This week I want to dig in on bonds. We started the conversation in the first column briefly discussing how when a company borrows money, it delivers a bond (or “fixed income”) to the lender. Bondholder = Lender. Bonds can be bought and sold through brokers/dealers. Each bond is assigned a CUSIP [Committee on Uniform Security Identification Procedures.] Bonds work like most loans. You lend money for a specified period of time, e.g. 10 years, known as the maturity of the bond. At maturity, you should expect to get the exact amount of your loan back. To compensate you for lending money, the company pays you a specified coupon (interest), for example 2 percent each year.

There are risks involved with bonds. Inflation, for example, occurs when the prices of goods and services continue to go up. This means that a dollar that doesn’t grow will buy you less and less over time, decreasing your “buying power.” This can affect the real value of bonds at maturity and their interest payments, which remain steady over time. Contrary to inflation, deflation occurs when prices of goods and services are going down.

Bonds can be traded, like unto a stock, and will appear on your statement with a current value. That is because due to the current rate environment the value of your bonds change. One of the most important concepts to understand about risk associated with bonds is the inverse relationship between market interest rates and your bond price.

If rates go up in the market, your bond price (what other investors will pay you for it) goes down. If market rates go down, your bond prices goes up. Think about this concept with numbers: if you have a bond paying 3 percent, but rates go up and now other buyers can purchase a bond paying 4 percent, this makes your bond less desirable in the open market. If you have purchased the bond and know that you will hold it until maturity, then you may be less concerned with the market fluctuations in the value of your bond. Why?

Because you are still getting the stated coupon payments and you should still get your principal back at maturity. However, selling your bond to another investor prior to maturity could lead to a gain (appreciation) or a loss (depreciation.) Bond holders make money in two ways: Interest (the specified coupon payment over a specified period) or Appreciation (bond prices go up).

Also like stocks, bonds can be categorized in several ways:

• By Issuer: Corporations, governments and municipalities can all borrow money (issue bonds.) Corporate or Government bonds (often referred to as “Sovereign Debt”) can be Domestic (U.S.) or International (non-U.S. Developed or Emerging Markets.) Municipalities are also known as tax-free bonds because they are exempt from federal taxes and most state and local taxes.
• By Quality: The financial stability of a company, the likelihood that it will be able to pay back the loan. This determination is made by several rating agencies, for example Moody’s and Standards & Poors (S&P). AAA to AA (High Quality), A+ to BBB- (Moderate Quality), BB+ to D (Speculative).
• By Maturity. The term of the loan. Short-Term (<5 years), Intermediate-Term (5-10 years), Long-Term (>10 years).

Another term often related to bonds is duration, which is the sensitivity of bond price to changes in interest rates. The higher the duration, the more sensitive to rate changes. The lower quality, the longer maturity, and the longer duration the higher the yield because there is greater risk of loss.

Fixed income can play a vital role in a portfolio, but does take on its own risks. As always, talk with your advisor about if or when fixed income may be appropriate to meet your goals.

 

The information provided is for information purposes only and should not be considered an individual recommendation or personalized investment advice. Each investor needs to review his or her particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. Investing in stocks and the equities market always carries risk. Equities are subject generally to market, market sector, market liquidity, issuer and investment style risks, among other factors, to varying degrees.

The statements and opinions expressed in this article are those of the authors as of the date of the article, are subject to rapid change as economic and market conditions dictate, and do not necessarily represent the views of Davenport & Company LLC. This information may contain forward looking predictions that are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. This article does not constitute investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. Investing always carries risk.

There is no guarantee that a company will continue to pay dividends.

MEGHAN COUNCILL is a Registered Representative with Davenport & Company LLC. Member NYSE-SIPC-FINRA