Investment Tips: Short Term Bonds

Here's essential information to help you evaluate whether an investment in short term bonds makes sense for you, written for the novice bond investor.

Bonds don't get much press, especially compared with stocks, so they are often overlooked as an investment alternative. Yet they have some characteristics that make them a smarter buy than stocks in some situations.

The correct situation will usually be one where safety and predictability are primary concerns. Whereas, stocks have the reputation of being a high-yield investment vehicle, bonds, especially short term bonds, have a limited potential for profits. The shorter the term, the lesser the interest rate that is usually paid. So short term bonds (those with terms up to five or ten years) have the most disadvantage that must be outweighed by other considerations.

If you are investing for a specific objective--to fund your child's college education in five years, say, or to buy a new house when your lease expires--a stock investment could cause you to miss your goal in a number of different ways. If the economy looks rosy when you invest and then runs into problems, your stocks could under perform your expectations, or even end up losing you money. Despite the stock market's average rate of return of over 10% over the last 80 years, there have been several 10-year stretches when stocks have yielded a negative return, and many more negative 5-year stretches. So, even a well diversified portfolio of stocks carries this risk.

A less diversified portfolio carries the additional risk that the sectors that your stocks represent, or the stocks themselves, will under perform the stock market as a whole. This can drag down the return on your investment.

A third risk is the stock market's vulnerability to sudden fluctuations. Your investment could be performing well, but then just before you plan to sell a sudden shock causes your stocks to plummet. This could be a terrorist attack, an industry-wide accounting scandal, or an unexpected reading from one of the various barometers of economic health that causes a shift the consensus view of the economy's stability.

Lastly, a company whose stock you own might declare bankruptcy, in which case you stand to lose everything you invested in the company.

All these risks are reduced with short-term bonds in your investment portfolio. If you plan to hold the bonds until they mature, the first three risks have been eliminated entirely. You will be paid exactly what you expected. Your sole remaining risk is the possibility of the company or entity that issued the bonds declaring bankruptcy, and even in this eventuality your risk is lessened. Because bondholders are creditors, they have a place near the head of the line when any assets that remain are distributed. Those who had purchased stock in the company, meanwhile, are part owners up to the extent of their investments, and they are more likely to lose everything they invested.

Short term bonds are securities that can be traded like stocks. You need not hold the bond for its entire term. The bond's interest rate remains fixed throughout its entire term, but you'll most likely have to pay more than its face value for a bond that was issued when interest rates were higher, so its effective yield will be close to that of similar newly issued bonds. This sensitivity to interest rate changes can cause the total gains of your investment to be less than 100% predictable. To minimize this uncertainty, you should try to purchase a bond that matures fairly close to your target date for selling. The further away the maturity date - the greater the fluctuation in the bond's price. You also need to take into account that your broker will charge a commission when you sell. The fee is sometimes stated, and sometimes it's built into the price (both buy price and sell price). Bonds purchased directly from the government are free of commissions.

A change in your bond issuer's credit rating will also impact your bond's price. Again, the shorter the remaining term the lesser the impact.

A short term bond with a low credit rating will generally earn a greater return than one rated higher, but the risk is greater also. Moody's and Standard & Poors (S&P) provide the two most common ratings for bonds, and each uses slightly different symbols. Both have four tiers of ratings for "investment grade" bonds. These ratings run from an AAA rating (Aaa for Moody's) to a BBB rating (Baa for Moody's). They also utilize numbers, or plus and minus signs, to rank bonds within these main levels. Just below the lowest investment grade is the BB rating (Ba for Moody's), a category considered somewhat speculative. These ratings go down another five levels to the single C rating (D for S&P), which is the "I didn't need that money anyway" category. The issuer is in default.

The yields on the four investment grade levels of short term bonds are spaced closely together, but below that the variation widens considerably. One bond issue I checked which has a CCC rating (3 levels below investment grade) and matures in 6 years had a yield over 3 times that of investment grade bonds. It falls well within the "junk" bond category and might possibly be considered if you absolutely need a stellar yield to fund something and you have no particular need for the money otherwise.

