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Frequently Asked Questions
How To… What If… and Why Questions

These are questions from real investors phoned in to my past TV show, live. I’ve included them here in the same phrasing used by callers, which is not always the “correct” phrasing(!) But I thought that many other investors who are not bond professionals may be able to relate to the callers’ way of talking.

Some of my answers are quite long and informative. Others are short, to the point, “zesty zingers!” Sorry. No one ever accused me of being too tactful!

Question:
Should I invest in Total Return bonds?

Answer:
There’s no such thing as “Total Return” bonds. One can invest in bonds with a goal of earning total return, or one can invest in bonds with a goal of high income, or one can invest in bonds with a goal of capital growth like Zero Coupon bonds. I think that investing in bonds with a goal of earning maximum total return would be my preference. Total Return would be the return earned from interest payments plus realized capital gain.

Question:
For a taxable investor, would it be wiser to invest in corporate bonds or in stock?

Answer:
They’re not comparable. The asset allocation question of “What amount of my portfolio should be in cash, stocks, bonds, or other financial securities” has to be answered for each investor. Everyone ought to own a presence in each of the asset categories unless certain circumstances prevail for a particular investor, such as, “I can’t sleep at night with any money invested in the stock market.” After the asset allocation decision is made, the tactical decisions of “which stock” and “which bonds” can be made.

Question:
Are preferred stocks as good as bonds?

Answer:
They’re not comparable. Preferred stocks are equity. Bonds are contracts. While it is true that many preferred shares have high dividend payout rates that may be comparable to the yield available on bonds, with many preferred stocks, there is no principal redemption (maturity) date, as there is with a bond, so the safety of capital can be quite different. Also, many of the preferred shares that have been issued in recent years contain short-term call provisions. These calls are very attractive options for the corporation issuing the preferred stock, but are generally to the investor’s disadvantage. I prefer common stock for growth potential, and bonds for income and generally lower risk. Unless you can get a high dividend perpetual preferred stock that has no call on it, I would stay away from the preferred market. By the way, all debt instruments of a corporation get paid back in a bankruptcy before preferred shareholders receive any money!

Question:
It appears you get a similar interest rate from bonds and the money market. What’s the advantage then of purchasing bonds over money market?

Answer:
Opportunity costs! Whenever the Fed is bringing about a slowdown in the economy, we see the short-term rates rise, and that makes money market rates seem very attractive. This can be a fool’s play, however, because once the market becomes convinced that the Fed will bring about a slowdown, intermediate and long rates drop while short rates may still be moving higher. But by the time the Fed begins to lower those short-term rates and the investor looks for an alternative to the money market, the intermediate and long-term rates will likely already be unattractively low. So, be advised. When money market rates are high and similar to bonds, it may be a signal to go long before those bond rates are no longer available.

Money market funds are typically managed to preserve a net asset value of $1.00 per share. If/When the share price falls below $1.00 per share, the Fund Company can, but is not obligated to, add money to the money market fund to support the $1.00 per share price.

In comparison, bonds are subject to greater potential fluctuation in value, especially in changing interest rate environments.

Question:
What is accrued interest? When do you have to pay it?

Answer:
In general, bonds pay interest every six months. Bonds pay this six months’ worth of interest to whoever is holding the bond on the interest payment date. If you buy or sell a bond between interest payment dates, the person selling the bond is owed interest that accrued from the last interest payment to the date of the sale. The person purchasing the bond is only entitled to interest from the date of purchase until the next interest payment. However, the buyer is going to receive a full six months’ worth of interest because they will be the holder of the bond on the next interest payment date. The way to even this out is for the buyer to pay the seller the amount of interest that accrued until the date of sale. At the next interest date, the buyer will receive a full six months’ worth of interest and at that moment netting out the accrued interest by the buyer, both buyer and seller will have received the exact amount of interest owed to each of them.

Question:
What are interest-bearing bonds?

Answer:
They are bonds which have a coupon on them that is greater than zero.That coupon defines how much of an interest payment you will receive on each interest payment date. A Zero Coupon bond is one that doesn’t pay interest until maturity. We would call that “non-interest bearing.”

Question:
Do you ever pay premium prices for bonds?

Answer:
I almost always pay premium prices for bonds! I love premium bonds! If you compare par versus premium bonds, you will frequently find that the premium bonds have a higher yield. We Americans are generally adverse to paying a premium for anything, because it feels like we’re being taken advantage of! So the market, in order to entice investors to purchase premium bonds, will price in a yield advantage. Put ice cubes in your veins and consider buying the higher yielding bond, regardless of the price, because the yield is the actual “return on investment.” See my article under Investment Strategies called “How to Get a Bargain By Paying a Premium.”

