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How do you make bonds work for your investment goals? Strategies for bond investing range from a buy-and-hold approach to complex tactical trades involving views on inflation and interest rates. As with any kind of investment, the right strategy for you will depend on your goals, your time frame and your appetite for risk. Bonds can help you meet a variety of financial goals such as: preserving principal, earning income, managing tax liabilities, balancing the risks of stock investments and growing your assets. Because most bonds have a specific maturity date, they can be a good way to make sure that the money will be there at a future date when you need it. This section can help you:
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Decide how bonds can best work for you Understand where bonds fit within your asset allocation Learn about how different types of bonds help you reach different goals Think about sophisticated trading strategies based on market views and signals Discern the difference between bonds and bond funds
Your goals will change over time, as will the economic conditions affecting the bond market. As you regularly evaluate your investments, check back here often for information that can help you see if your bond investment strategy is still on target to meet your financial goals.
Bond Investment Strategies
The way you invest in bonds for the short-term or the long-term depends on your investment goals and time frames, the amount of risk you are willing to take and your tax status. When considering a bond investment strategy, remember the importance of diversification. As a general rule, it’s never a good idea to put all your assets and all your risk in a single asset class or investment. You will want to diversify the risks within your bond investments by creating a portfolio of several bonds, each with different characteristics. Choosing bonds from different issuers protects you from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds of different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in any particular market sector. Choosing bonds of different maturities helps you manage interest rate risk. With that in mind, consider these various objectives and strategies for achieving them.
Preserving Principal and Earning Interest
If keeping your money intact and earning interest is your goal, consider a “buy and hold” strategy. When you invest in a bond and hold it to maturity, you will get interest payments, usually twice a year, and receive the face value of the bond at maturity. If the bond you choose is selling at a premium because its coupon is higher than the prevailing interest rates, keep in mind that the amount you receive at maturity will be less than the amount you pay for the bond. When you buy and hold, you need not be too concerned about the impact of interest rates on a bond’s price or market value. If interest rates rise, and the market value of your bond falls, you will not feel any effect unless you change your strategy and try to sell the bond. Holding on to the bond means you will not be able to invest that principal at the higher market rates, however. If the bond you choose is callable, you have taken the risk of having your principal returned to you before maturity. Bonds are typically “called,” or redeemed early by their issuer, when interest rates are falling, which means you will be forced to invest your returned principal at lower prevailing rates. When investing to buy and hold, be sure to consider:
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The coupon interest rate of the bond (multiply this by the par or face value of the bond to determine the dollar amount of your annual interest payments) The yield-to-maturity or yield-to-call. Higher yields can mean higher risks. The credit quality of the issuer. A bond with a lower credit rating might offer a higher yield, but it also carries a greater risk that the issuer will not be able to keep its promises.
If your goal is to maximize your interest income, you will usually get higher coupons on longerterm bonds. With more time to maturity, longer-term bonds are more vulnerable to changes in interest rates. If you are a buy-and-hold investor, however, these changes will not affect you unless you change your strategy and decide to sell your bonds. You will also find higher coupon rates on corporate bonds than on U.S. treasury bonds with comparable maturities. In the corporate market, bonds with lower credit ratings typically pay higher income than higher credits with comparable maturities. High-yield bonds (sometimes referred to as junk bonds) typically offer above-market coupon rates and yields because their issuers have credit ratings that are below investment grade: BB or lower from Standard & Poor’s; Ba or lower from Moody’s. The lower the credit rating, the greater the risk that the issuer could default on its obligations, or be unable to pay interest or repay principal when due. If you are thinking about investing in high-yield bonds, you will also want to diversify your bond investments among several different issuers to minimize the possible impact of any single issuer’s default. High yield bond prices are also more vulnerable than other bond prices to economic downturns, when the risk of default is perceived to be higher.
Managing Interest Rate Risk: Ladders and Barbells
Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of bonds with different maturities, for example: one, three, five and ten years. A laddered portfolio has principal being returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder if you want to keep it going. If rates are rising, that maturing principal can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the longer-term holdings. With a barbell strategy, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver attractive coupon rates. Having some principal maturing in the near term creates the opportunity to invest the money elsewhere if the bond market takes a downturn.
Smoothing Out the Performance of Stock Investments
Because stock market returns are usually more volatile or changeable than bond market returns, combining the two asset classes can help create an overall investment portfolio that generates more stable performance over time. Often but not always, the stock and bond markets move in different directions: the bond market rises when the stock market falls and vice versa. Therefore in years when the stock market is down, the performance of bond investments can sometimes help compensate for any losses. The right mix of stocks and bonds depends on several factors. To learn more, read Asset Allocation.