If you want to keep open the possibility of realizing a large surprise gain, you might consider a "convertible" bond. These bonds usually pay a lower rate of interest, but the bearer has the right to convert the bond's value for the company's stock at a set price after a certain date. If the stock rises above that price, you can trade your bond for stocks, then sell the stocks and pocket the profits. In essence, this works like an call option on the stocks, so you might consider buying a regular bond instead and using the extra interest income to buy an option on the stocks.

Bond prices can be confusing for first-time buyers. They are usually listed somewhat like 113.739 or 97.114, no matter the face value of the bond. To determine what you'll actually pay, move the decimal point two places to the left and multiply it times the bond's face value. The price of a bond listed at 100.000 is equal to the face value.

Bonds fall into four main categories: corporate, government, agency, and municipal. Both the government and municipal bonds have tax advantages that a short term bond buyer might find attractive. Interest from U.S. treasury bills (matures in one year or less) and notes (matures in two to ten years) are exempt from state and local income taxes. Interest from municipal bonds are exempt from federal income tax and may be exempt from state and local income taxes as well. Some states have reciprocity agreements with other states, so if you buy a municipal bond issued from outside your home state, that may also be exempt from your state's income tax. Both treasury and municipal bonds have relatively low yields, so they will be most suitable for you if you are in a high tax bracket. Both are considered very safe investments. Treasury bonds are backed by the full faith and credit of the U.S. government.

Agency bonds, issued by entities such as Fannie Mae, the Small Business Administration and the Tennessee Valley Authority, are sometimes thought to be backed by a government guarantee, but they are not. However, the government would most likely step in to support any of these agencies that ran into trouble. Because of this, they are considered safer than average, and their yields are low.

Corporate bonds require the most research when purchasing to see if the issuer is credit worthy and is likely to stay that way. The interest rates they pay is higher, as a whole, but the bonds are also vulnerable to nasty surprises. If predictability is essential, then you'll want to shy away from corporates.

The yields of short term bonds with the least risk are so low that you may want to consider a couple of alternatives. U.S. savings bonds share the safety and tax advantages of treasury bonds. Their interest rates are set at a percentage of treasuries', but the rates are only set twice a year (in May and November) so if there has recently been a steep decline in interest rates they may actually pay more. They can be purchased at most banks or over the internet commission free.

Certificates of Deposits from an FDIC insured bank also have the safety advantage of short term treasuries, but they lack the tax advantage. However, your bank or an online bank may offer higher interest rates that may outweigh this. You don't have to worry about paying commissions to purchase a CD, but there are penalties for early withdrawals which vary from bank to bank. They have the advantage of being available in any denomination whereas treasuries can only be purchased in multiples of at least $1,000. If the issuing bank goes into default, your money is insured, but your money could be tied up until a settlement is made.

When purchasing a short term bond, there are several features you should check because they affect the safety and predictability of your investment.

You should know whether the bond is secured or unsecured. Unsecured bonds are called debentures. Secured bonds are backed by some sort of collateral, which can give you an extra measure of safety.

You should know whether the bond is callable. If it is, that means the issuing company can pay you off before the bond's maturity date. This can affect the predictability of your investment because a company is more likely to call your bond back after interest rates have declined, in which case you would have to reinvest your money at a lower rate of return.

You should know whether the bond is a zero coupon bond (or "strips" for treasury bonds). If it is, that means that the face value of the bond includes all the interest that will be paid until it matures. Like a savings bond, the original purchase price has been set at a discount to its face value. A normal bond, by contrast, is originally sold at face value. Its coupons represent interest payments and can be detached and cashed in after each coupon's due date.

If you are undecided whether to opt for the safety of short term bonds or the higher return of riskier investments, you'll want to consider mixing the two. A 50-50 split would cut your losses from a 50% decline in your stock portfolio to less than 25% of your investment capital. Of course, you'll need to be content with a gain of a little more than 50% if your stock portfolio doubles. You can adjust the mix to best suit your investment objectives, but try to keep your risk from jeopardizing an essential objective. Even in the case of a 90% sure thing, it's better to be among the 90% who lost extra earnings than among the 10% whose objective became impossible to realize.

© High Speed Ventures 2011