Fixed Income: Purchasing Bonds & Bond Investment Strategy
Updated: Mar 3, 2020
Now that you’ve learned the basics of fixed income, we’re back with our second installment of fixed income education. Let’s build your bond knowledge base! Today’s post will provide more understanding of the different types of fixed income investment vehicles and bond investment strategies, as well as an update of current bond market conditions.
Ways to Purchase Bonds
Bond Funds – Bond funds are pooled investments made up of bonds or other debt instruments. Bond funds are differentiated by the type (or types) of bonds they invest in. The types of bonds can include government bonds, mortgage backed securities, US Treasuries, corporate bonds, high yield bonds, municipal bonds, and international bonds. Bond funds can also be diversified and invested in several of the above-mentioned bond types. The benefits that a bond fund can provide to a portfolio include:
Addition to portfolio diversification and potentially managing volatility in non-favorable market conditions. Bonds funds are typically less volatile than equities and their performance can display negative correlation to stocks.
Bond funds typically pay monthly interest.
However, bond funds may experience a decrease in principal when interest rates are rising and may lose value in an inflationary environment.
Individual Bonds - This involves purchasing an individual security directly from the issuer or in the secondary market, requiring them to pay a fixed amount of interest over a specified period of time. At maturity the issuer is required to pay the principal back to the bond investor. Types of issuers include the US or foreign Government, a specific state or municipality, or a specific company. The benefits of purchasing bonds are as follows:d
They generate income. Because individual bonds offer fixed interest payment amounts on specific dates, they can be utilized to create a predetermined (ie monthly, quarterly) income stream for individuals who have a goal of creating portfolio income.
Implementing a well-constructed individual bond strategy can potentially reduce portfolio volatility and protect against downside risk.
Preservation of Capital: Unlike bond funds where your principal may fluctuate in value, investors receive their principal back at maturity with individual bonds (unless that bond defaults).
Bond Investment Strategies
Ladder – This strategy involves staggering the maturities of your bonds, so as bonds mature they can be reinvested. As an example, consider a 1 – 5 year bond ladder using 5 bonds. This would involve purchasing a bond with a maturity starting 1 year from now, then a bond with maturities of 2, 3, 4, and 5 years. Once the first bond matures after one year, the proceeds could either be harvested by the investor or reinvested in a 5 year bond. This highlights the two primary benefits of the strategy, which are ongoing liquidity as bonds mature and/or being able to invest bond proceeds at potentially higher rates as interest rates increase. Therefore, a ladder is a very suitable strategy if one is anticipating a rising interest rate environment in the short-term.
Barbell - With a barbell strategy, one would invest some of their fixed income in short-term and some in intermediate-term bonds. The short-term bonds provide liquidity to invest in higher rate bonds should rates increase and the flexibility to invest in other asset classes should rates continue to decline. With the intermediate-term bonds, higher rates are locked in and one would continue to earn a consistent level of income regardless of what happens to rates. This strategy is suitable for an environment where rates may decline in the short-term before moving into a long-term rising rate trend.
Tax Mitigation Strategies - The interest paid by municipal bonds is exempt from federal income taxes and may be exempt from state income tax, which is why municipal bonds are sometimes referred to as tax free. This makes them an attractive investment option for individuals who are in the higher federal and state income tax brackets
Current Bond Market Conditions
As we embark into the second half of 2019, many investors are wondering if the economy is just slowing down or if it is actually headed into a recession. Some of the economic data we have seen as of late shows that growth in the economy is starting to decelerate:
While the unemployment rate is still close to record low levels, there are signs that job growth has started to slow.
Manufacturing numbers have weakened a bit but are not yet signaling contraction.
Consumer spending continues to increase although at a slower pace.
This data reads as more indicative of a slow down than actual recession. However, there are still questions about how trade wars will play out and affect the economy. These are some of the same factors that the Fed will watch as it makes the decision if and when to implement a rate cut. If economic growth is slowing, the Fed may wait to assess its magnitude prior to cutting rates. However, if the Fed’s evaluation determines that there is a greater likelihood of further slowdown and recession, they could take action as early as this month to cut rates. Regardless of what the Fed decision is, the expectation is that we will potentially be in a low interest rate environment for the foreseeable future. Because no one is certain how long these low rate conditions may last, both of the above mentioned strategies make sense due to the fact that each of them will help maximize and lock in an income stream and they both offer flexibility to be able to adjust your fixed income or overall portfolio strategy regardless of what interest rates do.
Contact the Peninsula Wealth Team for a free consultation to begin building a financial and investment plan customized to your goals.