Saving for a Definite Future Goal
If you have a three-year-old child, you may face your first college tuition bill 15 years from now. Perhaps you know that in 22 years you will need a down payment for your retirement home. Because bonds have a defined maturity date, they can help you make sure the money is there when you need it. Zero coupon bonds are sold at a steep discount from the face value amount that is returned at maturity. Interest is attributed to the bond during its lifetime. Rather than being paid out to the bondholder, it is factored into the difference between the purchase price and the face value at maturity. You can invest in zero coupon bonds with maturity dates timed to your needs. To fund a four-year college education, you could invest in a laddered portfolio of four zeros, each maturing in one of the four consecutive years the payments will be due. The value of zero coupon bonds is more sensitive to changes in interest rates however, so there is some risk if you need to sell them before their maturity date. It is also best to buy taxable (as opposed to municipal) zeros in a tax-deferred retirement or college savings account because the interest that accumulates on the bond is taxable each year even though you do not receive it until maturity. A bullet strategy can also help you invest for a defined future date. If you are 50 years old and you want to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way may help you benefit from different interest rate cycles.
Reasons You Might Sell a Bond Before Maturity
Investors following a buy-and-hold strategy can encounter circumstances that might compel them to sell a bond prior to maturity for the following reasons:
1. They need the principal. While buy-and-hold is generally best used as a longerterm strategy, life does not always work out as planned. When you sell a bond before maturity, you may get more or less than you paid for it. If interest rates have risen since the bond was purchased, its value will have declined. If rates have declined, the bond’s value will have increased. 2. They want to realize a capital gain. If rates have declined and a bond has appreciated in value, the investor may decide that it’s better to sell before maturity and take the gain rather than continue to collect the interest. This decision should be made carefully, as the proceeds of the transaction may have to be reinvested at lower interest rates. 3. They need to realize a loss for tax purposes. Selling an investment at a loss can be a strategy for offsetting the tax impact of investment gains. Bond swapping can help achieve a tax goal without changing the basic profile of your portfolio. 4. They have achieved their return objective. Some investors invest in bonds with the objective of total return, or income plus capital appreciation or growth. Achieving capital appreciation requires an investor to sell an investment for more than its purchase price when the market presents the opportunity.
Using bonds to invest for total return, or a combination of capital appreciation (growth) and income, requires a more active trading strategy and a view on the direction of the economy and interest rates. Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather than holding the bond to maturity. Bond prices fall when interest rates are rising, usually as the economy accelerates. They typically rise when interest rates fall, usually when the Federal Reserve is trying to stimulate economic growth after a recession. Within different sectors of the bond market, differences in supply and demand can create short-term trading opportunities. For some ideas, read the content articles under “Profiting from Market Signals” and “Which Trade?”—in Learn More-Strategies Section. Various futures, options and derivatives can also be used to implement different market views or to hedge the risk in different bond investments. Investors should take care to understand the cost and risks of these strategies before committing funds. Some bond funds have total return as their investment objective, offering investors the opportunity to benefit from bond market movements while leaving the day-to-day investment decisions to professional portfolio managers.
Total Return Strategies Using Callable Securities
Many investors use callable securities within a total return strategy—with a focus on capital gains as well as income—as opposed to a buy and hold strategy focused on income and preservation of principal. Owners of callable securities are expressing the implicit view that yields will remain relatively stable, enabling the investor to capture the yield spread over noncallable securities of similar duration. They must also have views on the likely range of rates over the investment period and the market’s perception of future rate uncertainty at the horizon date for reasons explained in Risks of Investing in Callable Securities. If an investor has the view that rates may well be volatile in either direction over the near term but are likely to remain in a definable range over the next year, an investment in callable securities can significantly enhance returns. Premium callables may be used when the bullish investor believes that rates are unlikely to fall very far. Discount callables are a better choice when the investor believes volatility will be low but prefers more protection in an environment of rising interest rates.
Tax Advantaged Investing
If you are in a high tax bracket, you may want to reduce your taxable interest income to keep more of what you earn. The interest on U.S. government securities is taxable at the federal level, but exempt at the state and local level, making these investments attractive to people who live in high tax states. Municipal securities offer interest that is exempt from federal income tax, and, in some cases, state and local tax as well. Because of variables in supply and demand, tax-exempt yields in
the municipal market can sometimes be quite attractive when compared to their taxable equivalents (see the 2010 Tax Year Tax-Exempt/Taxable Yield Equivalents). Ladders, barbells and bullets can all be implemented with municipal securities for a taxadvantaged approach best achieved outside of a qualified, tax-deferred retirement or college savings account. Buying municipals in a tax-deferred account is like wearing a belt and suspenders. Bond swapping is another way to achieve a tax-related goal for investors who are holding a bond that has declined in value since purchase but have taxable capital gains from other investments. The investor sells the original bond at a loss, which can be used to offset the taxable capital gain or up to $3,000 in ordinary income. He or she then purchases another bond with maturity, price and coupon similar to the one sold, thus reestablishing the position. To comply with the IRS “wash sale” rule, which does not recognize a tax loss generated from the sale and repurchase within 30 days of the same or substantially identical security, investors should choose a bond from a different issuer.
