Considering Bonds as a Safe Haven?

After thirteen interest rate cuts, seventeen subsequent raises, and a change at the top of the Federal Reserve Board from the world-famous Alan Greenspan to the lesser-known Ben Bernanke, many bond investors have been left with their heads spinning. Add in the latest wild ride in the stock market and you will find many investors looking for an alternative place to put their money. Lately, there has been a lot of buzz on the financial channels, touting bonds once again. Since so many investors jumped into the bond market wholeheartedly after the last stock market crash, only to suffer the painful effects of rising interest rates, now may be a good time to review these securities before you put your hard-earned cash to work.

You may be asking yourself what a bond actually is. Is it like a CD? Is it a savings bond like the one that your Grandmother gave you? According to The Bond Market Association, a bond is a debt security similar to an IOU. When you purchase a bond you are essentially lending money to a government, municipality, corporation, federal agency, or other entity known as the “issuer.” In return for the loan, the issuer promises to pay you a specified rate of interest for the life of the loan (bond) and to repay the face value (also known as the principal) when it matures.

This sounds pretty simple, but like most investments, bonds are subject to several types of risk, some of which are covered here. Credit risk is a very important consideration. The borrower’s credit rating may very well drop below where it was when you purchased the bond and the borrower may even go bankrupt. (Enron, anyone?) The longer the time that an investor has to wait until the maturity date, the greater the opportunity to experience credit risk. If the borrower, or bond issuer, is a good credit risk, the bond is more valuable, and less valuable if the borrower is a poor credit risk. A bond’s market price will reflect any change in the likelihood that its terms will be honored. For example, bonds issued by the major airlines fell sharply in price after the tragic events of September 2001 disrupted the airline business (which has yet to completely recover).

In addition, many bonds may have “call features,” giving the issuer the right to call in the bond at a stated price beginning on specific dates—generally when interest rates fall—leaving investors subject to reinvestment risk, which has been to the detriment of many investors who planned to live off of the income provided when they originally purchased their bonds.

Some tax-free municipal bonds are subject to Alternative Minimum Tax (AMT). When considering an investment of this type, investors who are subject to AMT will want to pay special attention to tax implications, as this tax will reduce their overall anticipated rate of return. Please consult your tax advisor to learn more about your personal situation prior to investing.

As bonds investments begin to appear more attractive, perhaps the timeliest consideration that investors may want to review is interest rate risk. This is an extremely important factor to keep in mind in a rising interest rate environment. During this time, the price of bonds moves inversely to interest rates. Interest rates are set by market expectations for future inflation, money supply, and other economic factors. When interest rates rise, bond prices fall, and vice versa. Investors learned this lesson firsthand in 1994 when bonds suffered double-digit negative returns as interest rates rose and bond prices fell sharply.

Investors should keep in mind that bond investing involves total return—interest paid plus changes in price. For example, it is possible to own a portfolio of bonds paying a reasonable interest rate, yet the portfolio value can fall due to rising interest rates. If you need to sell your bonds during a period of rising interest rates, you will likely receive less money than you would if you held your bonds to maturity.

For more information on the risks and rewards of bond ownership you should contact your Financial Consultant. Take care to become fully aware of all of the risks as well as the rewards before you purchase a bond or any other investment product. Remember that knowledge is the key to your financial future.