Bonds: Investment of Choice for Seniors
Dec 17, 2000
A senior in my family suddenly had to invest a large sum for income. A successful businessman and real estate person, he had no idea how to do that. I researched the available investments and found out quite a bit about bonds, the investment of choice for income investors. I'll share what I shared with him here.
You can find out more than you probably want to know about bonds in the Vanguard Plain Talk library (http://www.vanguard.com. Then look in the Plain Talk Library for the section on bonds). Here are a few basics on bonds and their place in a portfolio.
WHAT IS A BOND?
A bond is simply a loan. A government, government agency, or corporation wants to borrow money. It then issues bonds in which it agrees to pay principal and interest on a set schedule at a predetermined interest
rate. Typically the issue pays interest on a regular schedule and pays the principal at maturity.
Of course bonds involve some risk to investors. Some issuers of bonds are more stable than others, so default is possible. Interest rates go up and down.
To assist prospective investors, Moody's Investors Service and Standard and Poor's Corporation rate the credit quality of bonds. Moody's rating go from Aaa to D and Standard and Poor's from AAA to D.
The interest rate is determined by the amount of risk the investor is subjected to. The issuer doesn't want to pay any more interest than necessary, but realizes that if it is putting investors ar risk, it has to offer more income. Longer term bonds are riskier than shorter term bonds and less stable companies are considered riskier than more stable companies.
WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF BONDS?
While bonds do not perform as well as stocks do over the long term, they do not have as wide of fluctuations as stocks do. If you buy a high grade bond for a fixed rate, you are almost certain to get that rate for the term of the bond. With a stock, you never know. Even a dividend paying stock can suddenly stop paying its dividends if the company so decides.
Bonds are the instrument of choice for investors who are currently living off their investments. This is true of most senior-aged investors.
It is often recommended that retirement investors have mostly stocks in their portfolios before the age of 40 and gradually move toward a portfolio composed largely of bonds as they move toward retirement.
There are actually periods in which bonds do better than stocks. Bonds do well when interest rates are going down and business conditions are not really good. Some suggest that we are going into that type of period
Some suggest that seniors in their early years of retirement should have some conservative stock holdings to achieve growth.
Also, don't make the mistake that the senior in my family made. He assumed that he wasn't going to live up to his present age, so he didn't invest with that assumption. Now he is in his upper 70's with good physical and mental health, but without the fiscal health to enjoy these years.
Also, there has never been a period of five years when a portfolio consisting of 50% stocks and 50% bonds has lost money.
WHY DO BOND PRICES VARY?
Not everyone who buys a bond keeps it to maturity. People sell their bonds. Like any other used good, the price of a bond will be determined by its desirability.
Let's say that Flaky Jake's Stereo Company is desperate for money and issues low-rated, high-interest bonds. Investors who believe in Flaky Jake buy the bonds because they want the high interest.
A few years later, Flaky Jake gets its act together and is making a profit. Interest rates go down and Flaky Jake's bonds are paying higher rates than you can get in most bonds and the company isn't at as much risk as before. Flaky Jake's bonds are considered one desirable commodity and some investors are willing to pay a premium price to buy them. Some original investors are quite happy to charge that premium price and the sale is made through a broker.
Let's say Stable Sam's Widget Company offers some bonds at a relatively low interest rate because everyone knows that Stable Sam will pay. Then let's say that what everyone knows turns out not to be true and the
company is at risk. Meanwhile, interest rates have gone up and you can get the same interest rate elsewhere for less risk. In that case, a holder of Stable Sam's bond who needs to sell will have to do so at bargain basement prices. Bargain basement buyers are out there.
Generally speaking, the price of bonds will go up when interest rates go down because the higher interest bonds are more desirable and will go down when interest rates go up because the older bonds are less
desirable. The price of a bond will go up when the company or agency becomes more creditworthy and will go down if the company becomes less creditworthy.
WHAT ABOUT MUNICIPAL BONDS?
Municipal bonds are bonds issued by state and local government for a variety of purposes. Municipal bonds can have high or low ratings. They can be general obligation bonds, meaning that they come from the coffers of the agency issuing them, or they can be revenue bonds meaning that the money to pay the bonds comes from the revenue of the project financed, for example a toll road.
Interest rates are lower on municipal bonds, but you pay no federal and in some cases no state tax on the income. Therefore, they make sense for people in high tax brackets while people in lower tax brackets are
better off receiving the higher interest and paying the taxes on them.
INDIVIDUAL BONDS OR BOND FUND?
You can buy bonds individually or you can buy bond mutual funds. There are advantages and disadvantages of going both ways.
If you plan to buy bonds only of good companies and use them for income, you may want to consider buying the bonds individually. You will have to go through a broker and pay a commission and will have to keep track of
the paperwork. You can buy treasury bonds through the government auction. If you buy individually, though, you don't have to worry about the value of your bonds going down for some reason unrelated to the soundness of the company and you determine the companies you invest in.
Bond mutual funds are readily available and are often narrowly focused on one type of bond. The price per share of the bond fund is based on the market value of the bonds that are in that fund. Income is distributed on a regular basis, usually monthly. You can use that income to buy more shares or have it sent to you. The bond fund trades bonds as the management sees fit and takes a cut, called the expense ratio. Bond funds are rated by Morningstar and the expense ratios are published so you can know the price of owning different funds. You can get a lot of information about bond funds on quicken.com.
WIth a bond fund, you get diversification and someone else does the research and record keeping. Hopefully, that someone else knows that (s)he is doing and gets the best bonds within the type of bond the fund is
committed to holding.
If you plan to buy lower rated bonds (anything with a letter other than "A" in its rating for either service), you will be well served to buy them in funds to get diversification. In these bonds, default is a realistic possibility. If you have only, say, five bonds and one goes, there's a major portion of your portfolio gone. Bond funds have many
more bonds and hopefully have the expertise to select the best of the speculative bonds. Be prepared for relatively wide swings on the value of high yield bond funds.
A portfolio heavy in bonds are the investment of choice for seniors who need to live off their money because they are no longer employed. Do the research to find exactly what bonds or funds are right for you and you can make it work.