Question:
A bond I’m holding has its first call in 2012 and another call in 2029! Can they call it in between those dates?

Answer:
A bond is callable anytime once a first call has been hit. You cannot think that if you were not called on the first call date that you are going to keep the bond to maturity.

Question:
GNMA, FNMA, Freddie Mac. What’s the difference between them?

Answer:
These are all mortgage-backed securities associated with the Federal Government. Only GNMA carries the full faith and credit guarantee of the U.S. government as to timely payment of principal and interest. Fannie Mae and Freddie Mac, which are Government-Sponsored Enterprises (GSE), have a perceived tie to the federal government as instituitions established under federal legislation, and thus have an implied AAA rating but carry greater credit risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Finance Agency became the conservator of FNMA and Freddie Mac. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies.

Question:
I have $410,000 in a one-year Treasury that will mature in the beginning of May. Are there any other safe investments I can put the money in with higher interest rates?

Answer:
What are you doing with all your eggs in one basket? Even though it is not required to diversify into different debtors when you are investing in Treasuries (because Treasuries are assumed to be credit “risk-free”), it is still prudent to diversify into different maturity ranges when building a bond portfolio. I would have to criticize putting all of this money in just one maturity year.

In answer to your question now that I’ve lectured you (!) there are Ginnie Maes, of course, which have the same credit quality as Treasury bonds, but which pay almost a full percentage point higher yield. They have a variable maturity as they return principal each month throughout their life. However, you are rewarded handsomely, in my opinion, for that variable return of principal. Government agency bonds are just one step down in creditworthiness from Treasuries and still have an implied AAA rating.. These would also be considered of generally lower risk and would pay a higher yield than the comparable term Treasury. (See my comments in the question above.)

Mortgage-backed securities, such as Ginnie Maes, represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securities react to different market conditions.

Question:
How can you go from a quotation of an asking price of a bond to the effective yield? Is there some sort of conversion?

Answer:
Yes, you need a bond yield calculator. The asking price tells you what you will have to pay per bond, but in order to determine what the yield to maturity is (the actual return on your investment), you need to take into account the coupon rate of interest as well as the length of time to maturity. Bond yield calculators are designed to do the mathematics for you.

Question:
I have $1 million in AAA bonds. If I go down to an A or AA rated bond, is that a greater risk to the principal?

Answer:
Yes, that’s why the rating is lower! There are no free lunches out there! You cannot have AAA quality and AA or single A yield. The name of the game is risk and return. The greater your risk, the greater your potential return. Do I view AA rated or single A rated bonds as particularly risky? In my opinion, no. However, the rating agencies have determined, through their rigorous financial analysis, that an A rated bond is riskier than a AAA rated bond. As a result, the yield is higher. There are no free lunches!

Question:
How do you buy a corporate bond? Is it only through a bond fund, or can you purchase it individually?

Answer:
You purchase it individually, of course. A bond fund is an entirely different animal than a bond. It’s actually more like a stock! You buy individual corporate bonds from your financial advisor. There are corporate bonds that are listed on the bond exchange, and you can see them in the newspaper. Please be advised that the listed bonds represent a very, very small percentage of the corporate bonds that are available and traded in the market at any particular time. Your financial advisor can show you a vast array of corporate bonds that are available for investment.

Question:
Is there something you can do with your 401(k) or 403(b), other than roll over to an IRA?

Answer:
There’s nothing wrong with rolling over tax-deferred money from an ERISA account into your IRA account, which is also tax-deferred money. Over the years, banks have come to call their Certificates of Deposit (CDs) that are put into IRAs by the term “IRA,” as if an IRA was an investment! This has confused investors about what an IRA is. An IRA is simply an account with a certain tax status. Which investments you choose to put in your IRA are entirely up to you! There are very few limitations on the types of investments you can purchase in an IRA. Certainly, the full array of stocks, bonds, and cash instruments would be appropriate in an IRA. By all means, you don’t want to take your money out of tax-deferred status unless you have to. You’d be giving up a great tax-free compounding opportunity.

Question:
Where do you get information on fixed income prices?

Answer:
You can get some prices from the newspaper, some from the Internet, some from your financial advisor. It’s not a perfect system.

Question:
When you consider asset allocation, how do you fit high yield bonds into your portfolio? As an equity or a bond?

Answer:
This is a very good question, because the answer is not clear! In my opinion, I would place the high yield bonds in the fixed income section, because after all, they are a debt instrument, they do promise a fixed amount of interest paid periodically, and they do promise a return of your principal on a specified day. So high yield bonds are definitely bonds. In assessing risk, however, they may be more akin to stocks. High yield bonds have greater credit risk than higher quality bonds. You may want to assess your portfolio first by asset category then, secondly, by risk characteristics. I think you will find that your placement of high yield bonds will be different in each case.

