Yield curves depict how a bond’s yield is related to its maturity. Yield curves based on the US Treasury are published daily in major financial newspapers. Yields on shorter-term bonds, such as 1-month, 3-month, and 6-month Treasuries, are depicted on the left side of the curve. Yields for longer-term bonds, up to the 30-year bellwether Treasury, are on the right side of the curve.
Typically, higher yields are available on longer maturities. This is because investors expect to be compensated for giving up their capital for longer periods of time. On a yield curve, this translates into an upward-sloping line. A “flat” yield curve has only a small spread between the yields available on the shortest and longest securities. As a practical example of a flat yield curve, if the 1-month Treasury yielded 5.00% when the 30-year Treasury was yielding 5.80%, the spread would be just 0.80%, or 80 basis points. Conversely, if the 30-year Treasury was yielding 6.50%, the spread would be 1.50% and the yield curve would be considered “steep”. During times of steep yield curves, investors demand a significantly higher yield on their long-term securities.
Sometimes, however, higher yields are actually available on shorter maturities. This results in a downward-sloping or “inverted” yield curve. Usually inverted yield curves happen when investors believe that interest rates are about to decline. And since interest rates usually decline during recessions, an inverted yield curve can sometimes predict tough economic times ahead. However, the inverted yield curve tends to be somewhat pessimistic: it has predicted nine out of five recessions.
Historically the yield curve has moved all over the place. There have been periods of long bonds yielding much more than short bonds (steep yield curves), to long bonds yielding just a little more than short bonds (flat yield curves), to long bonds actually yielding less than short bonds (inverted yield curves.)
Say you’ve looked at the yield curve and determined that it is upward-sloping; that is, longer-term bonds are yielding more than short-term bonds. Why would you ever buy a lower-yielding short or intermediate-term security under these conditions? The answer is that long-term securities present both greater risks and greater rewards. The primary risk for long-term bond investors is interest rate risk. If interest rates increase, the price of long-term bonds will decline more than the price of short-term bonds will decline. If you need to reclaim your capital before the bond matures, you will need to sell it into the market at a loss. This is a large and misunderstood risk for bond investors, and it is one that the yield curve can help you mitigate.
Shorter-term securities are less susceptible to interest rate risk, but they offer a lower yield. There is no perfect solution; only a tradeoff between security and maximum potential return. The yield curve captures this trade-off clearly, on a daily basis. For example, if 90% of the yield on a 30-year bond is available on a 10-year bond, you will probably be best served by buying the 10-year bond. The yield curve tells you that you will not be adequately compensated for the additional risk inherent in the long-term bond.
On the other hand, what if you are looking at an inverted yield curve? Why would you buy a longer-term, lower-yielding security rather than a less risky, higher-yielding security? The answer is simple: you will lock in returns for longer. During the 1980’s, interest rates rose to unprecedented highs. Investors who locked in the high yields for long periods of time made a lot more money than those who were forced to reinvest their money at lower interest rates just a year or two later.
In summary, a yield curve shows you how a bond’s yield is related to its maturity. A careful look at the yield curve can help you determine if you are being adequately compensated for the risk you are assuming with your bond portfolio, and thereby increase the security and return of your entire portfolio.
Thursday 3 September 2009
tax-free municipal bonds
After a tumultuous ride in the stock market, you begin to think about other types of investments; ones that offer a bit more stability. For this you are willing to trade a relative reduction in potential capital gains for a possible safer return. Perhaps you could invest in a vehicle that could provide you with a modest income, free from taxation. Would it be an appropriate investment for you? Does such an investment exist? It does and it’s literally right outside your door – municipal bonds and municipal bond funds.
Debt securities issued by a state or local government or governmental entity are referred to as municipal bonds. The money raised by these securities is used to build roads, schools, as well as other public projects such as stadiums and parks. When you purchase a municipal bond, you are essentially lending your state or municipality the value of the bond and, in return, they pay you interest. If you are a resident of the state issuing the bond, there is a good chance the interest will be free from all taxes; federal, state and local. The reason you wouldn’t have to pay federal taxes is due to the separation of powers, where the federal government can’t tax state issues, just as states cannot tax federal issues. Since you are lending the money to your state or municipality, those entities usually waive the taxes. Check with a tax professional to find out the specifics of the bonds that you are interested in since there are some instances where taxes can be levied. As a general rule, most residents of the state from whom they purchased the bond enjoy the triple tax-free status of these investments.
