WEALTH MANAGEMENT CPAs presents…

Bonds: A Potentially Powerful Tool in an Investor’s Portfolio

With Robert J. Beck, CPA

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The Basics of Bonds

Bonds can be a powerful tool that you’ll want to consider adding to your portfolio.

A great way to describe a bond is it’s similar to postdated check that is going to pay out a certain amount by a specified date. Most bonds usually come in a $10,000 increment. 

Now, when purchasing a bond, you might notice that it doesn’t mature for several years. 

It could be a ten year bond, a twenty year bond, or even a thirty year bond. Now why on earth would someone buy a bond if it doesn’t even mature for thirty years? The answer is simple—oftentimes, the bond comes with a coupon. A coupon states the annual percentage rate, which will be paid to the bond holder semiannually.

The Concerns of the Bond Holder

What are the concerns with owning bonds? Number one, I’m always concerned if the company defaults. If this happens, they will miss a coupon payment.

It’s like when someone misses a credit card payment (or any sort of obligation where they owe somebody money and they miss that payment), then what happens? They also go into default. Now, can that person (or business) come out of default? Yes, they can. But what happens to their credit score or their rating? Well, it’s a big black eye, so they don’t want to ever miss those payments and go into default.

Another concern is if they go bankrupt, meaning that they close their doors, and are no longer operating as a business. When they start going through the bankruptcy proceedings here in the United States, we have the bankruptcy laws and there’s a pecking order on who gets paid off first.

One nice thing about being a bond holder (versus a stock holder) is that they are higher up on the pecking order. Typically, when a company defaults, the bond holders collect ~50% of the maturity value. So rather than receiving $10,000, they may receive $5,000. The fortunate thing is they’ve usually also been able to collect some coupons along the way.

The Diversified Portfolio

Another thing that is important when it comes to purchasing bonds is that the portfolio is properly diversified.

Avoid putting all your money inside one particular company or bond. You’ll likely want to make sure you diversify those bonds out, due to the risk of default or bankruptcy. It’s also good to ladder them, so that they have different maturity dates.

The Rise and Fall of Interest Rates

Next, I’d like to talk about interest rates and bonds. The fair market value (FMV)—what you’re paying or what you could sell your bond for on the open market—works inversely to interest rates.

If interest rates rise, then typically the current fair market value of a bond is going to go down. Why? Because people can get a higher interest rate out in the market than what your bond is paying.

Conversely, when the Federal Reserve lowers interest rates, the fair market value of a bond is likely going to rise. Why? Because I’ve already locked in a higher interest rate than what people can get out in the marketplace.

That’s important to recognize, because for the last 40 years, we have watched interest rates decline all the way to zero. Once they hit zero then they only had one way to go, unless the Federal Reserve decided to go into negative interest rates.

30-Year Fixed Rate Mortgage Average in the United States

Direct Ownership of Bonds vs. Bond Funds

Bonds can be owned directly or via a bond fund. If owned directly, the bond owner should be able to see each individual bond held in their account on each statement. However, if they are owned via a bond fund, the bond fund owner will likely only see the name of the bond fund on their statement. This can be an indication that many investors have their money co-mingled with yours, within the bond fund.

What Happens When the Federal Reserve raises interest rates?

If bonds are owned directly, the bond owner can simply hold their bond to maturity and it is not as concerning. In fact, we welcome this because it may allow bond owners to purchase new bonds at higher yields.

However, if an investor owns shares in a bond fund (as opposed to direct bond ownership), then they cannot control when all the other co-mingled investors in the fund decide to sell their shares in the bond fund, thus forcing the other investors to potentially recognize a loss.

At Wealth Management CPAs we strongly encourage our clients to own bonds directly.

Bonds are Powerful!

At our firm, we see bonds as a really powerful tool for a portfolio, However, we always want to make sure that our clients are structuring them properly, and understand how they operate.

If you have any questions or concerns, feel free to reach out to our firm. Just give us a call at (801) CPA-HELP (801-272-4357) or contact us through our website.

Upcoming Webinar: “The Basics of Bonds” with Monica Sonnier, CFA

We’re excited to announce the Basics of Bonds webinar/Q&A on Wednesday, November 2nd at noon, where we will be joined by Monica Sonnier—the head of the TownSquare Capital’s bond team. [EVENT DISCLOSURES]

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