Question:
In planning asset allocation, should I consider my pension payments as part of the fixed income allocation?

Answer:
The payments from your pension plan are part of your income stream, not part of your asset allocation. The principal in your pension plan, unless it is yours to distribute as a lump sum or invest in any way you choose, is really not your principal, and therefore, it’s not part of your asset allocation plan.

Question:
What is tax loss swapping, and does it make sense?

Answer:
Tax loss swapping is something you do when there’s a bad bond year! I believe it’s an excellent technique for saving up tax losses that you can use against tax gains.

As an illustration, if one has a bond they bought at a price of 110, which matures in ten years, and which has a coupon of 6%, and the bond market falls (interest rates have risen) and now the bond is selling at a price of 104, the bond has experienced a six-point loss. One might sell that bond at 104 and turn around and buy another bond at a similar price and a similar maturity, with a similar coupon but from a different issuer. For all intents and purposes the profile of your bond portfolio has not changed, but what you have done is created a six-point loss which can be used against gains in computing taxes. Because the new bond is virtually identical to the old bond, the character of the bond portfolio has not changed!

If you don’t have any gains to use in this particular year, so what! Tax losses from bond swapping can be carried forward into future years and used without limitation against tax gains. In addition, you can use $3,000 of those tax losses against ordinary income each year.

Tax loss swapping is a great technique for sheltering gains. I advise people, particularly people with large bond portfolios, to employ tax loss swapping in any year that they can. We had a good tax loss swapping year in 1993 when the Fed raised rates and again in 1999. As with all tax-related matters, you should consult with your tax advisor about your particular situation. (We’ve had subsequent good tax-loss swapping years in 2008 and 2009 too.)

Question:
A young investor wants to know what are the advantages of owning bonds at a young age?

Answer:
In general, people who are younger, say, in their 30s and 40s and young 50s, are in their highest income-earning years and ought to be invested in stocks, because this is the time in their life when, if they lose money on investments, they still have time to earn it back. Later, when you are approaching retirement, is the time when you should be thinking of allocating a greater proportion of your money to the fixed income category, because you may not have the opportunity to earn back losses. Having said that, I always use as a rule of thumb: “If you can’t sleep at night owning any stock, you shouldn’t own any stock no matter what your age.”

Question:
If a bond defaults on an interest payment, what are the chances of getting that payment back?

Answer:
It all depends on the reason for the default. If a company or municipality goes into bankruptcy and is going to cease to exist, the likelihood of getting back all of the owed interest and principal might not be very good. However, many times bonds will default for a period of days, maybe hours or weeks, as contracts get signed, political negotiations get settled, or letters of credit get replaced. During this brief period when, contractually, the municipality or corporation cannot distribute the cash, the bond is in default. Generally, these are cleared up very quickly.

Question:
If you have $1 million in municipal bonds at 5.5%, how do you get 6% or 6.5% with that same $1 million?

Answer:
You can buy lower-rated bonds, but I wouldn’t recommend it, and it’s not likely that you could pick up a full percentage point in tax-free yield. You can try and employ certain techniques to improve the total return of your bond portfolio: Selling a bond when it becomes pre-refunded, selling a bond when it becomes uprated, selling a bond following a merger. In effect, you may be able to increase the portfolio’s yield by adding some capital gains in addition to the coupon yield. However, those gains would be subject to capital gains tax.

You can also switch to taxable bonds, which usually pay a higher rate of interest, and that would enable you to increase your yield. But after paying taxes on that higher interest, your after-tax yield will not likely be higher than the yield from tax-free bonds if you’re in the 28% or higher tax bracket. You have to accept the markets for what they are. (I fully believe free and open markets are the best pricing vehicle we could have!)

Be sure you have a laddered structure of maturities that includes mid-term and long-term bonds. You can’t make a bond whose market yield is 5% suddenly turn into a 6% yield and still have all of the same features of everything else in that market. It just can’t be.

Question:
If you have $1 million in municipal bonds at 5.5%, how do you get 6% or 6.5% with that same $1 million?

Answer:
You can buy lower-rated bonds, but I wouldn’t recommend it, and it’s not likely that you could pick up a full percentage point in tax-free yield. You can try and employ certain techniques to improve the total return of your bond portfolio: Selling a bond when it becomes pre-refunded, selling a bond when it becomes uprated, selling a bond following a merger. In effect, you may be able to increase the portfolio’s yield by adding some capital gains in addition to the coupon yield. However, those gains would be subject to capital gains tax.