Because of the tax-free status of these bonds, they usually trade at a reduced rate of interest to corporate issues. In order to determine whether the interest you will receive from a municipal bond is in keeping with your desired net return, or yield, there is a simple equation to assist you. When comparing your net return from municipal bonds to corporate bonds, you must compute what is known as the ‘tax-equivalent yield’. Take your tax-free yield divided by 1- (your federal tax rate) = tax equivalent yield. As an example, say you are considering two different bonds for purchase; one, a taxable corporate bond, the other a tax-free municipal bond. The taxable corporate bond has a 5% interest rate, the tax-free municipal bond offers a 4.5% interest rate. Let’s assume you are in the 25% tax bracket. To calculate what the taxable equivalent of the tax-free municipal bond yield would be, divide the tax-free rate by 1 minus your tax bracket: 4.5% divided by 1-.25 (which equals .75) = 4.5 divided by .75 = 6%. The tax-free municipal bond’s tax equivalent yield of 6% is higher than the taxable investment's 5% interest rate. In other words, a taxable investment would have to pay you 6% interest in order to equal the interest you would receive from a municipal bond issue that pays 4.5% interest.
Municipal bonds come in three basic forms. First is the general obligation bond, which is backed by the full faith and credit, in the form of the municipality’s taxing power, of the issuing agency. Second is the revenue bond, which is backed by the revenue generated from a specific project, authority, or agency. These bonds are not backed by the full faith and credit of the agency and are only as good as the specific projects they support. Third is the industrial development bond, or IDB, which is issued to support the purchase or construction of industrial facilities that will be leased to private businesses. The leasing fees are used to pay the interest and principal to the bondholders.
There are two ways to invest in municipal bonds. You can buy them from a broker who will likely advise you that they come in $5,000 par values and require a $25,000 minimum investment, or you can purchase them through a mutual fund. Most mutual funds require a minimum investment of $1,000 - $2,000, making them much more affordable to your average investor.
To determine which bonds are considered of a higher quality than others, Moodys and Standard & Poors have created a rating system to assist investors. The highest rated bonds, usually with their principal and interest insured by an outside private concern such as MBIAC, are given a quality rating of AAA. On the opposite side of the spectrum, the lowest rating a bond can receive is C, and is considered an extremely poor prospect. These low-rated issues should be considered only by those investors with a high level of risk tolerance, and should be avoided by conservative investors altogether.
Municipal bonds and municipal bond funds can be a great means of creating a tax-free income, particularly for those with a large tax burden. For those who purchase municipal bonds in the form of a mutual fund, the tax-free interest can be re-invested to purchase additional shares, thereby increasing the principal and, subsequently, future interest. These issues make a solid addition to a well-diversified investment plan, and represent the more conservative side of a balanced portfolio.
Debt securities issued by a state or local government or governmental entity are referred to as municipal bonds. The money raised by these securities is used to build roads, schools, as well as other public projects such as stadiums and parks. When you purchase a municipal bond, you are essentially lending your state or municipality the value of the bond and, in return, they pay you interest. If you are a resident of the state issuing the bond, there is a good chance the interest will be free from all taxes; federal, state and local. The reason you wouldn’t have to pay federal taxes is due to the separation of powers, where the federal government can’t tax state issues, just as states cannot tax federal issues. Since you are lending the money to your state or municipality, those entities usually waive the taxes. Check with a tax professional to find out the specifics of the bonds that you are interested in since there are some instances where taxes can be levied. As a general rule, most residents of the state from whom they purchased the bond enjoy the triple tax-free status of these investments.
Because of the tax-free status of these bonds, they usually trade at a reduced rate of interest to corporate issues. In order to determine whether the interest you will receive from a municipal bond is in keeping with your desired net return, or yield, there is a simple equation to assist you. When comparing your net return from municipal bonds to corporate bonds, you must compute what is known as the ‘tax-equivalent yield’. Take your tax-free yield divided by 1- (your federal tax rate) = tax equivalent yield. As an example, say you are considering two different bonds for purchase; one, a taxable corporate bond, the other a tax-free municipal bond. The taxable corporate bond has a 5% interest rate, the tax-free municipal bond offers a 4.5% interest rate. Let’s assume you are in the 25% tax bracket. To calculate what the taxable equivalent of the tax-free municipal bond yield would be, divide the tax-free rate by 1 minus your tax bracket: 4.5% divided by 1-.25 (which equals .75) = 4.5 divided by .75 = 6%. The tax-free municipal bond’s tax equivalent yield of 6% is higher than the taxable investment's 5% interest rate. In other words, a taxable investment would have to pay you 6% interest in order to equal the interest you would receive from a municipal bond issue that pays 4.5% interest.
