If you take a look at any successful portfolio, you will see a mix of stocks and bonds. While perhaps not as sexy as their equity counterparts, the value and importance of bonds is often overlooked by the rags to riches or in many cases, the riches back to rags story of stocks.
In a nutshell, bond investing involves lending money to a corporation, for a fixed term, and getting a fixed rate of return. This return on your investment is called the coupon rate. The key is in knowing how much of your portfolio should be invested in bonds and how much should be invested in the stock market.
Each bond is rated by their risks, and the reward is provided accordingly. Too bad stocks arent rated the same way! This provides a unique advantage over stocks. Also, bonds have a fixed term (2 years, 5 years and 10 years are common terms), at which time, you will get your initial investment back. Another great advantage of investing in bonds is that you will be paid a steady income equal to the return rate. For example, if you were to invest $100 000 in a bond that has a coupon rate of 4% each year, you will receive $4 000 worth of interest payments. During the duration of the term, you get a steady income and you get back your initial investment at the end of it.
Sounds simple, right? Here's where it gets a bit more complicated, but, more profitable. The key is in establishing what is the best strategy when it comes to investing in bonds. The answer of course, is it depends! What types of bonds are you looking at buying? Short term (which are less than 5 years in length of term) usually have a low coupon rate, however, your investment isn't tied up for a longer duration.
This may prove helpful if there is a chance that you may need access to your funds in the case of an emergency, as odds are, you will have a bond maturing around the time you'll need it most. Medium bonds can tie up your money for 5-10 years, while long term bonds can enjoy a term of 10-30 years.
The coupon rate will also vary depending on the credit worthiness. A lower credit rating often means a higher coupon rate (to match the higher risk involved), while a high credit rating is rewarded with a lower coupon rate (and less volatility and risk).
While the coupon rate is the most understand concept in bond investing, its not necessarily where all the money is made. Remember, people buy and sell bonds well before their maturity date. As such, when the interest rate moves lower, the price of an existing bond moves higher, thanks to its higher rate of return than a newer bond would provide. On the flip side, if interest rates move higher, the bond price moves lower, simply because new bonds will now provide a higher rate of return than your existing ones. If you make the call on the direction of interest rates correctly, you'll find yourself in the money by a few percentage points. That can make a huge difference in your portfolio.
Finally, there's the yield of the bond, which is a bit more involved, but simple to calculate. The yield rate is the ratio of the annual return of the coupon rate divided by the current purchase price of the bond. For example, that $100 000 bond with an annual payout of $3 500 has a yield of 3.5% if it's bought at $100 000. If it were purchased at $90 000 (due to an increase in interest rates), it would still return $3 500 per year, and would have a yield of $3 500/$90 000 = 3.8%. Just like the purchase price varies inversely with the interest rate, so does the yield.
By: Christopher Smith
ABOUT THE AUTHOR
Want to improve your stock market returns? Get tips on penny stocks, investing in bonds and what the buzz about the mutual fund store at 1source4stocks: http://www.1source4stocks.com/bonds/index.asp
Wednesday, December 26, 2018
Monday, November 19, 2018
Are Inflation-Indexed Bonds Right For You?
Inflation-indexed bonds offer inflation protection. These bonds are exempt from state and local taxes, but federal taxes apply. Semi annual interest payments are based on the interest rate applied to the inflation-indexed value of the principal. Inflation-protected bonds make the most sense in periods of high inflation.
Government bonds are the most popular type of bond that many investors and savers use because they carry the full faith and credit of the U.S. government. Being relatively safe, the are appropriate for investors that can't tolerate much risk and are seeking to preserve their principal. The problem is that they generally pay low returns relative to other investments and face significant inflation risks. Therefore, investors who predominantly use bonds in their portfolios as part of a retirement planning strategy or funding a child's education may be hurting themselves due to the detrimental affects of inflation.
In order to remedy this situation and still keep U.S. government bonds attractive to investors, the U.S. Treasury issued inflation-protected bonds with a return that is indexed to the inflation rate. There are three maturities for these types of bonds issued at 5, 10, and 20 years. These issues are avaiable for purchase in $1,000 increments through financial advisors, banks, and TreasuryDirect (http://www.treasurydirect.gov/).