You can also switch to taxable bonds, which usually pay a higher rate of interest, and that would enable you to increase your yield. But after paying taxes on that higher interest, your after-tax yield will not likely be higher than the yield from tax-free bonds if you’re in the 28% or higher tax bracket. You have to accept the markets for what they are. (I fully believe free and open markets are the best pricing vehicle we could have!)

Be sure you have a laddered structure of maturities that includes mid-term and long-term bonds. You can’t make a bond whose market yield is 5% suddenly turn into a 6% yield and still have all of the same features of everything else in that market. It just can’t be.

Question:
Why do inverted yield curves happen?

Answer:
There are lots of reasons, but let’s look at the basics. When short-term rates are higher than long- and intermediate-term rates, the curve is “inverted.” This generally happens when the Fed begins to increase interest rates in an attempt to slow down an economy that is growing too fast. The Fed raises the short-term interest rates because the Fed is only allowed to raise rates in the short end of the Treasury market. Usually, long and intermediate rates will first rise along with the short rates. But, as the market begins to view the Fed as taking control of potential future inflation, the intermediate and long rates stabilize and then begin to fall, even as the Fed continues to raise rates. This reflects investors’ expectations of future inflation not being an issue because the Fed is addressing it now. But, the yield curve is temporarily inverted.

Question:
When is it time to get into bonds? When interest rates are high?

Answer:
One needs to get into bonds whenever they’re building an investment portfolio! Having said that, let me say how to handle a bond portfolio for a changing rate enviornment. You should build a ladder structure of maturities that includes short-, mid-, and long-term bonds. How you “weight” that ladder will vary depending on the prevailing interest rate market and your expectations of future rates. Also, each time there is a significant change in the interest rate market, you might want to reevaluate the weighting of your bond ladder.

Many institutions and very large investors are able to move assets between the stock market and the bond market and the cash market very quickly in response to interest rate changes, and individual investors are not able to do this because they lack the liquidity, size, and the ability to move as fast as the institutions. Don’t be confused by the news stories that sometimes talk about institutional maneuvers but fail to remind you that they are not appropriate for individual investors.

Question:
To counter falling interest rates, would you not invest extensively in high-yield preferred stocks?

Answer:
When interest rates have peaked, if you were able to call the peak, an investment strategy that may be profitable is to buy utility stocks (common stocks) and very liquid preferred shares with high dividend payouts (perpetual preferreds) and hold them during the period that interest rates fall and through the trough of interest rates. The trick is to sell out the utilities and preferreds before rates start to rise again! With this strategy, one picks up good dividend payout rates while other investments’ interest rates are falling, and one picks up very good capital gains potential if one is willing to sell the stock.

By the way, the same technique can be employed using very liquid bonds. One can purchase Treasury bonds (not bills) when it appears that interest rates have peaked, hold them through the interest rate decline and through the trough, and sell them out before rates start to rise again. There would be significant capital gains, and you would receive interest up until the point you sell. (Long-term zero-coupon treasuries may be another way to profit from a dip in interest rates. This is risky, and for another conversation!)

It is a strategy for playing the interest rate market. It is certainly not a strategy advisable for anyone who is not willing to take on the risk of trading. Timing the market is difficult if not impossible to accomplish, as no one can predict the markets with any certainty.

Question:
Is the Fed afraid of a flat yield curve?

Answer:
I wouldn’t think so. All the Fed is concerned about is maintaining a stable price environment for the United States economy, to curtail inflation and to avoid depression. How investors choose to price their own expectations of future inflation, which is what longer-term rates really reflect, is not the Fed’s particular interest.

Question:
I have a 1-month-old baby. Are savings bonds still the way to go for a child of this age?

Answer:
I don’t think so. I prefer to buy stock for young children and put that stock on the dividend reinvestment program, or purchase a very high-quality stock fund* and reinvest the dividends and capital gains. Over the long term, if history is any indication, no financial asset will perform as well as equities will. For a newborn child, there’s adequate time for good potential equities growth before that child will be going to college or purchasing a home or whatever other reason you are beginning the fund for the child. While there is additional risk in stocks, stocks would be my preference over savings bonds.

*Investors should consider a fund’s investment objective, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other important information, is available from a Financial Advisor and should be read carefully before investing. The investment return and principal value of an investment will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

Frequently Asked Questions
How To… What If… and Why Questions

These are questions from real investors phoned in to my past TV show, live. I’ve included them here in the same phrasing used by callers, which is not always the “correct” phrasing(!) But I thought that many other investors who are not bond professionals may be able to relate to the callers’ way of talking.

Some of my answers are quite long and informative. Others are short, to the point, “zesty zingers!” Sorry. No one ever accused me of being too tactful!

Question:
Should I invest in Total Return bonds?

