The strategies used for bond investing will depend on the financial objectives you are pursuing. Consider these financial objectives and bond strategies:
• Earning interest while preserving principal. This is the most typical role for bonds and is usually accomplished with a buy-and-hold strategy. With this strategy, you purchase a bond and hold it to maturity, looking for the highest return potential for a given time frame within a comfortable risk level. By holding the bond to maturity, you don't have to worry about interest rate changes impacting your bond's price.
• Maximizing income. Since bonds with longer maturities typically have higher interest rates, this strategy typically involves investing in longer-term bonds. Interest rate changes will typically affect a longer-term bond's price more because long-term bonds have a longer stream of interest payments that don't match current interest rates. Someone looking to maximize income will also be more likely to sell a bond before maturity to lock in capital gains. Another strategy to help achieve this objective is to invest in high-yield bonds, which are bonds with lower credit ratings. Due to the lower credit rating, these bonds often have to offer higher interest rates to obtain investor interest.
• Managing interest rate risk. One of the most significant bond risks is interest rate risk, or the risk that increases in interest rates will cause a decrease in your bond's price. Bond ladders can help manage this risk. A bond ladder is a portfolio of bonds of similar amounts maturing in several different years. When one of the bonds matures, the principal is reinvested in another bond at the bond ladder's longest maturity. By spreading out maturity dates, you lessen the impact of interest rate changes. Holding the bond to maturity prevents interest rate changes from resulting in a loss when you sell the bond. Since your bonds mature every year or so, your principal is reinvested over a period of time instead of in one lump sum. If interest rates rise, you have principal maturing every year or so to reinvest at higher rates. In a declining interest rate market, you have some funds in longer-term bonds with higher interest rates. But the main advantage is you don't continue to hold only short-term bonds while you wait for interest rates to peak, an event that is difficult to predict.
• Help reduce the volatility of stock investments. The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully help offset this decline. For instance, in 2008, the Standard & Poor's 500 (S&P 500) returned -37%, while long-term government bonds returned 25.9%, and intermediate-term government bonds returned 13.1%.* One way to assess the percentage of bonds to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.
• Investing for a specific future goal. Because bonds have a definite maturity date, you can select maturity dates to coincide with when you need your principal. You might want to consider zero-coupon bonds for this purpose. Zero-coupon bonds are issued with a deep discount from face value and do not pay interest during the bond's life. The return results from the bond's price increasing gradually from the discounted value to face value, which is reached at maturity. The longer a zero-coupon bond has until maturity, the greater its price discount will be. Like other fixed-income investments, a zero-coupon's price moves up when interest rates fall and down when rates rise. However, since zeros lock in a fixed reinvestment rate of return, they are affected more drastically by interest rate changes. One important fact to consider is taxation. Even though you do not receive any interest income until the zero-coupon bond matures, you are taxed on the yearly growth in the zero's value (called accretion).
• Recognizing a loss for tax purposes. A bond swap, which is simply the sale of one bond and the purchase of another, can help achieve this objective without changing the basic composition of your bond portfolio. In essence, you sell a bond with a current market value less than your purchase price to realize a loss and deduct it on your tax return. You then use the proceeds to purchase similar bonds. The end result is that you still own a comparable bond, but you also have a tax loss. Review the cost of the swap before executing the transactions to ensure costs don't offset most of your expected tax savings. Make sure to comply with the wash sale rules or your loss won't be deductible. A wash sale occurs when an investor sells a security and within 30 days before or after, purchases a substantially similar security. Bonds purchased within the 30-day window must differ from the bonds sold in a material way, which includes different issuers, coupon rates, or maturity dates.
• Reducing income taxes. One strategy would be to invest in municipal securities, since municipal bond interest is generally exempt from federal, and sometimes state and local, income taxes. Your marginal tax bracket is a major factor when deciding whether to include municipal bonds in your portfolio. Thus, you should compare a muni bond's yield to the after-tax yield of a comparable taxable bond. To do that, calculate the muni bond's taxable equivalent yield. If you're not investing in a municipal bond issued in your resident state, the calculation is: the taxable equivalent yield equals the tax-exempt interest rate divided by one minus your marginal tax bracket. For instance, if you are considering a municipal bond with a yield of 4.5% and you're in the 25% tax bracket, the taxable equivalent yield is 6.0% (4.5% divided by 1 minus 25%). Thus, you should compare 6.0% to any corporate bonds you are considering.
* Source: Stocks, Bonds, Bills, and Inflation 2010 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.