Municipal bonds come in three basic forms. First is the general obligation bond, which is backed by the full faith and credit, in the form of the municipality’s taxing power, of the issuing agency. Second is the revenue bond, which is backed by the revenue generated from a specific project, authority, or agency. These bonds are not backed by the full faith and credit of the agency and are only as good as the specific projects they support. Third is the industrial development bond, or IDB, which is issued to support the purchase or construction of industrial facilities that will be leased to private businesses. The leasing fees are used to pay the interest and principal to the bondholders.
There are two ways to invest in municipal bonds. You can buy them from a broker who will likely advise you that they come in $5,000 par values and require a $25,000 minimum investment, or you can purchase them through a mutual fund. Most mutual funds require a minimum investment of $1,000 - $2,000, making them much more affordable to your average investor.
To determine which bonds are considered of a higher quality than others, Moodys and Standard & Poors have created a rating system to assist investors. The highest rated bonds, usually with their principal and interest insured by an outside private concern such as MBIAC, are given a quality rating of AAA. On the opposite side of the spectrum, the lowest rating a bond can receive is C, and is considered an extremely poor prospect. These low-rated issues should be considered only by those investors with a high level of risk tolerance, and should be avoided by conservative investors altogether.
Municipal bonds and municipal bond funds can be a great means of creating a tax-free income, particularly for those with a large tax burden. For those who purchase municipal bonds in the form of a mutual fund, the tax-free interest can be re-invested to purchase additional shares, thereby increasing the principal and, subsequently, future interest. These issues make a solid addition to a well-diversified investment plan, and represent the more conservative side of a balanced portfolio.
Government and corporate bonds
Most people know about the basics of investing in the stock market but many people are puzzled as to what bonds are. In one word a bond is a loan. The loans can be form the federal government, a federal agency, municipality, or corporation. When you purchase bonds you are lending your money to whomever you buy the bonds from. In return for lending them your money you are paid a fixed rate of interest over a set period of time. When the bond matures the investor’s money is usually returned with the earned interest included. Bonds are like stocks because they are both traded. Therefore you can buy the bonds after they are originally issued while at the same time you can sell bonds before they mature. Bond prices are subject to volatility in relation to market conditions.
When a person is issued a bond they are basically promised to get their money back. Bondholders are paid before anyone else, even stockholders and creditors if the company runs into hard times or goes bankrupt. Bonds give you a stream of income based on their rate of return. Bonds are usually much less volatile then stocks are. Bonds also can provide a tax break because municipal and government bonds are sometimes exempt from state and federal taxes.
The main disadvantage to bonds is that they generally have lower returns than stocks and mutual funds. Bonds are like stocks because their prices are sensitive to interest rates as well. Bonds also carry with them some heavy terminology, which can be confusing and hard to understand.
Type of Bonds:
Government Bonds
The U.S. Department of Treasury and other federal agencies issue treasuries and federal agency bonds. Treasuries are basically risk free because the U.S. government backs them. They are issued to help finance all of the costs involved in operating the government. Municipal Bonds – State and local governments to help pay for schools, streets, highways, hospitals, bridges, airports, and other public works issue municipal bonds. You usually don’t have to pay federal taxes on the interest earned from municipal bonds.
Corporate Bonds
Corporate bonds are issued by businesses to help pay for business expenses. There are a ton of different corporate bonds available all with their own interest rates, maturities, and credit ratings. Corporate bonds are generally higher risk bonds in comparison to municipal and government bonds. They also have a higher rate of return than municipal and government bonds. However you do have to pay taxes on the interest earned from corporate bonds. Municipal bonds are issued by more than 50,000 state and local governments and their agencies to fund projects such as schools, streets, highways, hospitals, bridges, and airports.
When a person is issued a bond they are basically promised to get their money back. Bondholders are paid before anyone else, even stockholders and creditors if the company runs into hard times or goes bankrupt. Bonds give you a stream of income based on their rate of return. Bonds are usually much less volatile then stocks are. Bonds also can provide a tax break because municipal and government bonds are sometimes exempt from state and federal taxes.
The main disadvantage to bonds is that they generally have lower returns than stocks and mutual funds. Bonds are like stocks because their prices are sensitive to interest rates as well. Bonds also carry with them some heavy terminology, which can be confusing and hard to understand.
Type of Bonds:
Government Bonds
The U.S. Department of Treasury and other federal agencies issue treasuries and federal agency bonds. Treasuries are basically risk free because the U.S. government backs them. They are issued to help finance all of the costs involved in operating the government. Municipal Bonds – State and local governments to help pay for schools, streets, highways, hospitals, bridges, airports, and other public works issue municipal bonds. You usually don’t have to pay federal taxes on the interest earned from municipal bonds.
