Finding a Bond: Where to Start
Reflect
Now that you've recognized certain impacts your allocation and individual needs will effect which bonds go into your portfolio, it's time to think about a few important points as you find a bond or bond fund to purchase: bond pricing, interest rate sensitivity, credit quality, category risk ratio, expenses and taxes.
Bond Pricing and Interest Rate Sensitivity
For individual bonds, its maturity determines interest rate sensitivity. The longer the maturity, the longer investors' dollars are tied to a fixed interest rate. Additionally, bond yield is income received divided by the price paid for the bond.
Falling interest rates reduce overall yield, which means higher prices are paid for bonds with larger relative coupons. On the other hand, rising interest rates raise yield, which also means that lower prices are paid for bonds with smaller relative coupons.
The bond's duration shows how sensitive it's price is to interest rate changes. A good rule of thumb is a bond's price will move by 1% times a bond's duration for every one percentage point move in bond prices; for example, if interest rates rise from 1% to 2%, bond with a five-year duration will decline by 5%.
Credit Quality
As you can see from the worksheet, there are also different grades for credit quality. Credit quality refers to the perceived risk of a bond falling in price. The two main grades include:
- Investment Grade: AAA/Aaa to BBB/Baa
- Non-investment Grade: BB/Ba to D (C for Moody's); also known as high yield or junk
The worse the credit rating, the higher the yield investors will demand as compensation.
Taxes on Bonds
When choosing which types of bonds to purchase, you will want to consider taxes; for example:
- Treasury bonds: Interest is exempt from federal taxes
- Municipal bonds: Interest is generally exempt from state, local and federal income taxes; consider
- Corporate bonds: Interest is fully taxable
A few other important notes to consider is that the tax equivalent yield can be used to compare municipal bonds against Treasury and corporate bonds: Tax-exempt yield ÷ (1 – Your marginal tax rate). Municipal bond interest influence Medicare Part B premiums and taxation of Social Security benefits.
Considerations for Bond Funds
If you find bond funds that have higher returns and yield, this can be the result of the manager taking on more credit risk relative to peers. The category risk ratio, available in the AAII Mutual Fund and ETF guides, can tell you which funds more volatile and which ones are more stable. And just as it is with stock funds, bond funds will have expenses that you will need to plan for and manage. With bond funds, you can distribute both taxable income and taxable capital gains distributions. Make sure to use our guides to review the tax cost ratio before investing.
Your Overall Asset Allocation
There are a few aspects that will impact where certain types of bonds are allocated such as:
- Corporate bonds and bond funds should be held in tax-preferred accounts like IRAs and 401(k)s
- Municipal bonds are best suited for taxable accounts in order to realize the tax equivalent yield
Make sure you understand the different types of bonds so you can add them to the correct portfolios and accounts. Your investment management preferences and allocation will determine where certain bonds should be held.
Participate
For this lesson, we ask our members to choose 2-3 bonds or bond funds to compare and see how they will impact your overall allocation and portfolio. Use the checklist attached to the bottom of this lesson as you go through the various aspects that are important to consider before choosing the types of bonds or funds you add.
Now, we want to hear about your findings. Let us know in the comments below!
Download the "Selecting and Managing Your Investments" worksheet
Questions about coursework, webinars, worksheets, etc.? Drop your inquiries in the discussion below. We're happy to help!
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Jenna Brashear
AAII Community Manager
Chicago, IL
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