Bond Basics and the Fed
Baby boomers nearing retirement should invest in bonds to safeguard their assets and reduce their risks in the stock market. However, many fear with interest rates at a low level, bonds will decline in value with the Federal Reserve projecting a rate hike in the near future.
Freddie Offenberg, partner and portfolio manager with Andres Capital Management discussed with me for FOXBusiness.com the basics of bonds and why they should be included in your retirement portfolio.
Boomer: What is a bond and what types of bonds are available?
Offenberg: Simply put, a bond is a financial instrument, or debt investment in which an investor loans money to an entity (usually government, municipal or corporate). The funds are generally borrowed for a defined period of time at a fixed rate of interest. They can be purchased by individuals and institutional investors, and the proceeds are used to finance a variety of projects and activities of the issuing entity. All bonds are considered to be fixed-income securities.
Boomer: What is a bonds credit risk and are they insured?
Offenberg: Regardless of their entity, all bonds have two major risk components. Interest rate risk, which impacts the current value of a given bond issue based on any upward movement in prevailing benchmark interest rate levels (e.g. the federal funds rate, the yield on the 10-year U.S. Treasury note etc.). This in turn can reduce the comparative price and principal value. The second kind of risk is credit risk, which is usually identified by credit ratings assigned by large credit rating companies such as Moody’s (NYSE:MCO) or Standard and Poor’s. The ratings serve as a way of categorizing and quantifying varying degrees of creditworthiness when comparing the current financial condition of any bond issuer. Credit risk is generally reflected by the amount of yield differential perceived as adequate enough to compensate the investor for the increased risk of owning a lower rated bond.
Some bonds pay bond insurance companies for insurance, which offers the investor increased assurance as to payment of principal and interest. This is not an ironclad guarantee, as only a handful of insurance companies play in this space. While this results in a higher credit rating, the underlying credit of the insurer comes into play.
Boomer: What determines the price of a bond?
Offenberg: Many factors determine a bond’s current price. The primary considerations are coupon (the fixed rate of interest at time of issue), maturity date and credit rating. These factors combine to establish a general yield range that a bond trader is willing to pay to buy/position the bonds. Another factor that comes into play is principal amount. Odd-lots—usually anything under one million dollars face value—are generally subject to greater mark-up or mark-down (in the case of selling), than round or institutional lots. Additionally, supply and demand for a particular bond and the size of the client can affect the bid or offer price. Most bond levels are expressed in yield (e.g. 3.65 yield to maturity), and in the spread in interest rates over a U.S. Treasury bond having a similar maturity. The resulting yield or rate is then calculated and expressed as a dollar price.
Boomer: What are the tax advantages in purchasing bonds?
Offenberg: Interest on all but municipal bonds is federally taxable at an individual’s income tax rate. Municipal bonds, or “tax-exempts,” are exempt from federal tax and usually exempt from state and local taxes if issued in one’s state of residence. Certain U.S. Agency bonds such as the Federal Farm Credit Bank (FFCB) or the Federal Home Loan Bank (FHLB) are tax advantaged and exempt from state income tax. Of course, for any bond held in a 401(k) or an IRA, interest is not taxed.
Boomer: How is my financial advisor compensated on my purchase of bonds?
Offenberg: Financial advisors are generally compensated in one of two ways. A fee-based schedule, where the advisor or RIA (Registered Investment Advisor) charges the client a percentage of value of assets under management on an annual basis. The other method is a commission-based model where the broker is paid a commission based on the mark-up or amount of spread built into the trade. For stocks, the commission is added to the transaction price.
Boomer: How can baby boomers utilize bonds to further ensure their financial security entering retirement?
Offenberg: As masses of baby boomers enter their retirement years and begin living on a strict fixed income, they can’t neglect the role of bonds in their portfolios. Bonds can offer steady income streams, less volatility and less principal risk, when compared to the stock market, while also addressing the need for balance and low correlation to the higher risk components of a portfolio.
Even in an environment of lower interest rates, bonds can provide significant total returns and in the current period of negligible inflation, real inflation adjusted returns are historically favorable versus nominal rate levels.
In my recent article in the Andres Review co-authored with Bob Andres titled “Asset Allocation for Baby Boomers,” we offer additional financial and lifestyle motivation for baby boomers to use bonds as a way of building wealth.