Corporate Bonds
Corporate bonds are issued by businesses to help pay for business expenses. There are a ton of different corporate bonds available all with their own interest rates, maturities, and credit ratings. Corporate bonds are generally higher risk bonds in comparison to municipal and government bonds. They also have a higher rate of return than municipal and government bonds. However you do have to pay taxes on the interest earned from corporate bonds. Municipal bonds are issued by more than 50,000 state and local governments and their agencies to fund projects such as schools, streets, highways, hospitals, bridges, and airports.
Investing in u.s. savings bonds
Investing in U.S. savings bonds is a great way to add to your investment portfolio. They are a safe and solid way to make your money grow and work for you. The United States government’s faith and credit securely back them. If they ever become lost, stolen, or destroyed, they will be replaced.
What are the tax benefits of investing in U.S. savings bonds? There are fantastic tax benefits to be gained by investing in United States savings bonds. The interest earned is fully exempt from state and local income taxes. Federal tax payment isn’t required until the bonds mature or you decide to redeem them. If you decide to use your savings bonds to pay for college tuition and related expenses, you may be exempt from paying taxes on the interest you’ve earned. Because of this, United States savings bonds are a wonderful way to save for college.
So, how do United States savings bonds compare to other types of savings plans? They are actually very competitive. The interest earned accrues once a month and is semiannually compounded. Your money will grow year after year until your bonds reach maturity.
What if I need my money unexpectedly? If an emergency or other need arises and you need to cash out your savings bonds, you can do so after one year. . If you need to cash in your HH Savings Bonds or I Bonds before you have held them for 5 years, you will lose 3 months of interest. Keep in mind, the longer you hold on to them, the more interest your bonds will gain.
What denominations are savings bonds available in? Both I Bonds, and Series EE Bonds are available in $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000 denominations. This means, for only $25 you can start investing in U.S. savings bonds. You are limited to buying up to $15,000 in Series EE Bonds and $30,000 in I Bonds yearly.
Series I Savings Bonds are available at face value. For instance, you will pay $100 for a $100 Savings Bond. These are a great value because they always provide a rate of return above inflation.
Series EE Bonds are available for half their face value. For instance, you will pay $50 for a $100 savings bond. On five-year Treasury securities they gain 90% of market rates. They are a fantastic value for the money. Although they can only earn interest for up to 30 years, they can be exchanged for Series HH Savings Bonds that can be held tax-free for up to 20 additional years.
Where can I buy United States savings bonds? You can purchase U.S. savings bonds online from the United States Treasury, or you can buy them at credit unions, banks, and many other financial institutions. They are very easy and convenient to purchase. Some employers offer automatic savings bond purchases that are deducted from payroll checks. Ask your employer if this benefit is available to you.
In conclusion, millions of people are investing in United States savings bonds. They are an extraordinary way to save for occasions such as college, retirement, a new home, or any other future goal. U.S. savings bonds can definitely make the financial future brighter for you and your loved ones.
What are the tax benefits of investing in U.S. savings bonds? There are fantastic tax benefits to be gained by investing in United States savings bonds. The interest earned is fully exempt from state and local income taxes. Federal tax payment isn’t required until the bonds mature or you decide to redeem them. If you decide to use your savings bonds to pay for college tuition and related expenses, you may be exempt from paying taxes on the interest you’ve earned. Because of this, United States savings bonds are a wonderful way to save for college.
So, how do United States savings bonds compare to other types of savings plans? They are actually very competitive. The interest earned accrues once a month and is semiannually compounded. Your money will grow year after year until your bonds reach maturity.
What if I need my money unexpectedly? If an emergency or other need arises and you need to cash out your savings bonds, you can do so after one year. . If you need to cash in your HH Savings Bonds or I Bonds before you have held them for 5 years, you will lose 3 months of interest. Keep in mind, the longer you hold on to them, the more interest your bonds will gain.
What denominations are savings bonds available in? Both I Bonds, and Series EE Bonds are available in $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000 denominations. This means, for only $25 you can start investing in U.S. savings bonds. You are limited to buying up to $15,000 in Series EE Bonds and $30,000 in I Bonds yearly.
Series I Savings Bonds are available at face value. For instance, you will pay $100 for a $100 Savings Bond. These are a great value because they always provide a rate of return above inflation.
Series EE Bonds are available for half their face value. For instance, you will pay $50 for a $100 savings bond. On five-year Treasury securities they gain 90% of market rates. They are a fantastic value for the money. Although they can only earn interest for up to 30 years, they can be exchanged for Series HH Savings Bonds that can be held tax-free for up to 20 additional years.