Diversifying Risk by Investing in Bond Funds
Investors who want to achieve automatic diversification of their bond investments for less than it would cost to construct a portfolio of individual bonds can consider investing in bond mutual funds, unit investment trusts or exchange-traded funds. These vehicles each have specific investment objectives and characteristics to match individual needs. To learn more, see Bonds and Bond Funds.
Swapping for Other Objectives
A tax loss is not the only reason to swap a bond. Investors can also swap to improve credit quality, increase yield or improve call protection. Remember to factor the sell and buy transaction costs into your estimations of return. For more information, see Bond Swapping.
Where to Hold Your Bond Investments: Taxable or TaxDeferred Accounts?
In a taxable investment account, your capital gains and investment income are subject to taxation in the year they are earned. In a qualified tax-deferred account such as an IRA or some college savings account, income and capital gains are not taxed until you start taking withdrawals, presumably at a future date. Bonds and bond funds can be held in either type of account, but some investors will have a reason to choose one account type over the other. Municipal investments, for example, are best held in a taxable account, where they can serve to reduce the taxable returns. Taxable zero coupon bonds are best held in a tax-deferred account because their annual interest credits are taxable when earned, even though the investor does not actually receive them until the bond matures.
Since the maximum tax on capital gains was reduced to 15% in 2003, total return investors in a high income tax bracket may find advantages to holding their bonds in a taxable account. Others may prefer to invest for maximum income in their tax deferred accounts. The best solution depends on your individual circumstances and tax situation. Your tax or investment advisor can help you analyze the alternatives and reach the best solution.
How Much of Your Portfolio Should Be in Bonds?
The answer to this question depends on that asset allocation that is right for you, your goals, your age and your appetite for risk.
Asset allocation describes the percentage of total assets invested in different investment categories, also known as asset classes. The most common broad financial asset classes are stocks (or equity), bonds (fixed income) and cash. Real estate, precious metals and “alternative investments” such as hedge funds and commodities can also be viewed as asset classes. Each broad asset class has various subclasses with different risk and return profiles. In general, the more return an asset class has historically delivered, the more risk that its value could fall as well as rise because of greater price volatility. To earn higher potential returns, investors have to take higher risk. Asset classes differ by the level of potential returns they have historically generated and the types of risk they carry. Virtually all investments involve some type of risk that you might lose money. Asset subclasses of stocks include:
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Large cap stocks stocks of large, well established and usually well known companies Small cap stocks stocks of smaller, less well known companies International stocks stocks of foreign companies
Large cap, small cap and international stocks can in turn be considered:
Value stocks whose prices are below their true value for temporary reasons Growth stocks of companies that are growing at a rapid rate.
Asset subclasses of bonds include:
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Different maturities long-term (10 years or longer), intermediate-term (3-10 year) or short-term (3 years or less) Different issuers government and agencies, corporate, municipal, international Different types of bonds callable bonds, zero-coupon bonds, inflationprotected bonds, high-yield bonds, etc.
Stocks are generally considered a risky investment because, among other things, their values can decline if the stock market goes down (market risk) or the issuing company does poorly (company risk). As owners of the company, stockholders are paid after all creditors, including bond holders, are paid. In theory at least, a stock’s value can go to zero. Historically, stock prices have been the most volatile of all the different types of investments, meaning their prices can move up and down quickly, frequently and not always in a predictable way. Bonds are considered less risky than stocks because bond prices have historically been more stable and because bond issuers promise to repay the debt to the bondholders at maturity. That promise is generally kept unless the issuer falls on hard times; some bonds have credit risk based on the financial health of their issuer. When a bond issuer goes into bankruptcy, bondholders are paid off before stockholders. Bonds are also vulnerable to interest rate risk: when interest rates rise, bond prices fall and vice versa. Cash investments carry opportunity risk. For example, investing in very safe, short-term investments like Treasury bills may protect you from loss, but you may miss the opportunity of more generous returns offered by other investments. Even people who keep their money under their mattress have the risk that their money will be worth less in the future because of inflation that reduces the purchasing power of the cash.
Smart investors do not put all their assets in one type of investment or “asset class.” Instead, they spread or diversify their risk by investing in different types of investments. When one asset class is performing poorly, another may be doing well and compensating for the poor performance in the other. Some studies have shown that overall asset allocation is more important to investment success than the choice of investments within the allocation.
“Model” Asset Allocations
Investment firms often publish recommended asset allocations based on their outlook for the relative performance of the stock, bond and money markets. Personal finance Web sites and different types of investment advisers sometimes offer standard asset allocation recommendations for people of different age ranges or risk tolerance. The asset allocation that is right for you, however, depends on several personal factors, such as life and financial goals, and will change over time with different life events.
