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BONDALERT
2/29/16 WhatInvestorsShouldKnow
Thisspecialreportwillhelpyouunderstandthecurrentenvironmentforbondsanddiscusshowthatenvironmentmaychangewithrisinginterestrates.Wewillalsodetailstrategiesinvestorsmayadopttohelpmitigatebondrisksandpotentiallyrepositiontheirportfolio.
UnderstandingBondsWH AT I N V E S T O R S S H O U L D K N OW
INTRODUCTION
Bondsaregenerallypopularwithinvestorswhoareseekingincomeandcanbeanexcellentadditiontoawell-roundedportfolioaspartofalong-term&inancialstrategy.Inrecentyears,theFederalReservehasaggressivelysoughteconomicgrowththroughbondpurchasesandultra-lowinterestratepolicies.Thesehistoricallylowinterestrateshavecreatedabullmarketforbondsissuedwithhigherstatedinterestrates.However,thesepolicieswilleventuallycometoanend,meaningbondinvestorsneedtounderstandthepotentialrisksandrewardsofholdingbondsduringaperiodofinterestrateincreases.
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BONDBASICS
Bondsareessentiallyloansthatinvestorsmaketothebondissuer,whichcanbeacorporation,government,federalagencyorotherorganization.Asaresult,bondsarefrequentlyreferredtoasdebtsecuritiessincetheyareadebttheissuerowestoitsbondholders.Sinceinvestorswon’tlendtheirmoneywithoutcompensation,bondissuerspromisebondholdersinterestaswellasrepaymentoftheoriginalsum(thebondprincipal).Bondsarealsoknownas-ixed-incomesecuritiesbecausemanypayoutinterestatarateandintervalsetwhenthebondisissued.
Investorsmaybeattractedtobondsforseveralreasons,including:1
£ Theirincome-generatingability;
£ Capitalappreciationpotential.Positiveevents(suchasimprovementsinthecreditqualityoftheissuer,ordeclininginterestrates)canrewardinvestorswithincreasesinthemarketvalueofbonds;
£ Security.Ifacompanyisliquidated,bondholdersusuallyhavepriorityoverstockholdersinapaymentstructureandmaybemorelikelytoreceiverepayment;
£ Portfolioriskdiversi.ication.Bondscanhelpinvestorsspreadassetsacrossdifferentsegmentsofthe'inancialmarket,reducingtheirconcentrationinanysingleassetclass.2Diversi'icationcannoteliminateriskorprotectprincipalduringperiodsofwidespreadmarketdeclines.
Likeallinvestments,bondsofferabalancebetweenriskandpotentialreturn.Theriskthatconcernsmostinvestorsisthechancethattheywilllosesomeorallofthemoneytheyinvest;thereturnisthemoneyinvestorsstandtomakeontheinvestment.Thebalancebetweenriskandreturnvariesbasedontheinvestment,theentitythatissuesthesecurity,thestateoftheeconomy,largemarketmovements,andmanyotherfactors.Ingeneral,toearnhigherreturns,aninvestormusttakegreaterrisks.
Bondsaregenerallyconsideredtobelessriskythanstocksforafewreasons:3
1“TypesofBonds.”InvestinginBonds.http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=19&id=1913“WhatYouShouldKnow.”InvestinginBonds.http://www.investinginbonds.com/learnmore.asp?catid=3&id=383
CommonQuestionsAboutBondDuration
Whatisbondduration?
Durationisanumberthatmeasuresabondprice’ssensitivitytointerestrates.Thehigherabond’sduration,themoresensitiveabond’spriceistointerestratechanges.
HowcanI)indthedurationofanindividualbond?
Anumberoffactorscanaffectabond’sduration.Thesimplestwayto4indthisinformationistoaskyourinvestmentprofessionalorthebond’sissuer.Youcanalsoconsultanonlinebonddurationcalculator.
Doeslowdurationmeanlowrisk?
No.Justbecauseabond’sdurationislow,itdoesnotmeanyourinvestmentisrisk-free.Inadditiontodurationrisk,bondsaresubjecttoin1lationrisk,callrisk,defaultriskandotherriskfactors.
Whataffectsabond’sduration?
Variablessuchashowmuchinterestabondpaysduringitslifespan,thebond’scallorredemptionfeatures,yield,creditqualityoftheissuer,maturity,allplayaroleindurationcomputations.
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£ Bondscarryanexplicitpromisetoreturnthefacevalue(principal)ofthesecuritytotheinvestoratmaturity.
£ Mostbondspromisetopayouta1ixedrateofinterestincometotheinvestor.Somestockspaydividends,butthereisnoexplicitpromisetodoso.
£ Historically,thebondmarkethasbeenlessvulnerabletopriceswingsandvolatilitythanthestockmarket.