Where can I buy United States savings bonds? You can purchase U.S. savings bonds online from the United States Treasury, or you can buy them at credit unions, banks, and many other financial institutions. They are very easy and convenient to purchase. Some employers offer automatic savings bond purchases that are deducted from payroll checks. Ask your employer if this benefit is available to you.
In conclusion, millions of people are investing in United States savings bonds. They are an extraordinary way to save for occasions such as college, retirement, a new home, or any other future goal. U.S. savings bonds can definitely make the financial future brighter for you and your loved ones.
short term bonds
Bonds don't get much press, especially compared with stocks, so they are often overlooked as an investment alternative. Yet they have some characteristics that make them a smarter buy than stocks in some situations.
The correct situation will usually be one where safety and predictability are primary concerns. Whereas, stocks have the reputation of being a high-yield investment vehicle, bonds, especially short term bonds, have a limited potential for profits. The shorter the term, the lesser the interest rate that is usually paid. So short term bonds (those with terms up to five or ten years) have the most disadvantage that must be outweighed by other considerations.
If you are investing for a specific objective--to fund your child's college education in five years, say, or to buy a new house when your lease expires--a stock investment could cause you to miss your goal in a number of different ways. If the economy looks rosy when you invest and then runs into problems, your stocks could under perform your expectations, or even end up losing you money. Despite the stock market's average rate of return of over 10% over the last 80 years, there have been several 10-year stretches when stocks have yielded a negative return, and many more negative 5-year stretches. So, even a well diversified portfolio of stocks carries this risk.
A less diversified portfolio carries the additional risk that the sectors that your stocks represent, or the stocks themselves, will under perform the stock market as a whole. This can drag down the return on your investment.
A third risk is the stock market's vulnerability to sudden fluctuations. Your investment could be performing well, but then just before you plan to sell a sudden shock causes your stocks to plummet. This could be a terrorist attack, an industry-wide accounting scandal, or an unexpected reading from one of the various barometers of economic health that causes a shift the consensus view of the economy's stability.
Lastly, a company whose stock you own might declare bankruptcy, in which case you stand to lose everything you invested in the company.
All these risks are reduced with short-term bonds in your investment portfolio. If you plan to hold the bonds until they mature, the first three risks have been eliminated entirely. You will be paid exactly what you expected. Your sole remaining risk is the possibility of the company or entity that issued the bonds declaring bankruptcy, and even in this eventuality your risk is lessened. Because bondholders are creditors, they have a place near the head of the line when any assets that remain are distributed. Those who had purchased stock in the company, meanwhile, are part owners up to the extent of their investments, and they are more likely to lose everything they invested.
Short term bonds are securities that can be traded like stocks. You need not hold the bond for its entire term. The bond's interest rate remains fixed throughout its entire term, but you'll most likely have to pay more than its face value for a bond that was issued when interest rates were higher, so its effective yield will be close to that of similar newly issued bonds. This sensitivity to interest rate changes can cause the total gains of your investment to be less than 100% predictable. To minimize this uncertainty, you should try to purchase a bond that matures fairly close to your target date for selling. The further away the maturity date - the greater the fluctuation in the bond's price. You also need to take into account that your broker will charge a commission when you sell. The fee is sometimes stated, and sometimes it's built into the price (both buy price and sell price). Bonds purchased directly from the government are free of commissions.
A change in your bond issuer's credit rating will also impact your bond's price. Again, the shorter the remaining term the lesser the impact.
A short term bond with a low credit rating will generally earn a greater return than one rated higher, but the risk is greater also. Moody's and Standard & Poors (S&P) provide the two most common ratings for bonds, and each uses slightly different symbols. Both have four tiers of ratings for "investment grade" bonds. These ratings run from an AAA rating (Aaa for Moody's) to a BBB rating (Baa for Moody's). They also utilize numbers, or plus and minus signs, to rank bonds within these main levels. Just below the lowest investment grade is the BB rating (Ba for Moody's), a category considered somewhat speculative. These ratings go down another five levels to the single C rating (D for S&P), which is the "I didn't need that money anyway" category. The issuer is in default.
The yields on the four investment grade levels of short term bonds are spaced closely together, but below that the variation widens considerably. One bond issue I checked which has a CCC rating (3 levels below investment grade) and matures in 6 years had a yield over 3 times that of investment grade bonds. It falls well within the "junk" bond category and might possibly be considered if you absolutely need a stellar yield to fund something and you have no particular need for the money otherwise.