Personalize, review, revise as needed
Once you establish your optimal asset allocation which takes into account return objectives, risk tolerance and time horizon, you need to review your investments regularly to see if your portfolio matches your plan and if your plan is still right for your age and goals. When one asset class performs well or poorly, it can shift your asset allocation. You can bring it back in line by “rebalancing” or selling assets that have appreciated and buying those that have fallen in price. In this way, asset allocation enforces a good discipline of selling high and buying low. Younger investors may want to allocate their longer-term retirement assets to riskier investments such as equities or stock, because they have time to ride out the market’s ups and downs. With age, however, asset allocations may shift toward safer investments such as bonds because retirement is getting closer and older investors should be more concerned about keeping what they have saved and gained. Take time every six months to a year or two to be sure your asset allocation matches your plan and that your plan remains appropriate for your age and goals. If not, you may want to take the steps to make sure your plan is appropriate for your age and goals and balance your asset allocation to match your plan. Your investment advisor can help with this process.
Techniques to lower your taxes and improve the quality of your portfolio
What is a Bond Swap?
A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for swapping because it is often easy to find two bonds with similar features in terms of credit quality, coupon, maturity and price. In a bond swap, you sell one fixed-income holding for another in order to take advantage of current market and/or tax conditions and better meet your current investment objectives or adjust to a change in your investment status. A wide variety of swaps are generally available to help you meet your specific portfolio goals.
Why You Would Consider Swapping
Swapping can be a very effective investment tool to:
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increase the quality of your portfolio; increase your total return; benefit from interest rate changes; and lower your taxes.
These are just a few reasons why you might find swapping your bond holdings beneficial. Although this booklet contains general information regarding federal tax consequences of swapping, we suggest you consult your own tax advisor for more specific advice regarding your individual tax situation.
Swapping for Quality
A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an issuer’s financial health. It is one of the factors in the market’s determination of the yield of a particular security. The spread between the yields of bonds with different credit quality generally narrows when the economy is improving and widens when the economy weakens. So, for example, if you expect a recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of income. Standard rating agencies classify most issuers’ likelihood of repayment of principal and payment of interest according to a grading system ranging from, say, triple-A to C (or an equivalent scale), as a quality guideline for investors. Issuers considered to carry good likelihood of payment are
“investment grade” and are rated Baa3 or higher by Moody’s Investors Service or BBB- or higher by Standard & Poor’s Ratings Services and Fitch Ratings. Those issuers rated below Baa3 or below BBB- are considered “below investment grade” and the repayment of principal and payment of interest are less certain. Suppose you own a corporate bond rated BBB (lower-investment-grade quality) that is yielding 7.00% and you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding 6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30 basis points (one basis point is 1/100th of one percent, or .01%). Moreover, during an economic downturn, higher-quality bonds, which represent greater certainty of repayment in difficult market conditions, will typically hold their value better than lower-quality bonds. Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your personal risk parameters. You may be willing to sacrifice some current income and/or yield in exchange for enhanced quality.
Swapping to Increase Yield
You can sometimes improve the taxable or tax-exempt returns on your portfolio by employing a number of different bond-swapping strategies. In general, longer-maturity bonds will typically yield more than those of a shorter maturity will; therefore, extending the average maturity of a portfolio’s holdings can boost yield. The relationship between yields on different types of securities, ranging from three months to 30 years, can be plotted on a graph known as the yield curve. The curve of that line is constantly changing, but you can often pick up yield by extending the maturity of your investments, assuming the yield curve is sloping upward. For example, you could sell a two-year bond that’s yielding 5.50% and purchase a 15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-maturity bonds might fluctuate more widely than that of short-term bonds when interest rates change. When the difference in yield between two bonds of different credit quality has widened, a cautious swap to a lower-quality bond could possibly enhance returns. But sometimes market fluctuations create opportunities by causing temporary price discrepancies between bonds of equal ratings. For example, the bonds of corporate issuers may retain the same credit rating even though their business prospects are varying due to transient factors such as a specific industry decline, a perception of increased risk or deteriorating credit in the sector or company. So, suppose you purchased in the past (at par) a 30-year A-rated $50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now being offered with a 6.50% coupon. Assume that you can replace your bond with another $50,000 A-rated corporate bond having the same maturity with a 6.50% coupon. By selling the first bond and buying the second bond you will have increased your annual income by 25 basis points ($125). Discrepancies in yield among issuers with similar credit ratings often reflect perceived risk in the marketplace. These discrepancies will change as market conditions and perceptions change.
Swapping for Increased Call Protection
Swaps may achieve other investment objectives, such as building a more diversified portfolio, or establishing better call protection. Call protection is useful for reducing the risk of reinvestment at
lower rates, which may occur if an issuer retires, calls or pre-refunds its bonds early. Call protection swaps are particularly advantageous in a declining interest rate environment. For example, you could sell a bond with a short call, e.g., five years, and purchase a bond with 10 years of call protection. This will enable you to lock in your coupon for an additional five years and not worry about losing your higher-coupon bonds in the near future. You may have to sacrifice yield in exchange for the stronger call protection.