Answer:
There’s no such thing as “Total Return” bonds. One can invest in bonds with a goal of earning total return, or one can invest in bonds with a goal of high income, or one can invest in bonds with a goal of capital growth like Zero Coupon bonds. I think that investing in bonds with a goal of earning maximum total return would be my preference. Total Return would be the return earned from interest payments plus realized capital gain.

Question:
For a taxable investor, would it be wiser to invest in corporate bonds or in stock?

Answer:
They’re not comparable. The asset allocation question of “What amount of my portfolio should be in cash, stocks, bonds, or other financial securities” has to be answered for each investor. Everyone ought to own a presence in each of the asset categories unless certain circumstances prevail for a particular investor, such as, “I can’t sleep at night with any money invested in the stock market.” After the asset allocation decision is made, the tactical decisions of “which stock” and “which bonds” can be made.

Question:
Are preferred stocks as good as bonds?

Answer:
They’re not comparable. Preferred stocks are equity. Bonds are contracts. While it is true that many preferred shares have high dividend payout rates that may be comparable to the yield available on bonds, with many preferred stocks, there is no principal redemption (maturity) date, as there is with a bond, so the safety of capital can be quite different. Also, many of the preferred shares that have been issued in recent years contain short-term call provisions. These calls are very attractive options for the corporation issuing the preferred stock, but are generally to the investor’s disadvantage. I prefer common stock for growth potential, and bonds for income and generally lower risk. Unless you can get a high dividend perpetual preferred stock that has no call on it, I would stay away from the preferred market. By the way, all debt instruments of a corporation get paid back in a bankruptcy before preferred shareholders receive any money!

Question:
It appears you get a similar interest rate from bonds and the money market. What’s the advantage then of purchasing bonds over money market?

Answer:
Opportunity costs! Whenever the Fed is bringing about a slowdown in the economy, we see the short-term rates rise, and that makes money market rates seem very attractive. This can be a fool’s play, however, because once the market becomes convinced that the Fed will bring about a slowdown, intermediate and long rates drop while short rates may still be moving higher. But by the time the Fed begins to lower those short-term rates and the investor looks for an alternative to the money market, the intermediate and long-term rates will likely already be unattractively low. So, be advised. When money market rates are high and similar to bonds, it may be a signal to go long before those bond rates are no longer available.

Money market funds are typically managed to preserve a net asset value of $1.00 per share. If/When the share price falls below $1.00 per share, the Fund Company can, but is not obligated to, add money to the money market fund to support the $1.00 per share price.

In comparison, bonds are subject to greater potential fluctuation in value, especially in changing interest rate environments.

Question:
What is accrued interest? When do you have to pay it?

Answer:
In general, bonds pay interest every six months. Bonds pay this six months’ worth of interest to whoever is holding the bond on the interest payment date. If you buy or sell a bond between interest payment dates, the person selling the bond is owed interest that accrued from the last interest payment to the date of the sale. The person purchasing the bond is only entitled to interest from the date of purchase until the next interest payment. However, the buyer is going to receive a full six months’ worth of interest because they will be the holder of the bond on the next interest payment date. The way to even this out is for the buyer to pay the seller the amount of interest that accrued until the date of sale. At the next interest date, the buyer will receive a full six months’ worth of interest and at that moment netting out the accrued interest by the buyer, both buyer and seller will have received the exact amount of interest owed to each of them.

Question:
What are interest-bearing bonds?

Answer:
They are bonds which have a coupon on them that is greater than zero.That coupon defines how much of an interest payment you will receive on each interest payment date. A Zero Coupon bond is one that doesn’t pay interest until maturity. We would call that “non-interest bearing.”

Question:
Do you ever pay premium prices for bonds?

Answer:
I almost always pay premium prices for bonds! I love premium bonds! If you compare par versus premium bonds, you will frequently find that the premium bonds have a higher yield. We Americans are generally adverse to paying a premium for anything, because it feels like we’re being taken advantage of! So the market, in order to entice investors to purchase premium bonds, will price in a yield advantage. Put ice cubes in your veins and consider buying the higher yielding bond, regardless of the price, because the yield is the actual “return on investment.” See my article under Investment Strategies called “How to Get a Bargain By Paying a Premium.”

Question:
A bond I’m holding has its first call in 2012 and another call in 2029! Can they call it in between those dates?

Answer:
A bond is callable anytime once a first call has been hit. You cannot think that if you were not called on the first call date that you are going to keep the bond to maturity.

Question:
GNMA, FNMA, Freddie Mac. What’s the difference between them?

Answer:
These are all mortgage-backed securities associated with the Federal Government. Only GNMA carries the full faith and credit guarantee of the U.S. government as to timely payment of principal and interest. Fannie Mae and Freddie Mac, which are Government-Sponsored Enterprises (GSE), have a perceived tie to the federal government as instituitions established under federal legislation, and thus have an implied AAA rating but carry greater credit risk than those guaranteed by the U.S. government. Since September 2008, the Federal Housing Finance Agency became the conservator of FNMA and Freddie Mac. As such, the U.S. Treasury has committed to provide necessary funding to support the net worth of these agencies.