If you want to keep open the possibility of realizing a large surprise gain, you might consider a "convertible" bond. These bonds usually pay a lower rate of interest, but the bearer has the right to convert the bond's value for the company's stock at a set price after a certain date. If the stock rises above that price, you can trade your bond for stocks, then sell the stocks and pocket the profits. In essence, this works like an call option on the stocks, so you might consider buying a regular bond instead and using the extra interest income to buy an option on the stocks.
Bond prices can be confusing for first-time buyers. They are usually listed somewhat like 113.739 or 97.114, no matter the face value of the bond. To determine what you'll actually pay, move the decimal point two places to the left and multiply it times the bond's face value. The price of a bond listed at 100.000 is equal to the face value.
Bonds fall into four main categories: corporate, government, agency, and municipal. Both the government and municipal bonds have tax advantages that a short term bond buyer might find attractive. Interest from U.S. treasury bills (matures in one year or less) and notes (matures in two to ten years) are exempt from state and local income taxes
. Interest from municipal bonds are exempt from federal income tax and may be exempt from state and local income taxes as well. Some states have reciprocity agreements with other states, so if you buy a municipal bond issued from outside your home state, that may also be exempt from your state's income tax. Both treasury and municipal bonds have relatively low yields, so they will be most suitable for you if you are in a high tax bracket. Both are considered very safe investments. Treasury bonds are backed by the full faith and credit of the U.S. government.
Agency bonds, issued by entities such as Fannie Mae, the Small Business Administration and the Tennessee Valley Authority, are sometimes thought to be backed by a government guarantee, but they are not. However, the government would most likely step in to support any of these agencies that ran into trouble. Because of this, they are considered safer than average, and their yields are low.
Corporate bonds require the most research when purchasing to see if the issuer is credit worthy and is likely to stay that way. The interest rates they pay is higher, as a whole, but the bonds are also vulnerable to nasty surprises. If predictability is essential, then you'll want to shy away from corporates.
The yields of short term bonds with the least risk are so low that you may want to consider a couple of alternatives. U.S. savings bonds share the safety and tax advantages of treasury bonds. Their interest rates are set at a percentage of treasuries', but the rates are only set twice a year (in May and November) so if there has recently been a steep decline in interest rates they may actually pay more. They can be purchased at most banks or over the internet commission free.
Certificates of Deposits from an FDIC insured bank also have the safety advantage of short term treasuries, but they lack the tax advantage. However, your bank or an online bank may offer higher interest rates that may outweigh this. You don't have to worry about paying commissions to purchase a CD, but there are penalties for early withdrawals which vary from bank to bank. They have the advantage of being available in any denomination whereas treasuries can only be purchased in multiples of at least $1,000. If the issuing bank goes into default, your money is insured, but your money could be tied up until a settlement is made.
When purchasing a short term bond, there are several features you should check because they affect the safety and predictability of your investment.
You should know whether the bond is secured or unsecured. Unsecured bonds are called debentures. Secured bonds are backed by some sort of collateral, which can give you an extra measure of safety.
You should know whether the bond is callable. If it is, that means the issuing company can pay you off before the bond's maturity date. This can affect the predictability of your investment because a company is more likely to call your bond back after interest rates have declined, in which case you would have to reinvest your money at a lower rate of return.
You should know whether the bond is a zero coupon bond (or "strips" for treasury bonds). If it is, that means that the face value of the bond includes all the interest that will be paid until it matures. Like a savings bond, the original purchase price has been set at a discount to its face value. A normal bond, by contrast, is originally sold at face value. Its coupons represent interest payments and can be detached and cashed in after each coupon's due date.
If you are undecided whether to opt for the safety of short term bonds or the higher return of riskier investments, you'll want to consider mixing the two. A 50-50 split would cut your losses from a 50% decline in your stock portfolio to less than 25% of your investment capital. Of course, you'll need to be content with a gain of a little more than 50% if your stock portfolio doubles. You can adjust the mix to best suit your investment objectives, but try to keep your risk from jeopardizing an essential objective. Even in the case of a 90% sure thing, it's better to be among the 90% who lost extra earnings than among the 10% whose objective became impossible to realize.
The correct situation will usually be one where safety and predictability are primary concerns. Whereas, stocks have the reputation of being a high-yield investment vehicle, bonds, especially short term bonds, have a limited potential for profits. The shorter the term, the lesser the interest rate that is usually paid. So short term bonds (those with terms up to five or ten years) have the most disadvantage that must be outweighed by other considerations.