Anticipating Interest Rates
If you believe that the overall level of interest rates is likely to change, you may choose to make a swap designed to benefit or help you protect your holdings. If you believe that rates are likely to decline, it may be appropriate to extend the maturity of your holdings and increase your call protection. You will be reducing reinvestment risk of principal and positioning for potential appreciation as interest rates trend down. Conversely, if you think rates may increase, you might decide to reduce the average maturity of holdings in your portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less in value, but may also result in a lower yield. It should be noted that various types of bonds perform differently as interest rates rise or fall, and may be selectively swapped to optimize performance. Long-term, zero-coupon2 and discount bonds3 perform best during interest rate declines because their prices are more sensitive to interest rate changes. Floating-rate, short- and intermediate-term, callable and premium bonds4 perform best when interest rates are rising because they limit the downside price volatility involved in a rising yield environment; their price fluctuates less on a percentage basis than a par or discount bond. However, you should remember that rate-anticipation swaps tend to be somewhat speculative, and depend entirely on the outcome of the expected rate change. Moreover, shorter- and longer-term rates do not necessarily move in a parallel fashion. Different economic conditions can impact various parts of the yield curve differently. To the extent that the anticipated rate change does not come about, a decline in market value could occur.
Swapping to Lower Your Taxes
Tax swapping is the most common of all swaps. Anyone who owns bonds that are selling below their amortized purchase price and who has capital gains or other income that could be partially, or fully, offset by a tax loss can benefit from tax swapping. You may have realized capital gains from the sale of a profitable capital asset (e.g., real estate, your business, stocks or other securities). Or you may expect to sell such an asset at a potential profit in the near future. By swapping those assets that are currently trading below the purchase price (due to a rise in interest rates, deteriorating credit situation, etc.) you can reduce or eliminate the capital gains you would otherwise have paid on your other profitable transactions in the current tax year.
The traditional tax swap involves two steps: (1) selling a bond that is worth less than you paid for it and (2) simultaneously purchasing a bond with similar, but not identical, characteristics. For example, assume you own a $50,000, 20-year, triple-A-rated municipal bond with a 5.00% coupon that you purchased five years ago at par. If interest rates increase (such that new bonds are now being issued with a 5.50% coupon), the value of your bond will fall to approximately $47,500. If you sell the bond, you will realize a $2,500 capital loss, which you can use to offset any capital gains you have realized. If you have no capital gains, you can use the capital loss to offset ordinary income. You then purchase in the secondary market a replacement triple-A-rated 5.00% municipal bond (from a different issuer), maturing in 15 years, at an approximate cost of $47,500. Your yield, maturity and quality of bond will be the same as before, plus you will have realized a loss that will save you money on taxes in the year of the bond sale. Of course, if you hold the new bond to maturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at that time. By swapping, you have converted a “paper” loss into a real loss that can be used to offset taxable gain.
Some Important Rules for Tax Swapping
Under current tax law, the maximum tax rate on long-term capital gains is lower than the maximum rate on short-term capital gains. In order to be entitled to the lower long-term capital gains rate, a taxpayer must hold the asset for more than one year. Because of ongoing discussions concerning possible changes in the tax treatment of capital gains, investors should consult their tax advisor for up-to-date advice. Capital losses from swap transactions are reflected on Schedule D of your tax return. If you have short-term or long-term capital gains, the losses from the swap transactions will offset these gains first—long-term losses will offset long-term gains, and short-term losses will offset short-term gains; net losses in either category will then offset gains in the other category. If the net result is an overall capital loss, the excess loss can be used to offset ordinary income dollar-for-dollar (up to a maximum of $3,000). If an investor has both net short-term and net long-term capital losses, the ordinary income is first offset by the short-term capital losses, then by the long-term losses. Excess capital losses can be carried forward indefinitely to reduce capital gains liability and ordinary income in future years. The tax basis of the new bonds will be their cost (the price paid for the bonds). If the new bonds are bought at a discount and held to maturity, or are sold at a price higher than their cost, a taxable gain will often result, unless also offset by losses. To the extent such gain represents accrued market discount, it will be taxed as ordinary income, with the balance treated as capital gain. Ask your tax advisor about the use of original-issue discount or market discount bonds, or the use of bonds issued at a premium, in tax swaps.
Other Tax Strategies
Changes in the tax laws always present an opportunity to review your bond holdings. Investors who expect their tax rate to increase will frequently swap taxable bonds for tax-exempt (municipal) bonds. This is done with the expectation that tax-exempt bonds will become relatively
more desirable in the marketplace than fully taxable bonds and will benefit from price appreciation. Investors not subject to the Alternative Minimum Tax (AMT) can obtain additional yield by purchasing municipals that are subject to that tax. Taxpayers who are subject to AMT can save taxes by swapping to non-AMT bonds.
