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Bond Investing: Active Vs. Passive Strategies

Decades ago, the image of the typical bond investor was someone who sat in an easy chair passively clipping coupons and living on the interest payments they represented. No longer. As a bond investor, you can be as passive or as active as you choose. Depending on your investment goals and attitudes, you may use several strategies within your bond portfolio to accomplish different goals.

Note: The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

Buy Individual Bonds at Par and Hold Them to Maturity

If you're buying bonds primarily to provide current income, whether for living expenses or some other reason, buying bonds at their face values and holding them to maturity provides a stable stream of income and the assurance that unless a bond issuer defaults, you'll receive your entire investment back. Zero-coupon bonds often are used with this strategy. Though it's bought at a deep discount rather than paying periodic income, a zero's maturity date can be targeted to coincide with a specific date when you need the principal.

Note: The value of zero coupon bonds is subject to market fluctuation. Because these bonds do not pay interest until maturity, their prices tend to be more volatile than bonds that pay interest regularly. Interest income is subject to ordinary income tax each year, even though the investor does not receive any income payments.

If you buy a newly issued bond, the transaction costs are built into the bond's par value. However, the selection of bonds available on the secondary market is much greater, allowing you greater flexibility in tailoring your bond portfolio.

If you're interested in long-term bonds, especially 20- or 30-year bonds, think carefully about whether you may need or want to sell the bond before it matures. Selling before maturity, especially if you sell when bond prices are down, can affect the yield you receive from your investment. Shorter-term bonds, though they have a lower yield, will likely have less dramatic changes in price. Having some bonds with shorter maturities may help you avoid the need to sell a long-term bond at an inopportune time.

Match Maturities to Anticipate Cash Needs

You can deliberately structure maturities to occur when you anticipate cash needs. For example, let's say that your son is expected to begin college in 8 years, your daughter in 10 years, and you have a mortgage balloon payment due in 3 years. You could buy bonds now with maturities of 3, 8, and 10 years. Try to choose maturity dates close to the due date of the payments for tuition and the balloon payment. By consciously structuring your bond maturities to meet the timing of your anticipated needs, you might be able to avoid having to sell bonds at a loss in an unfavorable market environment. When a portfolio's manager uses such a strategy, the portfolio is said to be a dedicated portfolio. Because the portfolio is timed to match interest payments to cash needs, this strategy minimizes the impact of changes in interest rates.

Target a Time Frame with A Bullet

With a bullet strategy, you can invest for a specific time period and still provide your portfolio with a bit of protection against interest-rate risk, though not as much as with some other strategies. If you'll need a certain amount of money on a specific date, you could buy bonds that mature at the same time, but stagger your purchases to take advantage of any changes in interest rates. This allows you to target a goal, but gives you some flexibility to adjust to changing economic conditions.

Ladder Maturities to Reduce Reinvestment Risk

If you own an individual bond, you're faced with reinvestment risk when it matures. Reinvestment risk means that, depending on what has happened with interest rates, you may not be able to reinvest the proceeds of your bond at the same interest rate. If all of your bonds mature when interest rates are down, you would be reinvesting all of your holdings at that lower rate, which would mean reduced income. That could be a problem if you're counting on a particular level of income from your bond holdings (e.g., if you're a retiree and are living on that income).

Laddering maturities (i.e., owning multiple bonds that mature at regular, staggered intervals) can help you deal with the uncertainties caused by fluctuation in interest rates. To adopt a laddering strategy, you can either make an initial purchase of multiple bonds with different maturities, or buy bonds periodically over time. For example, you could buy a bond every year, each time choosing a maturity date that's different from your existing bonds. Alternatively, you could divide an initial sum of money and buy several bonds at once, with different maturities. The overall yield of your portfolio would likely be greater than if all your bonds were short-term. This strategy also involves less risk than if all your bonds were long-term.

You should ladder maturities so that you receive the principal from one of those bonds every year (or any other interval with which you are comfortable). When the first bond matures, you could reinvest the money at prevailing interest rates. If short-term rates are high, you might choose to reinvest the money in short-term bonds. If not, you might choose to buy a longer-term bond to increase your overall yield. Buy a bond that comes due in a year when none of your other bonds are maturing, thus filling in your ladder. Or you could invest the money in another asset class, such as dividend-paying stocks.

Laddering can also be used to gradually increase the average duration of your overall bond portfolio over time. Assuming the typical scenario, in which long-term bonds pay higher interest rates than short-term bonds, that might also gradually improve your bond portfolio's overall yield.