Features of Inflation-Indexed Bonds :
•They are guaranteed a rate of return that is above the inflation rate.
•They protect the investor's principal from inflation by indexing the principal to the Consumer Price Index (CPI).
•They protect interest from inflation by providing the investor with semiannual interest payments based on the semiannual interest rate applied to the new inflation-indexed principal value.
•They guarantee a return of principal even if inflation drops. The Time to Buy is During Periods of High Inflation
Inflation-protected bonds are a good decision when an investor's outlook of inflation is that inflation will be going up in the coming years. For example, if you purchase a $1,000 bond and the Consumer Price Index rose by 3%, the value of your initial princiap will also increase by 3% to $1,030. Assuming the coupon rate on the bond was 3%, you will receive interest payments based on the new principal amount. If the following year the CPI rises to 4%, the principal will be adjusted from $1,030 to $1,071.20, and your interest payment would increase from 3% to 4%, paid twice a year.
How does this structure compare to the ordinary type bond - one that is not inflation protected? Well, assuming the inflation rate is 3% and the yield of the unprotected $1,000 10-year Treasury note is 6.3%, the real yield of this security would be the 3.3% which is derived by subtracting the inflation rate from the security's note. After a year, that note would be valued at $1,063, but you would lose $30 of that gain because of the erosive nature of inflation, leaving you with a bond that is worth $1,030. Hence, it makes sense to purchase inflation-indexed securities if you believe that inflation will pick up.
Inflation-Protected Securities Benefits and Drawbacks Benefits
•Guaranteed to outpace the inflation rate.
•Guarantee a return of principal. Drawbacks
•Some expenses may grow at rates greater than the inflation rate.
•Could generate poor results when there is deflation.
•Subject to federal taxes, which may not justify the lower interest rates.
Be careful when purchasing inflation-protected bonds for expenses such as college education, because that strategy is impractical. College tuition costs outpace the rate of inflation. For the 2008-2009 academic year, college costs including tuition, fees and room and board increased at an average of 5.8% which was substantially more then the increase in the Consumer Price Index (CPI).
Even though it is a fact that these inflation-indexed bonds are exempt from state and local taxes, federal income taxes still apply. It is also important to understand that you will have to be pay taxes on any increases in principal on a yearly basis; however, the increase in principal will be paid to you only once the bond matures. Hence, if you find that your bonds do not pay enough interest income to cover the tax bill on the increase in principal in any given year, they may not be appropriate investments for you unless you invest in these bonds through a tax-deferred account such as a retirement account.
Inflation indexing is especially appealing to investors that are in or near retirement. After all, during periods of inflation, inflation protection can make the difference to protect the retiree's principal.
Things to take away
•Inflation-indexed bonds offer inflation protection.
•Semi annual interest payments are based on the interest rate applied to the inflation-indexed value of the principal.
•These bonds are exempt from state and local taxes, but federal taxes apply.
•Investors must pay taxes on the increases in the value of the bond's principal in any given year, while the increase in principal will be paid to the investor only when the bond matures.
•It may be sensible to invest in inflation-indexed bonds in a tax-deferred retirement account. •Inflation-protected bonds make the most sense in periods of high inflation.
ABOUT THE AUTHOR
Isakov Planning Group financial advisors bring industry leading resources and expertise to help clients pursue and achieve their goals. Along with expert market analysis from the firm's top investment managers, your Isakov Planning Group financial advisor will work with you to develop and deliver tailored solutions that can help you get on track and ultimately achieve your most important objectives, whether you're looking to plan for retirement, build tax-free wealth, get your kid's through college, or build a lasting legacy for your family. http://www.isakovgroup.com/
Government bonds are the most popular type of bond that many investors and savers use because they carry the full faith and credit of the U.S. government. Being relatively safe, the are appropriate for investors that can't tolerate much risk and are seeking to preserve their principal. The problem is that they generally pay low returns relative to other investments and face significant inflation risks. Therefore, investors who predominantly use bonds in their portfolios as part of a retirement planning strategy or funding a child's education may be hurting themselves due to the detrimental affects of inflation.