How to Avoid a Wash Sale
The Internal Revenue Service will not recognize a tax loss generated from the sale and repurchase within 30 days before or after the trade or settlement date of the same or a substantially identical security—typically called a “wash sale.” While the term “substantially identical” has not been explicitly defined in this context, two bonds have generally not been considered substantially identical if (1) the securities have different issuers, or (2) there are substantial differences in either maturity or coupon rate.
For a Personal Appraisal
To learn more about what bond swapping may mean to you, consider your objectives and discuss them your financial consultant.
Swap Objectives and General Information
1. 2. 3. 4. 5. 6. 7. 8. Do you wish to establish a tax loss or realize a gain? Do you wish to improve quality? Do you wish to increase yield? Do you wish to increase call protection? Is there a change in your tax status? What is your tax bracket? What type of bond are you swapping? Do have any other specific investment parameters?
To accomplish any of these objectives are you willing to...
1. Extend maturity? _____Yes _____No 2. Adjust credit ratings? _____Yes _____No 3. Invest additional funds? _____Yes _____No
Bonds for Review Face Issuer and Coupo Maturity Purchase Date of CUSIP
1. All examples are for illustrative purposes and are not representative of actual market yields. 2. A zero-coupon bond is a bond for which no periodic interest payments are made. The investor receives one payment at maturity equal to the principal invested plus interest earned compounded semiannually at the original interest rate to maturity. 3. A discount bond is a bond sold at less than par. 4. A premium bond is a bond priced greater than par.
Putting Compound Interest to Work
With Zero Coupon Bonds
In chemistry, a compound substance refers to a combination of two or more elements that cannot be separated. In math, a compound fraction means a fraction that has a numerator, a denominator, or both that contain fractions. In finance, compound interest means you’re likely to achieve your financial goals sooner. The earlier you begin a regular investment program, the earlier compounding interest can go to work for you. As with most fixed-income securities, zero coupon bonds offer investors a high degree of safety when held to maturity and the opportunity to earn compound interest over the life of the bond. In addition, if you purchase a zero coupon bond issued by a state or local government entity, the interest compounds free of federal taxes, and in most cases, state and local taxes, too. With conventional bonds, the investor pays the face amount of the bond and receives interest payments every six months based on the coupon, or interest rate, offered when the bond is sold. When the bond matures, the investor then is reimbursed the full principal amount invested. When purchasing a conventional bond, you invest an amount equal to the face value of the security. As long as you own the bond, you receive regular interest payments and recoup the initial investment when the bond matures. A zero coupon bond, on the other hand, is sold at a discount from its face value and the issuer makes no interest payments during the life of the security. When it matures, you receive the full face amount which equals your initial investment plus accumulated interest compounded over the life of the bond. (The examples cited refer to issues sold in primary market offerings.) For example, an investor could purchase a 20-year municipal zero coupon bond with a face amount of $20,000 for approximately $6,757. When the bond matures, the investor receives the full, face amount, $20,000. The $13,243 difference is attributable to the accumulated compounded interest, in this case calculated on the basis of a 5.5% rate of return. Because the bonds are sold at a discount to their face value, the investor also benefits from having a lower upfront amount to invest, an advantage for those who are just starting out or have more modest amounts to invest. Zero coupon bonds were introduced to the fixed-income market in mid-1982. Today, the three largest categories of zero coupon securities are offered by the U.S. Treasury, corporations, and state and local government entities. As with all bond issues, zero coupons issued by the Treasury are generally considered the safest because they are backed by the full faith and credit of the U.S. government. Municipal zeros also offer a high degree of safety, and, because the interest earned is usually tax-free, can generate higher returns when calculated on a taxable equivalent basis.
For example, an investor filing a joint return in the 27.5% tax bracket would have to purchase a zero coupon bond at 7.59% to equal the tax-exempt municipal yield of 5.5%. The savings add up further if the municipal zero coupon bond is issued by an entity in the investor’s own state. Corporate zeros offer a potentially higher degree of risk, depending on the financial strength of the issuing corporation, but they also offer the opportunity to achieve a higher return. A zero coupon bond issued by a corporation or the U.S. Treasury is also taxable, unlike those offered by a municipal issuer. Even though you do not receive your interest payments in cash while you hold the bonds, you must pay income taxes each year on the interest as if you had. For that reason, you may want to purchase a taxable zero coupon bond for your Individual Retirement Account (IRA) or other tax-sheltered retirement account, such as a 401(k) plan. Zero coupon bonds enable investors to tailor their purchases according to their own time horizons. For instance, there are zeros with maturities ranging from one to 40 years, with the majority between 8 and 20 years. So, if you’re investing for a specific objective, such as retirement, or the start of college tuition, zero coupon bonds provide you with the ability to time the maturities to when you need the money. There are also different types and grades of bonds and, as with all bonds, credit quality is a factor. Most corporate and municipal zero coupon bonds are rated by the major rating agencies, Moody’s Investors Service, Standard & Poor’s, Fitch IBCA, and Duff & Phelps. The benefits of compound interest, which zero coupon bonds provide, may be the way you can get started toward meeting your financial goals.