If you are investing for a specific objective--to fund your child's college education in five years, say, or to buy a new house when your lease expires--a stock investment could cause you to miss your goal in a number of different ways. If the economy looks rosy when you invest and then runs into problems, your stocks could under perform your expectations, or even end up losing you money. Despite the stock market's average rate of return of over 10% over the last 80 years, there have been several 10-year stretches when stocks have yielded a negative return, and many more negative 5-year stretches. So, even a well diversified portfolio of stocks carries this risk.
A less diversified portfolio carries the additional risk that the sectors that your stocks represent, or the stocks themselves, will under perform the stock market as a whole. This can drag down the return on your investment.
A third risk is the stock market's vulnerability to sudden fluctuations. Your investment could be performing well, but then just before you plan to sell a sudden shock causes your stocks to plummet. This could be a terrorist attack, an industry-wide accounting scandal, or an unexpected reading from one of the various barometers of economic health that causes a shift the consensus view of the economy's stability.
Lastly, a company whose stock you own might declare bankruptcy, in which case you stand to lose everything you invested in the company.
All these risks are reduced with short-term bonds in your investment portfolio. If you plan to hold the bonds until they mature, the first three risks have been eliminated entirely. You will be paid exactly what you expected. Your sole remaining risk is the possibility of the company or entity that issued the bonds declaring bankruptcy, and even in this eventuality your risk is lessened. Because bondholders are creditors, they have a place near the head of the line when any assets that remain are distributed. Those who had purchased stock in the company, meanwhile, are part owners up to the extent of their investments, and they are more likely to lose everything they invested.
Short term bonds are securities that can be traded like stocks. You need not hold the bond for its entire term. The bond's interest rate remains fixed throughout its entire term, but you'll most likely have to pay more than its face value for a bond that was issued when interest rates were higher, so its effective yield will be close to that of similar newly issued bonds. This sensitivity to interest rate changes can cause the total gains of your investment to be less than 100% predictable. To minimize this uncertainty, you should try to purchase a bond that matures fairly close to your target date for selling. The further away the maturity date - the greater the fluctuation in the bond's price. You also need to take into account that your broker will charge a commission when you sell. The fee is sometimes stated, and sometimes it's built into the price (both buy price and sell price). Bonds purchased directly from the government are free of commissions.
A change in your bond issuer's credit rating will also impact your bond's price. Again, the shorter the remaining term the lesser the impact.
A short term bond with a low credit rating will generally earn a greater return than one rated higher, but the risk is greater also. Moody's and Standard & Poors (S&P) provide the two most common ratings for bonds, and each uses slightly different symbols. Both have four tiers of ratings for "investment grade" bonds. These ratings run from an AAA rating (Aaa for Moody's) to a BBB rating (Baa for Moody's). They also utilize numbers, or plus and minus signs, to rank bonds within these main levels. Just below the lowest investment grade is the BB rating (Ba for Moody's), a category considered somewhat speculative. These ratings go down another five levels to the single C rating (D for S&P), which is the "I didn't need that money anyway" category. The issuer is in default.
The yields on the four investment grade levels of short term bonds are spaced closely together, but below that the variation widens considerably. One bond issue I checked which has a CCC rating (3 levels below investment grade) and matures in 6 years had a yield over 3 times that of investment grade bonds. It falls well within the "junk" bond category and might possibly be considered if you absolutely need a stellar yield to fund something and you have no particular need for the money otherwise.
If you want to keep open the possibility of realizing a large surprise gain, you might consider a "convertible" bond. These bonds usually pay a lower rate of interest, but the bearer has the right to convert the bond's value for the company's stock at a set price after a certain date. If the stock rises above that price, you can trade your bond for stocks, then sell the stocks and pocket the profits. In essence, this works like an call option on the stocks, so you might consider buying a regular bond instead and using the extra interest income to buy an option on the stocks.
Bond prices can be confusing for first-time buyers. They are usually listed somewhat like 113.739 or 97.114, no matter the face value of the bond. To determine what you'll actually pay, move the decimal point two places to the left and multiply it times the bond's face value. The price of a bond listed at 100.000 is equal to the face value.
Bonds fall into four main categories: corporate, government, agency, and municipal. Both the government and municipal bonds have tax advantages that a short term bond buyer might find attractive. Interest from U.S. treasury bills (matures in one year or less) and notes (matures in two to ten years) are exempt from state and local income taxes
. Interest from municipal bonds are exempt from federal income tax and may be exempt from state and local income taxes as well. Some states have reciprocity agreements with other states, so if you buy a municipal bond issued from outside your home state, that may also be exempt from your state's income tax. Both treasury and municipal bonds have relatively low yields, so they will be most suitable for you if you are in a high tax bracket. Both are considered very safe investments. Treasury bonds are backed by the full faith and credit of the U.S. government.
