BOND PORTFOLIOS 101
Bond portfolios are one of the least popular investments. Although it has a vital role in overall asset allocation, many traders, especially the novice ones, do not notice what bonds can do to their portfolio. Also, they consider it as an afterthought or let it generate income for years. But, if properly constructed, bond portfolios can provide income, total return, diversify other assets, and become as risky or safe as designed.
Let us discuss the fundamentals of a bond portfolio. Bonds are primarily designed to give income to the holder in exchange for lending the money to the issuer. Coupon payments from the issuer passes through the issuer, the transfer agent, the bank, and the bondholder. Issuers include governments, municipalities, private placements, and publicly-held companies.
In earlier parts of the last century, holders were given a coupon book aside from the bond. Held in their name, they could go to a bank and present the coupon of payment or deposit. But this process has changed ever since. Bonds are now held in the street name, which does not only make buying and selling bonds easier, but also receiving coupons as income. It also makes holding and transferring of bonds easier and safer. Bond income is taxed in general whether filed as an individual or company.
Bonds may be used as collateral for loans such as margin loans used to purchase other bonds, stocks, and funds. Because of its versatility, bonds are considered an excellent liquid vehicles for reaching investment goals and objectives.
Bond income is taxed whether filed as an individual or company. This can be taxed at the federal level, or exempt from the federal tax. Besides, bonds may be levied on various state and local levels up to and including intangible tax. This type of tax has been heavily debated like estate tax that will most likely go to the wayside in the future.
There are various reasons why both individual and institutional investors integrate bonds in their balanced portfolio. First, the coupon income is only one segment of the bond’s total return. Also, the low correlation of bonds as an asset class with the equity asset offers some stability through diversification.
The total return in a bond portfolio refers to the total change in the value, including income and capital and appreciation/depreciation over a given time interval. Interest rates affect the market value fluctuations and risk characteristics, as gauged by the yield curve. The source of the return is not only the existing rate on a static yield curve, but the interest rate changes over the horizon or time period.
Due to its low correlation to other kinds of assets, bonds can help diversify a portfolio. A bond portfolio stands out in times of equity markets decline. While it differs over several time periods, bonds are not highly correlated with other assets. Bonds can reduce volatility even in the simplest form of a diversified portfolio because of its cross-correlation with the stock portfolio.
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