Question:
I have $410,000 in a one-year Treasury that will mature in the beginning of May. Are there any other safe investments I can put the money in with higher interest rates?

Answer:
What are you doing with all your eggs in one basket? Even though it is not required to diversify into different debtors when you are investing in Treasuries (because Treasuries are assumed to be credit “risk-free”), it is still prudent to diversify into different maturity ranges when building a bond portfolio. I would have to criticize putting all of this money in just one maturity year.

In answer to your question now that I’ve lectured you (!) there are Ginnie Maes, of course, which have the same credit quality as Treasury bonds, but which pay almost a full percentage point higher yield. They have a variable maturity as they return principal each month throughout their life. However, you are rewarded handsomely, in my opinion, for that variable return of principal. Government agency bonds are just one step down in creditworthiness from Treasuries and still have an implied AAA rating.. These would also be considered of generally lower risk and would pay a higher yield than the comparable term Treasury. (See my comments in the question above.)

Mortgage-backed securities, such as Ginnie Maes, represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securities react to different market conditions.

Question:
How can you go from a quotation of an asking price of a bond to the effective yield? Is there some sort of conversion?

Answer:
Yes, you need a bond yield calculator. The asking price tells you what you will have to pay per bond, but in order to determine what the yield to maturity is (the actual return on your investment), you need to take into account the coupon rate of interest as well as the length of time to maturity. Bond yield calculators are designed to do the mathematics for you.

Question:
I have $1 million in AAA bonds. If I go down to an A or AA rated bond, is that a greater risk to the principal?

Answer:
Yes, that’s why the rating is lower! There are no free lunches out there! You cannot have AAA quality and AA or single A yield. The name of the game is risk and return. The greater your risk, the greater your potential return. Do I view AA rated or single A rated bonds as particularly risky? In my opinion, no. However, the rating agencies have determined, through their rigorous financial analysis, that an A rated bond is riskier than a AAA rated bond. As a result, the yield is higher. There are no free lunches!

Question:
How do you buy a corporate bond? Is it only through a bond fund, or can you purchase it individually?

Answer:
You purchase it individually, of course. A bond fund is an entirely different animal than a bond. It’s actually more like a stock! You buy individual corporate bonds from your financial advisor. There are corporate bonds that are listed on the bond exchange, and you can see them in the newspaper. Please be advised that the listed bonds represent a very, very small percentage of the corporate bonds that are available and traded in the market at any particular time. Your financial advisor can show you a vast array of corporate bonds that are available for investment.

Question:
Is there something you can do with your 401(k) or 403(b), other than roll over to an IRA?

Answer:
There’s nothing wrong with rolling over tax-deferred money from an ERISA account into your IRA account, which is also tax-deferred money. Over the years, banks have come to call their Certificates of Deposit (CDs) that are put into IRAs by the term “IRA,” as if an IRA was an investment! This has confused investors about what an IRA is. An IRA is simply an account with a certain tax status. Which investments you choose to put in your IRA are entirely up to you! There are very few limitations on the types of investments you can purchase in an IRA. Certainly, the full array of stocks, bonds, and cash instruments would be appropriate in an IRA. By all means, you don’t want to take your money out of tax-deferred status unless you have to. You’d be giving up a great tax-free compounding opportunity.

Question:
Where do you get information on fixed income prices?

Answer:
You can get some prices from the newspaper, some from the Internet, some from your financial advisor. It’s not a perfect system.

Question:
When you consider asset allocation, how do you fit high yield bonds into your portfolio? As an equity or a bond?

Answer:
This is a very good question, because the answer is not clear! In my opinion, I would place the high yield bonds in the fixed income section, because after all, they are a debt instrument, they do promise a fixed amount of interest paid periodically, and they do promise a return of your principal on a specified day. So high yield bonds are definitely bonds. In assessing risk, however, they may be more akin to stocks. High yield bonds have greater credit risk than higher quality bonds. You may want to assess your portfolio first by asset category then, secondly, by risk characteristics. I think you will find that your placement of high yield bonds will be different in each case.

Question:
In planning asset allocation, should I consider my pension payments as part of the fixed income allocation?

Answer:
The payments from your pension plan are part of your income stream, not part of your asset allocation. The principal in your pension plan, unless it is yours to distribute as a lump sum or invest in any way you choose, is really not your principal, and therefore, it’s not part of your asset allocation plan.

Question:
What is tax loss swapping, and does it make sense?