Agency bonds, issued by entities such as Fannie Mae, the Small Business Administration and the Tennessee Valley Authority, are sometimes thought to be backed by a government guarantee, but they are not. However, the government would most likely step in to support any of these agencies that ran into trouble. Because of this, they are considered safer than average, and their yields are low.
Corporate bonds require the most research when purchasing to see if the issuer is credit worthy and is likely to stay that way. The interest rates they pay is higher, as a whole, but the bonds are also vulnerable to nasty surprises. If predictability is essential, then you'll want to shy away from corporates.
The yields of short term bonds with the least risk are so low that you may want to consider a couple of alternatives. U.S. savings bonds share the safety and tax advantages of treasury bonds. Their interest rates are set at a percentage of treasuries', but the rates are only set twice a year (in May and November) so if there has recently been a steep decline in interest rates they may actually pay more. They can be purchased at most banks or over the internet commission free.
Certificates of Deposits from an FDIC insured bank also have the safety advantage of short term treasuries, but they lack the tax advantage. However, your bank or an online bank may offer higher interest rates that may outweigh this. You don't have to worry about paying commissions to purchase a CD, but there are penalties for early withdrawals which vary from bank to bank. They have the advantage of being available in any denomination whereas treasuries can only be purchased in multiples of at least $1,000. If the issuing bank goes into default, your money is insured, but your money could be tied up until a settlement is made.
When purchasing a short term bond, there are several features you should check because they affect the safety and predictability of your investment.
You should know whether the bond is secured or unsecured. Unsecured bonds are called debentures. Secured bonds are backed by some sort of collateral, which can give you an extra measure of safety.
You should know whether the bond is callable. If it is, that means the issuing company can pay you off before the bond's maturity date. This can affect the predictability of your investment because a company is more likely to call your bond back after interest rates have declined, in which case you would have to reinvest your money at a lower rate of return.
You should know whether the bond is a zero coupon bond (or "strips" for treasury bonds). If it is, that means that the face value of the bond includes all the interest that will be paid until it matures. Like a savings bond, the original purchase price has been set at a discount to its face value. A normal bond, by contrast, is originally sold at face value. Its coupons represent interest payments and can be detached and cashed in after each coupon's due date.
If you are undecided whether to opt for the safety of short term bonds or the higher return of riskier investments, you'll want to consider mixing the two. A 50-50 split would cut your losses from a 50% decline in your stock portfolio to less than 25% of your investment capital. Of course, you'll need to be content with a gain of a little more than 50% if your stock portfolio doubles. You can adjust the mix to best suit your investment objectives, but try to keep your risk from jeopardizing an essential objective. Even in the case of a 90% sure thing, it's better to be among the 90% who lost extra earnings than among the 10% whose objective became impossible to realize.
Pakistani bonds best for investment during current year
Pakistan, wracked by a war with Taliban insurgents and a record current-account deficit, is this year’s best bond investment, according to JPMorgan Chase & Co. indexes. Money managers say the stock market, the region’s cheapest, may be next.
Dollar-denominated debt sold by Pakistan returned 86.4 percent so far this year, more than any of the 45 emerging markets tracked by New York-based JPMorgan and 19 developed countries followed by Merrill Lynch & Co. Shares in the Karachi Stock Exchange 100 Index trade at 9.6 times reported earnings, the lowest in Asia excluding Japan, after the gauge rose 21 percent in 2009.
Pakistan’s economy deteriorated in the past year as terrorist attacks led investors to sell a net $1.1 billion of stocks in the 11 months ended May 31, compared with purchases of $87.2 million of shares a year earlier, according to the central bank. Government forecasts for 3.3 percent economic growth in the year starting July 1, a bailout by the International Monetary Fund and equities trading near the cheapest levels in at least four years are making the country more attractive.
Dollar-denominated debt sold by Pakistan returned 86.4 percent so far this year, more than any of the 45 emerging markets tracked by New York-based JPMorgan and 19 developed countries followed by Merrill Lynch & Co. Shares in the Karachi Stock Exchange 100 Index trade at 9.6 times reported earnings, the lowest in Asia excluding Japan, after the gauge rose 21 percent in 2009.
Pakistan’s economy deteriorated in the past year as terrorist attacks led investors to sell a net $1.1 billion of stocks in the 11 months ended May 31, compared with purchases of $87.2 million of shares a year earlier, according to the central bank. Government forecasts for 3.3 percent economic growth in the year starting July 1, a bailout by the International Monetary Fund and equities trading near the cheapest levels in at least four years are making the country more attractive.
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