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Example(s): You have $40,000 to invest in bonds. Rather than buying one $40,000 bond, you decide to buy four $10,000 bonds. One of the bonds matures in 2 years, one in 3 years, one in 5 years, and one in 10 years. After 2 years, when the first bond matures, you decide to reinvest its $10,000 principal into a second 10-year bond, because 10-year bonds are paying a higher interest rate than 2-year bonds. The following year, the 3-year bond matures. Because interest rates for long-term bonds are still higher than those for short-term bonds, you might reinvest that $10,000 into yet another $10,000 bond. When the 5-year bond matures, however, long-term rates are essentially the same as those for a 3-year bond. You might choose to buy a 3-year bond rather than tie up your principal for a longer time with no additional reward. At this point, your overall monthly bond income probably would have increased because your three bonds with 10-year maturities are paying higher interest rates than the 2- and 3-year bonds they replaced.

There are no guarantees that laddering will increase your income, of course. However, having a ladder of short-, intermediate-, and long-term bonds provides you with liquidity as bonds periodically come due and principal is paid. That gives you greater flexibility to make choices that you feel will take advantage of changing interest rates and increase your return.

Hedge against Inflation with the Barbell

The barbell strategy involves buying bonds at opposite ends of the maturity spectrum. For example, you could buy 2-year and 10-year maturities, or 2-year and 30-year maturities. If inflation rises, you're partially hedged because you can reinvest the 2-year maturities at higher rates. If rates fall, your longer-maturity bonds will continue to pay interest at the higher rate. Also, they'll not only hold their value, but may rise in price and you might be able to sell them at a profit. A barbell strategy may be most useful in an extended period of falling interest rates.

Diversify Bond Holdings to Achieve Various Goals

Different types of bonds involve different types of risk, and may offer different advantages. For example, you could buy a low-risk Treasury bond for its security or a deeply discounted zero-coupon bond because you want to profit if its value rises. You could also invest in some TIPS for their ability to keep pace with inflation; and choose a convertible bond from a rapidly growing company for the opportunity to eventually convert it into shares of stock. Though it doesn't guarantee a profit or insure against a loss, diversification can help you take advantage of the variety of bonds available. Your mix should be re-evaluated as your financial objectives change.

Immunize a Portfolio by Matching Durations

An immunization strategy attempts to protect a bond portfolio from the impact of changes in interest rates over time. It's typically used when the portfolio must retain a certain value at the end of a given time period, or must lock in a certain level of return regardless of what happens with interest rates in the meantime. For example, a pension fund must have a certain amount of money to fund payments to retirees. To make sure the money to do that is available when it's needed, the pension fund manager might immunize the portfolio by matching the portfolio's duration, with the time period dictated by the portfolio's financial obligations or liabilities. Example(s): XYZ Corporation's pension fund is able to meet its $5 million annual obligations with its current return on secure 2-year Treasury bonds, but the fund manager knows that rate of return will not cover the $10 million annual payments that will be needed to cover benefits in 10 years. The fund manager decides to lengthen the fund's duration by holding a greater percentage of higher-paying, long-term bonds. That longer overall duration is calculated so that if interest rates drop in the future and interest income from the portfolio must be reinvested at a lower rate, the projected capital gain in the immunized portfolio's value plus the reinvested accumulated interest over 10 years will be enough to offset the impact of those lower rates. If interest rates rise, the fund could reinvest its interest income at higher rates to offset the drop in the portfolio's value.

Tax Bracket Strategies

Your income tax bracket can (and should) influence your bond investment strategy. Investors in high tax brackets often benefit from investments in tax-advantaged bonds, such as those issued by municipalities or the U.S. Treasury. Although tax-free bonds generally have a lower stated return than taxable bonds, once the effects of taxation are considered, the tax-free bonds may be more advantageous. This tax advantage applies only to the income from the bonds, not to any capital gains/losses you may incur.

Note: Interest paid by municipal bonds issued by your state or local government is typically free of federal income tax. If a bond was issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Some municipal bond interest could be subject to the alternative minimum tax.

Tip: The type of account in which you are holding the investments also has an effect on any tax benefit. Traditional IRAs and 401(k) plans carry certain tax advantages because of the deferral of tax on the income and growth. As a result, these plans are more suitable for taxable assets, not for tax-free bonds.



This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


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