All of our clients, even the most aggressive investors, own bonds in their portfolios.
Why? Because bonds serve a variety of purposes in the construction of a balanced portfolio.
They provide income to the investor. The issuer of a bond borrows money from the bond holder (which can be a mutual fund, or an individual investor) and pays that money back in the form of (a) periodic interest payments and (b) the principal at the maturity (e.g. 10, 20 or 30 years) of the bond.
Bonds also stabilize the value of a portfolio. The interest and principal of a bond must, by legal contract, be paid. In contrast, the value of a stock and the dividends paid by a company to the shareholders of a stock are not contractually guaranteed. If a company which has issued both bonds and stocks runs into financial trouble, it will always pay its bondholders before it pays anything to its stockholders. Therefore, the value of a bond is more secure and less volatile than a stock. It is this stability that makes bonds attractive to investors.
While it is true that bonds can rise in value (generally when interest rates fall), we do not hold bonds in our clients’ portfolios with the expectation that our clients will receive capital gains. Instead we invest in bonds because we are seeking preservation of principal. Said simply, we prefer not to lose money in the bond portion of a portfolio.
So, what affects the value of a bond? Changes in interest rates will cause the prices of bonds to fluctuate. When interest rates rise, bond prices will fall. Conversely, when interest rates fall, bond prices will rise. The length of the bond will also influence the price when interest rates change. The longer the time to maturity, the more volatile will be the price of the bond. The shorter the maturity of a bond, the more stable the price of the bond. The price of a bond will also be affected by the credit quality of the issuer (typically a government agency or a corporation). A bond issued by a borrower with poor credit will have to pay a higher interest rate (the bond’s “coupon”) than one with a good credit rating. Also, if the credit quality of an issuer of a bond erodes, the price of the bonds it issued will fall, because the risk of repayment has increased.
Some bonds issued by the government are tax-favored. Bonds issued by the federal government (United States Treasury bonds) are not subject to income taxation at the state and local level. However, they are subject to federal income tax. Bonds issued by municipalities (states, counties, cities, etc) are not subject to federal income taxation. If the owner of a municipal bond resides in the municipality in which the bond was issued, the interest payments from the bond will also be free of taxation by the municipality. So, if you live in Oregon and buy a bond issued by the State of Oregon, the income from that bond will be free of both federal and Oregon State income tax. But if you live in California, the income from that bond issued by the State of Oregon will be subject to California income tax.
That’s enough on bonds for now. We will address another question in a future blog post: Should you invest in individual bonds or bond funds?
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