- Bond Ladders
- Bond Ratings
- Tax Loss Swapping
- Inverted Yield Curve
- Municipal Bonds
- Investment Portfolio as a Machine!
- A Risky Looking Bond May Not Be What It Appears
A “bond ladder” structure of bonds is one in which bonds in a portfolio are redeemed at different times over a period of years, with each bond becoming due at a different “rung” or year on the redemption ladder. In this way, the portfolio is sure to have a mix of short-term, intermediate, and long-term bonds. This is an easy and reliable way to help insulate a portfolio from interest rate risk.
But how do you determine where on the ladder to place a particular bond: By its call year? Its sinking fund year? Its maturity year? How do you determine whether to weight one time segment of the bond ladder more or less heavily than the other segments, and by how much? These are issues that must be addressed in building a bond ladder.
Bond Laddering does not assure a profit or protect against a loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original investment.
|Moody’s Ratings||Standard & Poor’s|
|Speculative “Junk” Grade||Ba
Bonds rated below investment grade have greater credit risk than higher quality bonds and should not be over-emphasized in any portfolio.
Tax Loss Swapping
In preparation for tax day, it is worth your while to consider “swapping” bonds in your portfolio that have dropped in value from the price you paid for them. Sell a bond at a substantial loss and buy a very similar, but not identical bond in exchange. Swapping bonds in your portfolio in this way may not materially change the portfolio’s overall value, but it may create a very useful tax loss. Is this the right strategy for you?
You should consult your professional tax advisor regarding your particular situation.
Inverted Yield Curve
Normally, short-term bonds yield less than long-term bonds (normal yield curve). But when the Fed raises the short-term rates (1 year or less), intermediate and long-term rates can fall below the rates you’ll find for short-term offerings. This is an “inverted yield curve”: When short-term rates are higher than longer-term rates.
Don’t be tempted by short-term yields, however! When those short-term bonds mature, you may need to invest those funds somewhere else. By then, if the economy has slowed, intermediate and long-term bond rates may have already fallen a lot. What should you do?
The municipal bond market is huge, encompassing hundreds of billions of dollars in outstanding debt from communities, universities, hospitals, and other “municipalities.” The interest income for most municipal bonds is free from Federal income taxes. State and alternative minimum taxes may still apply, as may capital gains tax if bonds are sold prior to maturity.
Because municipalities operate differently from corporations, the criteria is different for determining the creditworthiness of municipal bonds. Are insured municipal bonds a safer investment? Is a General Obligation bond, whose debt obligation can be paid by raising taxes of the citizens of that municipality, worth more than other bonds with the standard ratings of A, AA, AAA?
Please note: Sharon Alister does not give tax advice. Any person considering an investment or portfolio management strategy should consult with his or her own tax advisor.
Investment Portfolio as a Machine!
Your investment portfolio should be like a machine, producing money for your use without removing parts of the machinery. To do this, I believe an investor needs to have an investment presence in each of the main asset categories: Cash, Stocks, and Bonds.
Assessing the risk of different securities in each asset class should not be dominated by “shoebox mentality,” which is what I call the psychological urge people have to be able to count and feel each penny! Each asset class offers investments that cover the entire range of “riskiness,” and each investor most likely will be able to find investments to suit his/her risk tolerance level in each asset class.
Asset allocation does not assure a profit and may not protect against loss in a down market.
A Risky Looking Bond May Not Be What It Appears
Many investors who are tolerant of the risks of owning stocks, even growth stocks with outrageously high price/earnings ratios, categorically refuse to consider a below investment-grade bond. These lower rated bonds are called High Yield (or Junk) Bonds. This may be overlooking a potentially profitable security whose risk characteristics you could find acceptable as part of your portfolio.
Understanding a corporation’s financial situation and the research analysis which has lead to its stock being recommended may go a long way toward easing fears of purchasing a BB-rated situation. A “Make Whole Default Call” may also bring added comfort. Similarly, bond ratings do not change as quickly as the news that leads to them. For example, any pending take-over details or presence on the watch list for positive indications may be additional factors to consider in evaluating the bond’s risk level.
When investing in bonds, it is important to note that as interest rates rise, bonds prices will fall.