Fixed Income Basics
Research for Online Investors

by John Dalt

7/20/09

We concentrate on stocks every day at galtstock, but many of us would benefit from fixed income assets in our portfolio.  One standard repeated often is your age should determine the percentage of bonds in your portfolio. If you are 25 years old, 25% of your portfolio should consist of fixed assets (bonds), if you are 55 years old, 55% goes into bonds.  A great resource is http://investinginbonds.com/  

Fixed income is not the area we concentrate on at GaltStock, but when the market is acting like a schizophrenic teenager, bonds look more attractive.  This is why Uncle Sugar can borrow money for almost 0.00%, when investors are scared of the equities market.  One popular bond strategy is laddering.

If you would like to minimize risk, diversify and manage your cash flow you may want to use this strategy. It is easy and a common-sense strategy. The bond ladder can be employed by investors at all levels of experience.

Say you have $50,000 to invest in the bond portion of your portfolio. If you put all $50,000 into bonds with 10-year maturities, then all of your money will be tied up for 10 years. You will not be able to capitalize on (or protect yourself from) bull and bear bond markets during that time. Not only that, but in 10 years when you get your money back, if you choose to reinvest it, you’ll be bound by the prevailing interest rate at that time.

You can avoid this situation by staggering maturity dates. With the same $50,000, you could choose five different bonds and put $10,000 into each. If each bond matures at a different time, say one per year, then you are more protected against volatile interest rates. By reinvesting a little each year at the prevailing rate, you are able to smooth out the fluctuations in the market.

After choosing bonds with different maturity dates, you can also control income by selecting bonds with different interest paid dates or coupons. Coupons are generally paid semiannually. Staggering your coupons means that rather than having all of your interest payments arrive on the same day every six months, you can spread your payments out and receive an interest payment every few weeks or months. This can be especially important if you are retired and depend on the income from your investments.

Laddering your Bonds:

• Determine the amount of money to invest in bonds.
• C hoose the number of “rungs” you want in your ladder. More diversification protects you from interest rate fluctuations.
• Project your income needs.  Decide how long into the future to stretch your bond ladder.  Long-term bonds generally pay higher interest rates.
• Determine the coupon payment dates that fit your needs.
• Research bonds that fit your ladder criteria.

Please do not run out and buy bonds on this article.  There is so much more you need to know to avoid mistakes.  Bonds are not liquid like stocks.  You cannot sell them as easily, if you need to raise money fast.

There are government treasuries, corporate bonds and municipal bonds that may pay interest tax free. This is to encourage you to help build the local school, and to let them borrow money at the lowest rates. There are also local bonds that are not backed by the taxing authority of the local government, but by the cash flow generated by the bond beneficiary.

Bonds fluctuate in market price, just like stocks.  When interest rates go up, the value of existing bonds goes down.  Conversely, when interest rates go down, existing bond prices go up.

It seems strange at first, but the bottom line is investors buy bonds to receive the interest payments.  If your 10-year bond’s face value is $1000 paying 5%, that means you receive a $25 interest payment every six months for ten years, plus the face value (principal) at maturity.  As interest rates fluctuate, the price of your bond goes up and down so it effectively yields the present interest rate offered.

If you want to sell your bond after five years, and five year like bonds are yielding 7%, you have to discount your bond to yield 7% on the sale price.  Your bond should be priced at about $714.  How did that happen?  $714 X 7%= $49.98 yearly coupons!  Keep in mind the purchaser of your bond receives the full $1000 face value at maturity.  You have lost $286 off the face value if you have to sell.  The buyer pockets a $286 capital gain if the bond is held to maturity!

Most discount brokers offer fixed income securities, although you may have to go through the office rather than online. If you have any questions send them to feedback@galtstock.com

In addition, I will recommend an old friend with over 35 years experience in fixed income securities.  You can contact him at coxmm@stifel.com

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

MarketToday Home Page

Back to Top