Answer:
Tax loss swapping is something you do when there’s a bad bond year! I believe it’s an excellent technique for saving up tax losses that you can use against tax gains.

As an illustration, if one has a bond they bought at a price of 110, which matures in ten years, and which has a coupon of 6%, and the bond market falls (interest rates have risen) and now the bond is selling at a price of 104, the bond has experienced a six-point loss. One might sell that bond at 104 and turn around and buy another bond at a similar price and a similar maturity, with a similar coupon but from a different issuer. For all intents and purposes the profile of your bond portfolio has not changed, but what you have done is created a six-point loss which can be used against gains in computing taxes. Because the new bond is virtually identical to the old bond, the character of the bond portfolio has not changed!

If you don’t have any gains to use in this particular year, so what! Tax losses from bond swapping can be carried forward into future years and used without limitation against tax gains. In addition, you can use $3,000 of those tax losses against ordinary income each year.

Tax loss swapping is a great technique for sheltering gains. I advise people, particularly people with large bond portfolios, to employ tax loss swapping in any year that they can. We had a good tax loss swapping year in 1993 when the Fed raised rates and again in 1999. As with all tax-related matters, you should consult with your tax advisor about your particular situation. (We’ve had subsequent good tax-loss swapping years in 2008 and 2009 too.)

Question:
A young investor wants to know what are the advantages of owning bonds at a young age?

Answer:
In general, people who are younger, say, in their 30s and 40s and young 50s, are in their highest income-earning years and ought to be invested in stocks, because this is the time in their life when, if they lose money on investments, they still have time to earn it back. Later, when you are approaching retirement, is the time when you should be thinking of allocating a greater proportion of your money to the fixed income category, because you may not have the opportunity to earn back losses. Having said that, I always use as a rule of thumb: “If you can’t sleep at night owning any stock, you shouldn’t own any stock no matter what your age.”

Question:
If a bond defaults on an interest payment, what are the chances of getting that payment back?

Answer:
It all depends on the reason for the default. If a company or municipality goes into bankruptcy and is going to cease to exist, the likelihood of getting back all of the owed interest and principal might not be very good. However, many times bonds will default for a period of days, maybe hours or weeks, as contracts get signed, political negotiations get settled, or letters of credit get replaced. During this brief period when, contractually, the municipality or corporation cannot distribute the cash, the bond is in default. Generally, these are cleared up very quickly.

Question:
If you have $1 million in municipal bonds at 5.5%, how do you get 6% or 6.5% with that same $1 million?

Answer:
You can buy lower-rated bonds, but I wouldn’t recommend it, and it’s not likely that you could pick up a full percentage point in tax-free yield. You can try and employ certain techniques to improve the total return of your bond portfolio: Selling a bond when it becomes pre-refunded, selling a bond when it becomes uprated, selling a bond following a merger. In effect, you may be able to increase the portfolio’s yield by adding some capital gains in addition to the coupon yield. However, those gains would be subject to capital gains tax.

You can also switch to taxable bonds, which usually pay a higher rate of interest, and that would enable you to increase your yield. But after paying taxes on that higher interest, your after-tax yield will not likely be higher than the yield from tax-free bonds if you’re in the 28% or higher tax bracket. You have to accept the markets for what they are. (I fully believe free and open markets are the best pricing vehicle we could have!)

Be sure you have a laddered structure of maturities that includes mid-term and long-term bonds. You can’t make a bond whose market yield is 5% suddenly turn into a 6% yield and still have all of the same features of everything else in that market. It just can’t be.

Question:
If you have $1 million in municipal bonds at 5.5%, how do you get 6% or 6.5% with that same $1 million?

Answer:
You can buy lower-rated bonds, but I wouldn’t recommend it, and it’s not likely that you could pick up a full percentage point in tax-free yield. You can try and employ certain techniques to improve the total return of your bond portfolio: Selling a bond when it becomes pre-refunded, selling a bond when it becomes uprated, selling a bond following a merger. In effect, you may be able to increase the portfolio’s yield by adding some capital gains in addition to the coupon yield. However, those gains would be subject to capital gains tax.

You can also switch to taxable bonds, which usually pay a higher rate of interest, and that would enable you to increase your yield. But after paying taxes on that higher interest, your after-tax yield will not likely be higher than the yield from tax-free bonds if you’re in the 28% or higher tax bracket. You have to accept the markets for what they are. (I fully believe free and open markets are the best pricing vehicle we could have!)

Be sure you have a laddered structure of maturities that includes mid-term and long-term bonds. You can’t make a bond whose market yield is 5% suddenly turn into a 6% yield and still have all of the same features of everything else in that market. It just can’t be.

Question:
Why do inverted yield curves happen?