Best Trades for Macro Views
How do you choose the best trade for implementing a given macroeconomic view, such as a change in the rate of economic growth, inflation or expectations about Federal Reserve policy? The Global Fixed Income and Foreign Exchange Strategy team at JPMorgan Securities ranked dozens of trades across liquid asset classes by their sensitivity to macro forces and discovered the best tactical trades are often the simplest ones.
Best trades for views on growth, inflation, Fed
For all implementing views on growth, inflation or Fed expectations, five instruments proved to be generating the highest risk-adjusted returns:
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Eurodollar futures Two-year U.S. Treasury Notes 5s/30s curve Swap spreads Commodity futures
The trades tested were buys (or a steepener in the case of the curve trade) when growth expectations fall, inflation expectations fall, and the Fed is expected to lower rates and sells (or flattener on the curve trade) when the consensus expectations were an increase in each area.
Best trades for views on growth, inflation, Fed
For investors with a view on growth, the best trades were two-year U.S. Treasury notes, Eurodollar futures, the U.S. 5s/30s curve, EUR/USD, USD/CHF, swap spreads, BBB credit, EMBI, S&P vs. U.S. Treasuries and industrial metals. Cross-market government spread trades, outright equity positions and precious metals were less efficient for trading on growth expectations. For investors with a view on inflation, the best trades were swap spreads, two-year U.S. Treasury notes, Eurodollar futures, 10-year U.S. Treasury notes, S&P outright, industrial metals and energy futures. Credit, S&P vs. U.S. Treasuries, cross-market government spreads and foreign exchange were less efficient means of positioning. For investors with a view on Fed policy, the best trades are two-year U.S. Treasury notes, Eurodollar futures, the U.S. 5s/30s curve, swap spreads, the 10-year U.S. Treasury note and industrial metals. Equities, credit and foreign exchange are comparatively worse markets in which to position. Consult your financial advisor if you want to discuss ideas like this further.
Trading on Market Signals
How do investors translate market signals into successful trades? The Global Fixed Income and Foreign Exchange Strategy team at JPMorgan Securities identified seven bond market signals in four market-driving categories, tested their theories and combined the signals into a composite bull/bear index on the market known as the Bond Barometer. Following are the seven signals by category and the trades they were tested on:
Two fundamental forces drive bond yields: growth and inflation. If you understand that bond prices are present values of future cash flows, then you know that forecasts of future growth and inflation are more important than historical data reports on what has already occurred. Signal one: Market consensus for year-ahead GDP growth, as measured monthly in the Blue Chip survey of 50 professional forecasters. Signal two: Market consensus for year-ahead inflation, as measured monthly in the Blue Chip survey of 50 professional forecasters. Trade: Buy the 10-year US Treasury note when the consensus lowers its estimate of year-ahead growth and inflation, suggesting interest rates will go down and bond prices will go up. Sell the 10-year Treasury note when the consensus raises its estimate of year-ahead growth and inflation, suggesting rates will rise and prices will fall. Hold for one month until next consensus figures are released. Roll trade if consensus moves in same direction; reverse if consensus turns; close if consensus in unchanged.
Presuming that asset prices fluctuate around a stable, long-term equilibrium, extreme deviations serve as lead indicators of trend reversals. Signal three: Real (inflation-adjusted) yields. Trade: Buy the 10-year US Treasury note when real yields are more than one standard deviation above the long-term moving average sell when they are more than one standard deviation below. Hold the position until real yields cross the opposite threshold. Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield. Trade: Buy bonds when the ratio is more than half a standard deviation below its long-run moving average (bonds are cheap relative to stocks) sell when it’s more than half a standard deviation above its long-run moving average (stocks are cheap relative to bonds).
Category: Risk appetite
Risk appetite refers to investors’ relative preference for safe and risky assets, prompted by business cycle fluctuations, policy developments or exogenous events. Signal five: JP Morgan Credit Appetite Index, where zero represents minimum appetite (widest spreads, positive for U.S. government bonds) and 100 represents maximum appetite (tightest spreads, negative for U.S. government bonds). Trade: Sell U.S. government bonds when credit appetite is high, as signaled by the CAI being more than one standard deviation above its 50-day moving average, and buy when it is low, or more than one standard deviation below its 50-day moving average.
Technical indicators trace market patterns in price and volume. Signal six: Price data. Trade: Buy when the short-term moving average of prices crosses the long-term average from below sell when it crosses from above. In this momentum measure, the strongest returns were generated when short-term was 10 days and long-term was 20 days. Signal seven: Flow data, defined as net purchases of U.S. bond market mutual funds, as an indicator of cash flow into the bond market Trade: Buy the 10-year Treasury when the flow indicator is more than one standard deviation above the long-term moving average sell when it’s more than one standard deviation below. JP Morgan’s testing of their Bond Barometer showed that trading rules offer no holy grail, but they can exploit systematic relationships in the market. In addition, diversification pays no single indicator works at all times or in all trading environments. In the absence of foresight, a diversified strategy that combines different information sources (fundamentals, value, risk appetite and technicals), trading strategies (momentum and contrarian) and holding periods (daily, weekly and monthly) far outperforms narrower approaches over the longer term. Consult your financial advisor if you want to discuss this information further.
