The last post explained general decisions in creating a portfolio, what financial professionals call asset allocation. This post focuses on the bonds in the portfolio.
Bond decisions focus on two main considerations, maturity risk and credit risk.
This is the tradeoff between yield and the term to maturity of the bonds. Long-maturity bonds tend to pay higher yields than short-maturity bonds, but their prices are also more sensitive to movements in interest rates, falling as they go up and rising as rates fall. (See the box in this post for a more complete discussion.) Unless you have strong convictions on the future direction of interest rates (always a problematic prospect) you should aim to balance the higher current yield of longer-maturity bonds against the risk of a price decline should rates rise.
Hint: Be aware that some bonds have a call provision that permits the bond issuer to call the bond back before it runs its full term to maturity. If interest rates fall below levels that prevailed when the bond was initially sold, the issuer may decide to borrow anew at a lower interest cost and use the money to call back your holding. You would get your money back and the interest due you to the date of the call, but you would lose the benefit of having a long-maturity bond appreciating in a falling rate environment.
As we mentioned in an earlier post, there is always a chance that the bond issuer will go bankrupt and fail to meet its obligations. The greater this risk, the higher yield the bond pays, but you must decide, based on your life cycle/life style needs, how much of this risk you are willing to assume. Even if there is no bankruptcy, the prices of bonds with a greater risk might suffer on bad economic news. With this trade-off in mind, we can identify three basic types of bonds:
- Treasuries: These are the obligations of the federal government. They are issued in different maturities and carry the same maturity risk as all bonds, but they never have call provisions. Because they are considered entirely secure credits, they generally offer lower yields than other bonds.
- Investment grade corporate bonds: These are issued by companies with strong finances. All else being equal, they generally pay a higher yield than U.S. treasuries. There is only a small chance that they might have problems meeting their obligations. Credit rating agencies (of which more in a later post) show this risk on a relative scale. (See the box at the end of this post.) Investment-grade bonds have little risk that they will fail to pay the holder all they owe. But they do have maturity risk, and many have call provisions.
- Junk bonds: Despite their colorful name, such bonds can play an important role in a portfolio. Because they either have low credit ratings or none at all, they are considered more vulnerable to failure than other bonds and accordingly pay higher yields than other bonds of comparable maturity. As with all bonds, these also carry maturity risk and often have call provisions.
This is a fourth type of bond that doesn’t fit neatly into any of these categories. “Municipals” or “munis” are issued by states, cities, and other municipalities. Their appeal is largely because their interest earnings are exempt from federal income tax as well as from state tax for the state in which they were issued. Because of that break, they generally pay lower yields than bonds on which interest earnings are subject to tax.
Hint: Except in rare circumstances, the only reason to buy municipal bonds is for the tax break. If you have a combined tax rate of less than 25-30 percent, you shouldn’t consider them. The tax break you would enjoy would not compensate you for accepting the lower yield munis pay.
If your tax situation warrants buying them, be aware that municipal bonds are otherwise much like other bonds. They carry more maturity risk at longer maturities and accordingly pay higher yields at longer maturities. Their credit ratings can vary from good down to junk status, depending on past behavior and the finances of the issuing municipality. As with other bonds, the less credit-worthy bonds tend to pay higher yields. Many munis carry call provisions. Municipal bonds come in three types:
- General Obligation Bonds (GOs): These are the safest because the full taxing authority of the issuer backs them. They finance roads, schools, and other government projects. They remain exempt from tax as long as no more than 10 percent of the money raised by them goes to finance a private enterprise, not pay for its services.
- Revenue Bonds: These pay from the income earned by a specific project or government agency, for instance the tolls from a road or a publically financed operation such as a hospital, a stadium, or convention center.
- Industrial Development Bonds: These bonds finance the construction of facilities that are then leased to a private corporation. Their tax-exempt status follows the same rules as GOs.
A Last Word
Remembering the necessity of diversification explained in the last post, the object here is not to settle on one bond or type of bond but to construct the bond portion of your portfolio with a variety of bonds that, when combined, both diversify your bond risk and meet your specific needs.
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