Answer:
There are lots of reasons, but let’s look at the basics. When short-term rates are higher than long- and intermediate-term rates, the curve is “inverted.” This generally happens when the Fed begins to increase interest rates in an attempt to slow down an economy that is growing too fast. The Fed raises the short-term interest rates because the Fed is only allowed to raise rates in the short end of the Treasury market. Usually, long and intermediate rates will first rise along with the short rates. But, as the market begins to view the Fed as taking control of potential future inflation, the intermediate and long rates stabilize and then begin to fall, even as the Fed continues to raise rates. This reflects investors’ expectations of future inflation not being an issue because the Fed is addressing it now. But, the yield curve is temporarily inverted.

Question:
When is it time to get into bonds? When interest rates are high?

Answer:
One needs to get into bonds whenever they’re building an investment portfolio! Having said that, let me say how to handle a bond portfolio for a changing rate enviornment. You should build a ladder structure of maturities that includes short-, mid-, and long-term bonds. How you “weight” that ladder will vary depending on the prevailing interest rate market and your expectations of future rates. Also, each time there is a significant change in the interest rate market, you might want to reevaluate the weighting of your bond ladder.

Many institutions and very large investors are able to move assets between the stock market and the bond market and the cash market very quickly in response to interest rate changes, and individual investors are not able to do this because they lack the liquidity, size, and the ability to move as fast as the institutions. Don’t be confused by the news stories that sometimes talk about institutional maneuvers but fail to remind you that they are not appropriate for individual investors.

Question:
To counter falling interest rates, would you not invest extensively in high-yield preferred stocks?

Answer:
When interest rates have peaked, if you were able to call the peak, an investment strategy that may be profitable is to buy utility stocks (common stocks) and very liquid preferred shares with high dividend payouts (perpetual preferreds) and hold them during the period that interest rates fall and through the trough of interest rates. The trick is to sell out the utilities and preferreds before rates start to rise again! With this strategy, one picks up good dividend payout rates while other investments’ interest rates are falling, and one picks up very good capital gains potential if one is willing to sell the stock.

By the way, the same technique can be employed using very liquid bonds. One can purchase Treasury bonds (not bills) when it appears that interest rates have peaked, hold them through the interest rate decline and through the trough, and sell them out before rates start to rise again. There would be significant capital gains, and you would receive interest up until the point you sell. (Long-term zero-coupon treasuries may be another way to profit from a dip in interest rates. This is risky, and for another conversation!)

It is a strategy for playing the interest rate market. It is certainly not a strategy advisable for anyone who is not willing to take on the risk of trading. Timing the market is difficult if not impossible to accomplish, as no one can predict the markets with any certainty.

Question:
Is the Fed afraid of a flat yield curve?

Answer:
I wouldn’t think so. All the Fed is concerned about is maintaining a stable price environment for the United States economy, to curtail inflation and to avoid depression. How investors choose to price their own expectations of future inflation, which is what longer-term rates really reflect, is not the Fed’s particular interest.

Question:
I have a 1-month-old baby. Are savings bonds still the way to go for a child of this age?

Answer:
I don’t think so. I prefer to buy stock for young children and put that stock on the dividend reinvestment program, or purchase a very high-quality stock fund* and reinvest the dividends and capital gains. Over the long term, if history is any indication, no financial asset will perform as well as equities will. For a newborn child, there’s adequate time for good potential equities growth before that child will be going to college or purchasing a home or whatever other reason you are beginning the fund for the child. While there is additional risk in stocks, stocks would be my preference over savings bonds.

*Investors should consider a fund’s investment objective, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other important information, is available from a Financial Advisor and should be read carefully before investing. The investment return and principal value of an investment will fluctuate, so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

If your portfolio is greater than $500,000, Sharon Alister can provide a free analytic review to help ensure that your portfolio is in line with your investment goals. Call Sharon Alister at (800) 745-7110 or email info@AlisterTalksBonds.com

 

Interest Rates (Indications only)

Please note the rates for Ins’d and Pre-Res are not available from Bloomberg and will be updated as soon as possible.

Treasuries AAA Munis
3mo 1.815 N/A
6mo 2.009 N/A
1yr 2.237 1.74
2yr 2.482 1.87
5yr 2.809 2.19
10yr 2.970 2.53
30yr 3.145 3.14
today's rates chart

AAA Rated Munis

Pre-Res Ins’d Pure*
2 yr 1.91 2.05 1.87
5 yr 2.23 2.49 2.19
10 yr N/A 2.89 2.53
15 yr N/A 3.20 2.82
30 yr N/A 3.50 3.14

*Rated AAA on its own
Source: Bloomberg

Investing involves risk, including possible loss of principal. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. Conversely, as interest rates fall, bond prices will rise.

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