Bond and Bond Funds
What You Should Know Before Deciding
When you invest in a bond, you buy the debt of its issuer, which might be the U.S. government or an affiliated entity, a state or city government or borrowing authority, or a corporation. Every bond has certain characteristics:
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A definite maturity date when the bond issuer promises to repay the bondholder who owns the security at the time. A promise to pay taxable or tax-exempt interest at a stated “coupon” rate in defined intervals over the life of a bond. A yield, or return on investment, which is a function of the bond’s coupon rate and the price the investor pays, which may be more or less than the bond’s face value depending on a variety of factors. A credit rating indicates the likelihood that the issuer will be able to repay its debt.
Risks of Bond Investing
While generally considered safer and more stable than stocks, bonds have certain risks:
Interest rate risk: when interest rates rise, bond prices fall. If you need money and have to sell your bond before maturity in a higher rate environment, you will probably get less than you paid for it. Interest rate risk declines as the maturity date gets closer. Credit risk: if the issuer runs into financial difficulty or declares bankruptcy, it could default on its obligation to pay the bondholders. Liquidity risk: if the bond issuer’s credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer. Bonds are generally more liquid during the initial period after issuance as that is when the largest volume of trading in that bond generally occurs. Call risk or reinvestment risk: If a bond is callable, the issuer can redeem it prior to maturity, on defined dates for defined prices. Bonds are usually called when interest rates are falling, leaving the investor to reinvest the proceeds at lower rates.
Diversifying Risk by Building a Portfolio
Bond investors can diversify risk by purchasing bonds from different issuers with different maturities. Treasury securities are available in $1,000 increments, but the minimum purchase for municipal and corporate bonds can be $5,000 or more. The cost of buying a bond includes a commission or a
“markup” on the price, depending on whether you are buying from a firm acting as an agent who is getting the bond from someone else, or as principal, meaning the firm owns the bond it is selling. Executing an effective diversification strategy requires a significant minimum investment to start. While there is no absolute requirement, a rule of thumb says it often takes at least $10,000 or more to build a fully diversified bond portfolio.
Bond Funds: Convenient, Affordable way to Invest in a Diversified Portfolio of Bonds—With some Differences
Bond funds—including mutual funds (open-end and closed-end, actively managed and indexed), exchange-traded funds and unit investment trusts—offer a convenient and affordable way to invest in a diversified portfolio of bonds, but a bond fund investment can differ from a bond investment in ways that are important to understand. When you buy a bond fund, you buy shares in a portfolio of bonds that is created or managed to pursue a specific investment objective such as current income, current tax-exempt income, total return, or to match the performance of a market index. The portfolio might invest in a particular type of bond (government, municipal, mortgage or high-yield) or a particular maturity range (short-term: three years or less; intermediate term: three to 10 years; or long-term: usually 10 years or longer). Many bond funds make monthly or quarterly “dividend” payments, as opposed to the semiannual payment schedule common to most bonds. Their price is based on their Net Asset Value (NAV), or the total market value of the portfolio divided by the total number of fund shares outstanding. A fund’s NAV changes daily with market conditions and in some cases with cash inflows and outflows to and from the fund portfolio.
Types of bond funds
Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds. For more details, see the comparison table.
Actively managed bond funds, as their names suggest, have managers who buy and sell bonds in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital gain, or at a loss if they need cash to pay shareholders who want to sell their shares. Index bond funds are not actively managed but constructed to match the composition of a given bond index, such as the Lehman 10-year Bond Index. When the index changes, the portfolio changes automatically. Sponsors of open-end bond funds (usually a mutual fund company) offer new shares and redeem existing shares continuously, requiring their managers to invest cash coming into the fund and liquidate positions when they need cash to meet redemptions. Investors in open end funds have the choice to collect their interest income and capital gains or reinvest them automatically in new funds shares.
Closed-end bond funds have a fixed number of shares that trade on exchanges similar to stocks at a price that may be above or below net asset value depending on supply and demand. Closed-end bond funds can be indexed or actively managed. To buy or sell shares in a closed end fund, you have to go through a broker and pay a commission. Exchange traded funds (ETFs) represent shares in a “basket” of bonds that mirrors an index, but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold through brokers who charge commissions. Unit investment trusts are a portfolio of bonds held in a trust that sells a fixed number of shares. On the trusts’ maturity date, the portfolio is liquidated and the proceeds returned to unit holders on a pro rata basis. UITs are usually created by brokerage firms that maintain a limited secondary market for the units. Unit holders who want to sell before maturity may have to accept less than they paid.
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