UNDERSTANDINGBONDRISKS
Bondsplayanimportantroleinmanyportfolios,butit’simportanttounderstandthattheyaresubjecttocertaingeneralandspeci/icrisks.Whilenotexhaustive,herearesomerisksyoushouldbeawareofwheninvestinginbonds:4
Reinvestmentrisk:Wheninterestratesaredeclining,investorsmustreinvestanyinterestincomeandreturnofprincipalatlowerrates,reducingtheirinvestmentreturns.
In#lationrisk:In#lationcausesfuturedollarstobeworthlessthantoday’s.Sinceabond’sprincipaldoesnotgrowovertime,investorsriskareductioninthepurchasingpoweroffutureinterestincomeandprincipalovertime.
Marketrisk:Thisistheriskthatthebondmarketwilldeclineasawhole,bringingdownthevalueofindividualbonds,regardlessoftheirfundamentalcharacteristics.
Callrisk:Somebondscontaina“callprovision,”whichallowstheirissuerstoredeemthempriortomaturity,causinganinvestor’sprincipaltobereturnedsoonerthanexpectedandmakingthemloseoutonfutureinterestpayments.Declininginterestratesmaytriggertheredemptionofacallablebond,forcinginvestorstoreinvesttheprincipalatlowerinterestrates.
Interestraterisk:Generally,wheninterestratesrise,bondpricesfall.Conversely,wheninterestratesdecline,bondpricestypicallyrise.Investorswhosellbondspriortomaturitymaylosesomeoralloftheirprincipal.
Durationrisk:Thesensitivityofabond’spricechangesinprevailinginterestrates.Thehigherabond’sduration,themoresensitiveitspricetointerestratechanges.
Interestrateriskanddurationriskhavebecomeofparticularimportanceintoday’sultra-lowinterestrateenvironment.Currently,interestratesareathistoriclows,meaningthatthereisastronglikelihoodthatinterestratesmayriseinthefuture.
INTERESTRATESANDTHEFEDERALRESERVE
TheU.S.FederalReservehasthedualmandatetopromoteeconomicgrowthandlowunemploymentwhilemaintainingpricestability(asmeasuredbythein5lationrate.)Oneofthemostpowerfultoolsin4ibid.
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theFed’sarsenalisitsabilitytosetthe“federalfundsrate,”whichistheratedepositoryinstitutionslendmoneytoeachother.Thisrateeffectivelysetsallotherinterestratesusedinbankingactivity,includingtheissuanceofbonds.
Inordertoboosteconomicactivityafterthe/inancialcrisis,theFedloweredthefederalfundsratetonearlyzero.Whenthisfailedtostimulatesustainedeconomicgrowth,theFedtookahistoricstepandembarkedonaseriesof“quantitativeeasing”programs,purchasingbothTreasurySecuritiesandMortgage-BackedSecuritiesinordertopushlong-terminterestrateslowerandsupport0inancialmarkets.QE3,thelatestroundofquantitativeeasing,targeted$85billioninmonthlygovernmentbondandmortgage-backedsecuritypurchases.Thesepurchasesaredesignedtoincreasedemandforthesebonds,pushingbondpricesupandinterestratesdown,boostingeconomicactivity.
Atsomepointinthefuture,theFedwillhavetoexitthesequantitativeeasingprogramsandbeginsellingofftheiraccumulatedbonds.Thepaceandtimingofthesesales,aswellasthetaperingoftheFed’saccommodativemonetarypolicywillaffectbondmarketsandbondinvestors.Asthequantitativeeasingprogramscometoanend,demandforbondsisexpectedtodrop,potentiallyresultinginadecreaseinbondvaluesandanincreaseinbondyields.Astheeconomyshowssustainedimprovement,theFedisalsoexpectedtoraiseinterestrates,pushingbondpricesstilllower.
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THERELATIONSHIPBETWEENBONDVALUESANDINTERESTRATES
Generallyspeaking,bondpricesandinterestrateshaveaninverserelationship,meaningthatwheninterestratesrise,bondpricesfallbecausenewbondsareissuedpayinghigher“coupon”orinterestrates,makingtheolder,lower-couponbondslessattractivetoinvestors.Wheninterestratesdecline,bondpricesrisebecausethehigherinterestpaymentsoftheolderbondsaremoreattractivethanthenewlower-payingbonds.
Generallyspeaking,thelongerthetermofthebond,thegreatertheprice-luctuationorvolatilitythatoccursfromachangeininterestrates.Durationriskistheriskassociatedwiththesensitivityofabond’spricetoaonepercentchangeininterestrates.Thehigherabond’sduration,thegreateritssensitivitytochangesininterestratesandthegreaterthe,luctuationsinmarketpricethebondmayexperience.Ifyousellabondbeforematurity,thepriceyouwillreceive(regardlessofthefacevalueofthebond)willbeaffectedbytheprevailinginterestratesandthe
bond’sduration,aswellasotherfundamentalfactorsofthebond.
