Archive for Monday, January 28, 2002

Advice on investing in bond market

Bonds can help investors diversify portfolios

January 28, 2002


Uncle Sam's decision to issue war bonds to help cover the cost of the fight against terrorism has piqued public interest in bonds that flagged in the face of a hard-charging stock market during the 1990s.

The new Patriot Bonds, which the Treasury started selling in December, are really the old Series EE bonds flying under a new name and design.

Bonds were a good bet when the stock market tanked in 2000, when bond mutual funds that buy medium-term Treasuries returned better than 12 percent to savvy investors, according to data trackers with Lipper Analytics.

For those who last paid attention to bonds when their grandparents sent that $25 savings bond on birthdays and Christmas, some timely reminders:

A bond is a loan you make for a specified period of time to the government or a business. In return for using your money, the borrower agrees to pay interest and to pay back the original amount when the loan comes due at the bond's maturity.

With a bond you get no ownership stake, but with a stock you do. However, stocks don't promise to pay you a dividend or that you'll get your investment back.

Many investors considered bonds boring during the '90s bull stock market, but bonds aren't entirely without risk. Here's what to weigh if you're thinking about buying Patriot Bonds or investing in the broader bond market:

Here is a glossary of bond terms:Bond: A debt instrument in which the issuer promises to pay to the bondholder principal and interest according to the terms and conditions of the bond.Bond ladder: A portfolio of bonds that have staggered maturities. This enables the investor to diversify in terms of default risk and reinvestment risk.Corporate bond: Corporate bonds represent debt of corporations. The bonds are fully taxable, and they typically pay interest twice a year. Corporate bonds are very safe when issued by strong companies.High yield bonds or junk bonds: Corporate bonds that are rated below investment grade by the major rating services.These bonds pay much higher interest than investment grade bonds, but there is usually a substantial risk of default.

Q: Why invest in bonds?

A: Bonds offer a steady stream of income for older investors and let younger investors diversify their holdings and protect against wild market swings.

Bernstein Investment Research and Management found that a "fully diversified portfolio" of 55 percent stocks, 35 percent bonds and 10 percent real-estate investment trusts would have returned 13.7 percent a year from 1981 through 2000, compared with 15.7 percent for all stocks. However, the diversified portfolio cut market swings by a third.

Q: Don't stocks outperform bonds?

A: Not always. Stock and bond returns were essentially the same until World War II. Only later did stocks start outperforming bonds long-term.

Short-term, stocks can lose big time. The 1987 crash wiped out 22.6 percent of stock market worth in one day. Patient investors who could afford not to sell were rewarded when stocks returned to their pre-crash level 18 months later, but in 10 of 11 years since 1950 that saw stocks decline, the bond market made money.

Bonds aren't sure moneymakers, however: The two big dangers are that:

Inflation will overtake a bond's interest rate, a worry that got the Treasury to issue one series of bonds indexed to inflation that pay interest that rises when price rises.

You'll hold bonds issued at today's low interest rates when the economy rebounds and interest rates rise again. Higher rates depress bond prices, but low interest rates push up bond prices.

If you hold a bond until it matures, however, you get all your interest and principal back, assuming the issuer is still in business. With bond mutual funds, like stock mutual funds, the value fluctuates depending on the price of the bonds held.

Q: What kind of bonds are there?

A: U.S. investors generally have a choice among four common types of bonds based on the issuing entity.

The federal government issues Treasury bonds, bills and notes to finance everything from the military to Medicaid that are backed by the "full faith and credit" of the U.S. government in other words, the U.S. taxpayer. That makes Treasuries the safest investment there is, and investors worldwide flock to them in times of uncertainty or upheaval. Another benefit: They're exempt from state and local income tax, and federal taxes can be deferred until the bond is cashed in.

State and local governments issue bonds to pay for highways, schools and hospitals. They usually pay less interest than other bonds, but they're exempt from federal and sometimes state and local income tax.

Mortgage-backed bonds are issued by Fannie Mae, Ginnie Mae (Government National Mortgage Assn.) and Freddie Mac (Federal Home Loan Mortgage Corp.). These bonds pay taxable interest monthly.

Corporations issue bonds that pay taxable interest at rates that vary according to the company's creditworthiness, as rated by Standard & Poor's and Moody's. High-grade bonds pay lower interest rates, and so-called "junk" bonds pay higher yields because they carry higher risks. Also, corporate bond interest is subject to federal, state and local tax.

Q: How long do I have to hold a bond?

A: Bonds come in all different maturities, whether they're public or private, so shop around to see what fits your need. A longer-term bond generally pays more interest. A short- to medium-term bond pays less interest, but it may be preferable if you need the money in the next few years.

Treasuries come in a range of maturities. EE or Patriot Bonds mature in 30 years and earn 4.07 percent interest through April, with the interest rate subject to adjustment every six months for the life of the bond. Other Treasury bonds have maturities of less than 30 years, and Treasury bills have the shortest maturity, at 13 and 26 weeks or a year.

Q: Are Patriot Bonds war bonds?

A: No and yes. No because the money from selling Patriot bonds in $50 to $10,000 denominations isn't earmarked for the war on terrorism but will help defray its cost. Yes, because they're the latest in a long line of bonds that include war bonds.

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