-time data feeds that assist your advisor in evaluation and comparison.
- New Issue Offerings
Income and Diversification
Developing personalized financial plans and managing evolving financial needs demands regular and comprehensive portfolio review. When it comes to fixed income investments, your Raymond James financial advisor will continuously analyze and update strategies to meet your individual objectives for income and to help grow and protect your assets.
Read about Raymond James‘ recognition for our commitment to the success of our advisors and their clients.
What you need to know about the risks of bond investing.
Next: Bond Market Update
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