Jun 18 2015
Part 1 was about mutual funds that invest in stocks. Now we switch to bonds.
The most familiar styles of Bond funds are short, medium and long. Similar to stock funds being small, medium and large-size companies, the standard bond fund strategy is to build a portfolio based on the length of the bonds maturity dates; short-term, mid-term and long-term maturities.
The maturity date is when a bond matures and pays you back its face value. Between the time you buy the bond and it matures, the bond typically pays an interest rate. I just described individual bonds but you are buying a bond mutual fund which will have thousands of individual bonds. Generally a short-term bond fund buys bonds with maturities 5 years or less. Mid-term is 5 to 10 years. Long-term is more than 10 years.
The maturity time matters because usually the longer the maturity the higher the interest rate. Well then you ask, “Why have short-term bonds?” Glad you asked…
Let’s say you buy an individual bond for $1000 and it pays 5% interest per year. As long as the country’s interest rates stay the same you have a bond valued at $1000 paying 5% a year. But suppose the nation’s interest rates change to 6%. Who would want your 5% bond if I can buy a new 6% bond? If you wanted to sell your 5% bond before maturity, to make it appealing to a buyer, you would have to decrease the price of your bond. The opposite is also true. If interest rates slipped to 4%, your 5% bond would be worth more if you wanted to sell.
The longer the maturities on your bonds, the more interest rate changes impact the bonds’ prices. Basically because you’re holding a bond longer with a positive or negative value. So managing the maturities on your bond funds can help control the impact of changing bond prices.
If you are looking for account value stability, a shorter term bond fund might be best. If bond fund value fluctuation isn’t a problem for you, you might choose to go with longer maturities for higher interest rate payments.
Another critical aspect of a bond’s value is its quality. Within the short-, mid-, long-terms is whether the bond is of high quality or low quality. Quality is determined by the organization that issues the bond. If the financial fundamentals of the organization are good, the bond’s quality is high. Financially unstable organizations issue lower quality bonds. The lower the quality, the higher the bond’s interest rate. This is because as the buyer you assume more risk. The risk being that you could lose your money if the organization defaults on its financial obligations.
The common terms to indicate quality are “investment grade” and “high-yield” or “junk” bonds. Another quality indicator is the bond’s quality rating. “AAA” is the highest quality and it goes down: AA, A, BBB, BB, B, CCC, you get it. BBB and up is considered investment grade.
There are also “insured” bonds which mean the organization insured the bonds to guarantee their safety and quality. Insured bonds are rated as high quality.
The type of organization that issues the bonds is another style category. Bonds are issued by corporations, governments at all levels, mortgage companies, and investment firms. Bonds issued by state, county and local governments can provide tax-free interest income.
There are special bonds issued by the federal government that offer protection against inflation.
And of course you can buy foreign bonds.
Put them all together and what do you have? You can buy a corporate, intermediate, investment grade bond fund. Or an insured short-term municipal bond from a specific state.
Each investment you own whether bonds or stocks is built and managed to meet a specific objective. You cannot choose any mutual fund until you have defined your objective. Here are some considerations to help define your objectives:
- Long-term investment horizon
- Short-term savings horizon
- Interest payments
- Capital gain and appreciation
- Regular deposits
- No regular deposits
- Emergency funds
- Saving for a home, car, furniture, etc.
- Consistent returns
- Best long-term returns
What are you shooting for? You see by defining your objectives it helps you decide which investment is best suited to meet the objective. Never make your investment selections based on media, marketing, family-friends, or because you have a feeling about it.
As the saying goes, “People don’t plan to fail; they just fail to plan.” Define your objectives, develop a strategy to achieve the objectives, select the proper investments to complete the strategy and achieve the objectives.
Learn more about these processes from these MOAA articles: