Investing In Bonds: 10 Things You Should Know

nvestors today clamor for bonds. As shown by mutual fund net new cash flow figures, investors have increased their bond purchases by 69% in 2002 compared to 2001 while, at the same time, reducing their investments in equities by 102% (data provided by the Investment Company Institute).

Investing in bonds is not easy (even through mutual funds). This article explores ten things you should know when deciding what individual bonds to buy and how to structure your bond portfolio.

First, consider the plethora of investment choices. As a bond investor, you can choose among U.S. government bonds, agency bonds, corporate bonds and municipal bonds. Each type of bond has different risk and return characteristics.

Second, diversify. Just as with stocks, don't put all of your eggs in one basket to reduce exposure to volatility and underperformance. Invest in several bonds. Moreover, do not limit your bond portfolio to bonds of companies located in a single state or region. Nor should you limit your municipal bonds to those of a single municipality. And avoid buying bonds in the same or similar industry sectors.

Third, do not over-insure. Some bonds carry insurance against the risk that they will default. Insurance may be suitable, but not for your entire bond portfolio. Bernstein Investment Research and Management ("Bernstein"), for example, generally recommends that insured bonds comprise less than 40% of a bond portfolio. Even then, you should attempt to structure your bond portfolio so that your bonds do not happen to be insured by the same insurance carrier.

Fourth, own large bond lot sizes. An ideal bond portfolio needs to be diversified, but within reason. Bernstein provides an example of an investor with a $12 million portfolio invested in 120 bonds with lots sizes of approximately $100,000 each. That number of bonds is too many because trading costs of these "retail" purchases will reduce the returns of the bond portfolio.

Fifth, consider duration. Duration is defined as the time it takes to collect a bond's interest and principal repayment, in essence, the term of the bond. Duration answers an important question for most bond investors, "If interest rates rise, what happens to the current market value of my bonds?" The answer is that for every 1% rise in interest rates, the current value of a five-year duration bond will fall 5%. Likewise, a ten-year duration bond will fall 10% in current value with a 1% rise in interest rates. On the other hand, if interest rates fall by 1%, the ten-year duration bond will increase in current value by 10%. Of course, the duration of a bond never affects the face value of the bond, which you will receive if you hold the bond until maturity.

Sixth, determine whether the "yield curve" is normal from a historical standpoint. The yield curve is a graphic representation of the actual or projected yields of bonds in relation to their maturities. Normally, the yield curve shows long term bonds having higher yields than short-term bonds. But that is not always the case, as yield curves may be "flat" or "inverted". A flat yield curve shows that the yields of short-term bonds are the same as the yields of long-term bonds. An inverted yield curve reflects a situation where short-term bonds have higher yields than long term bonds. The analysis can be complicated, but you need to consider the yield curve in buying bonds and structuring your bond portfolio. For example, in a low-interest-rate environment, an investor may be well advised not to invest in a great deal of intermediate (4 to 7 year) duration bonds, employing a "Barbell Strategy" instead that focuses on both short-term and long-term bonds.

Seventh, compare taxable to tax-free bonds. Tax-free bonds may or may not be better than taxable bonds. There are numerous factors to consider, and you should seek professional guidance regarding such important areas as the Alternative Minimum Tax (AMT).

Eighth, assess whether you should buy and hold to maturity. That strategy certainly is employed. Alternatively, consider a "laddered portfolio", in which you stagger your bond maturities such that, each year, one bond matures. A third alternative is active management, whereby you monitor your bond portfolio and sell a bond(s) when you believe it is the right time to do so without regard to its maturity.

Ninth, know the investment grade of corporate and municipal bonds. Bonds are either investment grade or non-investment grade. Generally, the higher the grade, the lower the yield as investors are willing to pay a premium for the perceived safety of the high-grade bond. Standard & Poor's and Moody's are the two best-known bond-rating services.

Tenth, understand the two categories of municipal bonds. Not all municipal bonds are created equal. There are General Obligation bonds, which are backed by the full faith, credit and taxing powers of the municipality. From a safety standpoint, these are preferred to Revenue bonds. The interest and principal payments from revenue bonds are not backed by the municipality's full faith and credit, and come only from the specific earnings of the project or operation.

In conclusion, you should know that investing in bonds requires as much careful analysis as investing in stocks - perhaps even more so.

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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat & Filipowski and can be reached at 312-621-4400.