PICKING THE RIGHT BOND
An investment portfolio is not complete without bonds. If you are in (or close to) the asset drawdown or want to preserve your capital, bonds can provide a stable, relatively safe income.
If your investment income pays for your bills and daily expenses, venture in bonds. A well-done bond portfolio can be designed to meet an investor’s financial needs. Income may be generated from coupon payments, or by combining coupon payments and the return of principal at a bond’s maturity. Any unused cash flow is reinvested in another bond. That way, income requirements are reached, while the maximum amount of capital is retained. Bonds are less volatile and less risky, and can give predictable source of income.
There are different kinds of bonds with corresponding maturities, including corporate bonds, emerging market bonds, foreign bonds, mortgage bonds, municipal bonds, and US Treasury bonds.
It is a debt security offered by a company. Considered riskier than government bonds, such bonds must be assessed according to the firm’s business prospects and cash flow. Remember, prospects and earnings are two different things. Credit rating agencies like Moody’s & Standard & Poor’s rate corporate bonds to help investors evaluate the issuer’s capacity to pay interest and principal. To gauge the relative value of corporate bonds with respect to US Treasuries, it is important to look at the yield. And when comparing two or more corporate bonds based on yield, take note of the maturity.
High-Yield Bonds, Muni Bonds, or Other Bonds
Other kinds of bonds may be incorporated in a well-diversified, income-generating portfolio. To grasp their risks, investors should perceive the yield of these bonds in relation to US Treasuries and other comparable bonds having the same type and maturity. Unlike stocks, bonds’ yields are not consistent from sector to sector. Traders can employ yield comparisons between bonds and sectors to analyze their value, provided you know where the disparity in yields come from. Also, one should also comprehend the correlation between the bond’s maturity and its yield.
Although similar to corporate bonds, mortgage bonds carry certain credit risk. Aside from trading at a yield spread to US Treasuries, such bonds have prepayment and extension risk. Hence, they have an embedded call option that borrowers can exercise at any time. The valuation of this call option hugely impacts mortgage-based securities’ yields. Investors comparing the relative value between mortgage bonds and/or other types of bonds must fully understand this concept. There are three general types of bonds: Ginnie Mae bonds, agency mortgage bonds, and private label bonds.
US Treasury Bonds
Known as one of the safest investments worldwide, US Treasury Bonds are considered to be risk-free and commonly used as a benchmark for other bond prices or yields. Looking at its yield is the best way to understanding any bond’s price. Most bonds’ yields are quoted as a yield spread to a comparable US Treasury bond. These bonds can be used to structure a portfolio with coupon payments and maturities in order to match your income needs. It will work if you are willing to relinquish some yield in return for a risk-free portfolio. The key here is to reduce the investment risk by matching the coupon payments and maturities to your income needs the closest possible.
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