In order to remedy this situation and still keep U.S. government bonds attractive to investors, the U.S. Treasury issued inflation-protected bonds with a return that is indexed to the inflation rate. There are three maturities for these types of bonds issued at 5, 10, and 20 years. These issues are avaiable for purchase in $1,000 increments through financial advisors, banks, and TreasuryDirect (http://www.treasurydirect.gov/).
Features of Inflation-Indexed Bonds :
•They are guaranteed a rate of return that is above the inflation rate.
•They protect the investor's principal from inflation by indexing the principal to the Consumer Price Index (CPI).
•They protect interest from inflation by providing the investor with semiannual interest payments based on the semiannual interest rate applied to the new inflation-indexed principal value.
•They guarantee a return of principal even if inflation drops. The Time to Buy is During Periods of High Inflation
Inflation-protected bonds are a good decision when an investor's outlook of inflation is that inflation will be going up in the coming years. For example, if you purchase a $1,000 bond and the Consumer Price Index rose by 3%, the value of your initial princiap will also increase by 3% to $1,030. Assuming the coupon rate on the bond was 3%, you will receive interest payments based on the new principal amount. If the following year the CPI rises to 4%, the principal will be adjusted from $1,030 to $1,071.20, and your interest payment would increase from 3% to 4%, paid twice a year.
How does this structure compare to the ordinary type bond - one that is not inflation protected? Well, assuming the inflation rate is 3% and the yield of the unprotected $1,000 10-year Treasury note is 6.3%, the real yield of this security would be the 3.3% which is derived by subtracting the inflation rate from the security's note. After a year, that note would be valued at $1,063, but you would lose $30 of that gain because of the erosive nature of inflation, leaving you with a bond that is worth $1,030. Hence, it makes sense to purchase inflation-indexed securities if you believe that inflation will pick up.
Inflation-Protected Securities Benefits and Drawbacks Benefits
•Guaranteed to outpace the inflation rate.
•Guarantee a return of principal. Drawbacks
•Some expenses may grow at rates greater than the inflation rate.
•Could generate poor results when there is deflation.
•Subject to federal taxes, which may not justify the lower interest rates.
Be careful when purchasing inflation-protected bonds for expenses such as college education, because that strategy is impractical. College tuition costs outpace the rate of inflation. For the 2008-2009 academic year, college costs including tuition, fees and room and board increased at an average of 5.8% which was substantially more then the increase in the Consumer Price Index (CPI).
Even though it is a fact that these inflation-indexed bonds are exempt from state and local taxes, federal income taxes still apply. It is also important to understand that you will have to be pay taxes on any increases in principal on a yearly basis; however, the increase in principal will be paid to you only once the bond matures. Hence, if you find that your bonds do not pay enough interest income to cover the tax bill on the increase in principal in any given year, they may not be appropriate investments for you unless you invest in these bonds through a tax-deferred account such as a retirement account.
Inflation indexing is especially appealing to investors that are in or near retirement. After all, during periods of inflation, inflation protection can make the difference to protect the retiree's principal.
Things to take away
•Inflation-indexed bonds offer inflation protection.
•Semi annual interest payments are based on the interest rate applied to the inflation-indexed value of the principal.
•These bonds are exempt from state and local taxes, but federal taxes apply.
•Investors must pay taxes on the increases in the value of the bond's principal in any given year, while the increase in principal will be paid to the investor only when the bond matures.
•It may be sensible to invest in inflation-indexed bonds in a tax-deferred retirement account. •Inflation-protected bonds make the most sense in periods of high inflation.
ABOUT THE AUTHOR
Isakov Planning Group financial advisors bring industry leading resources and expertise to help clients pursue and achieve their goals. Along with expert market analysis from the firm's top investment managers, your Isakov Planning Group financial advisor will work with you to develop and deliver tailored solutions that can help you get on track and ultimately achieve your most important objectives, whether you're looking to plan for retirement, build tax-free wealth, get your kid's through college, or build a lasting legacy for your family. http://www.isakovgroup.com/
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