The way you invest in bonds for the short-term or the long-term depends on your investment goals and time frames, the amount of risk you are willing to take and your tax status.
When considering a bond investment strategy, remember the importance of diversification. As a general rule, it’s never a good idea to put all your assets and all your risk in a single asset class or investment. You will want to diversify the risks within your bond investments by creating a portfolio of several bonds, each with different characteristics. Choosing bonds from different issuers protects you from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds of different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in any particular market sector. Choosing bonds of different maturities helps you manage interest rate risk.
With that in mind, consider these various objectives and strategies for achieving them.
Preserving Principal and Earning Interest: If keeping your money intact and earning interest is your goal, consider a “buy and hold” strategy. When you invest in a bond and hold it to maturity, you will get interest payments, usually twice a year, and receive the face value of the bond at maturity. If the bond you choose is selling at a premium because its coupon is higher than the prevailing interest rates, keep in mind that the amount you receive at maturity will be less than the amount you pay for the bond.
When you buy and hold, you need not be too concerned about the impact of interest rates on a bond’s price or market value. If interest rates rise, and the market value of your bond falls, you will not feel any effect unless you change your strategy and try to sell the bond. Holding on to the bond means you will not be able to invest that principal at the higher market rates, however.
If the bond you choose is callable, you have taken the risk of having your principal returned to you before maturity. Bonds are typically “called,” or redeemed early by their issuer, when interest rates are falling, which means you will be forced to invest your returned principal at lower prevailing rates.
When investing to buy and hold, be sure to consider:
Maximizing Income: If your goal is to maximize your interest income, you will usually get higher coupons on longer-term bonds. With more time to maturity, longer-term bonds are more vulnerable to changes in interest rates. If you are a buy-and-hold investor, however, these changes will not affect you unless you change your strategy and decide to sell your bonds.
You will also find higher coupon rates on corporate bonds than on U.S. treasury bonds with comparable maturities. In the corporate market, bonds with lower credit ratings typically pay higher income than higher credits with comparable maturities.
High-yield bonds (sometimes referred to as junk bonds) typically offer above-market coupon rates and yields because their issuers have credit ratings that are below investment grade: BB or lower from Standard & Poor’s; Ba or lower from Moody’s. The lower the credit rating, the greater the risk that the issuer could default on its obligations, or be unable to pay interest or repay principal when due.
If you are thinking about investing in high-yield bonds, you will also want to diversify your bond investments among several different issuers to minimize the possible impact of any single issuer’s default. High yield bond prices are also more vulnerable than other bond prices to economic downturns, when the risk of default is perceived to be higher.
Managing Interest Rate Risk: Ladders and Barbells: Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of bonds with different maturities, for example: one, three, five and ten years. A laddered portfolio has principal being returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder if you want to keep it going. If rates are rising, that maturing principal can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the longer-term holdings.
With a barbell strategy, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver attractive coupon rates. Having some principal maturing in the near term creates the opportunity to invest the money elsewhere if the bond market takes a downturn.
Smoothing Out the Performance of Stock Investments: Because stock market returns are usually more volatile or changeable than bond market returns, combining the two asset classes can help create an overall investment portfolio that generates more stable performance over time. Often but not always, the stock and bond markets move in different directions: the bond market rises when the stock market falls and vice versa. Therefore in years when the stock market is down, the performance of bond investments can sometimes help compensate for any losses. The right mix of stocks and bonds depends on several factors. To learn more, read Asset Allocation.
Saving for a Definite Future Goal: If you have a three-year-old child, you may face your first college tuition bill 15 years from now. Perhaps you know that in 22 years you will need a down payment for your retirement home. Because bonds have a defined maturity date, they can help you make sure the money is there when you need it.
Zero coupon bonds are sold at a steep discount from the face value amount that is returned at maturity. Interest is attributed to the bond during its lifetime. Rather than being paid out to the bondholder, it is factored into the difference between the purchase price and the face value at maturity.
You can invest in zero coupon bonds with maturity dates timed to your needs. To fund a four-year college education, you could invest in a laddered portfolio of four zeros, each maturing in one of the four consecutive years the payments will be due. The value of zero coupon bonds is more sensitive to changes in interest rates however, so there is some risk if you need to sell them before their maturity date. It is also best to buy taxable (as opposed to municipal) zeros in a tax-deferred retirement or college savings account because the interest that accumulates on the bond is taxable each year even though you do not receive it until maturity.
A bullet strategy can also help you invest for a defined future date. If you are 50 years old and you want to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way may help you benefit from different interest rate cycles.
Reasons You Might Sell a Bond before Maturity
Investors following a buy-and-hold strategy can encounter circumstances that might compel them to sell a bond prior to maturity for the following reasons:
Using bonds to invest for total return, or a combination of capital appreciation (growth) and income, requires a more active trading strategy and a view on the direction of the economy and interest rates. Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather than holding the bond to maturity.
Bond prices fall when interest rates are rising, usually as the economy accelerates. They typically rise when interest rates fall, usually when the Federal Reserve is trying to stimulate economic growth after a recession. Within different sectors of the bond market, differences in supply and demand can create short-term trading opportunities. For some ideas, read the content articles under “Profiting from Market Signals” and “Which Trade?”—in Learn More-Strategies Section.
Various futures, options and derivatives can also be used to implement different market views or to hedge the risk in different bond investments. Investors should take care to understand the cost and risks of these strategies before committing funds.
Some bond funds have total return as their investment objective, offering investors the opportunity to benefit from bond market movements while leaving the day-to-day investment decisions to professional portfolio managers.