Sinceinterestratesarecurrentlyhoveringnearhistoriclows,manyeconomistsbelievethatinterestratesarenotlikelytogetmuchlowerbutwilleventuallyrise.Ifandwhenthishappens,outstandingbonds,particularlythosepayingalowcouponrateandwithhighduration,mayexperiencesigni7icantdropsinmarketvalue.
Forexample,ifinterestratesweretorisebytwopercentfromtoday’sultra-lowlevels,amediuminvestmentgradecorporatebond(BBB,Baaratedorsimilar)withadurationof8.4(10-yearmaturity,3.5percentcoupon)couldlose15percentofitsmarketvalue.Asimilarinvestmentgradebondwithadurationof14.5(30-yearmaturity,4.5percentcoupon)mightexperiencealossinvalueof26percent.5Thehigherleveloflossforthelonger-termbondhappensbecauseitsdurationnumberishigher,makingitmoresensitivetointerestratechanges.
It’simportanttorememberthattheseprice1luctuationsonlymatterifyouintendtosellabondbeforematurity.Bondswillpayoutthesamefacevalueatmaturityregardlessoftheirmarketvalue,unlesstheissuergoesbankruptorotherwisefailstopaybacktheprincipal.
5“Duration—WhatanInterestRateHikeCouldDotoYourBondPortfolio.”InvestorAlert.FINRA.http://www.(inra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P204318[Accessed10-June-2013]
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STRATEGIESTOHELPMITIGATERISKIt’snotpossibletocompletelyeliminateinvestmentrisks,however,therearestrategieswecanemploytohelpreducetheimpactofcertainrisks.Whilefutureincreasesininterestratesposede3initeriskstobondinvestors,thecorrectsolutionmaynotbetoabandonthebondmarket;rather,investorsshouldseekoutsolutionsthathelpthempreparetheirportfoliosforrisinginterestrates.Indeed,risingratescanbepositiveforinvestorssincetheymayincreasetheavailabilityofhighquality,high-yieldbonds.
Oneofthestrongesttoolsinourarsenalisapersonalizedinvestmentstrategythatisneveronautopilot.Atanygiventime,therearemanyvariablesthatcanaffectthevalueofyourportfolioandweareconstantlyworkingtobalancereturnagainstrisk.Someofthestrategiesweemployinclude:
“Laddering”bonds,astrategyinwhichinvestorsbuybondswithdifferent,evenlyspacedmaturitiescanhelpreducetheeffectofrisinginterestratesonyouroverallbondportfolio.
Reducingmaturitiesthroughsellinglongerdurationbondsandbuyingshorterdurationdebtsecuritiescanhavetheeffectofreducingdurationandreducingyourportfolio’ssensitivitytointerestratechanges.
HoldinginternationalbondsfromcountrieswhereinterestratesarehigherthanintheU.S.canincreasebondyieldsandhelpreducedurations.However,ifconsideringthisstrategy,youmustbemindfulthatinternationalinvestingpresentsitsownuniquerisks,suchascurrency!luctuations,politicalrisks,anddifferencesinaccountingprocedures.
Afterpeakingatabove15percentin1981,theyieldon10-YearTreasuryBondshasbeenindecline,reachingahistoriclowofnear1.38percentinJuly2012.
Althoughitisimpossibletoknowforcertain,manyeconomistsbelievethatinterestrateswillbegintoriseinthenearterm,puttingdownwardpressureonbondprices.
Source:FederalReserveBankofStLouisasof2013-05-09
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Buyingin(lation-adjustedsecuritiessuchasTreasuryInvestmentProtectedSecurities(TIPS),whosepayoutsareadjustedaccordingtotherateofin4lationcanhelptoreduceduration.Thisassumesthattherateofin.lationrisesinconcurrencewithanincreaseininterestrates,thustriggeringanincreaseinthepayoutrateofthebond.
Investorscanalsolookbeyondthebondmarketforopportunitiestoearnhigherratesofreturn.
Holdingdividend-payingstockscanofferanincomestreamthatmayincreaseovertimeascompaniesincreasedividendpayments.Stocksoffergrowthpotentialovertimethatcanhelp!ighttheeffectsofin!lation.Theseadvantagesshouldbebalancedagainstthepotentiallyhighervolatilityofequityinvestments.
Pursuingalternativeinvestmentstrategiesthatmayhavetheabilitytohedgeagainstrisinginterestratesorearnahigherreturninarisingrateenvironment.Ifyouhavequestionsaboutthesestrategies,pleasecontactus.
CONCLUSIONS&NEXTSTEPSWehopethatyou’vefoundthisspecialreportinformative,educational,andreassuring.Wefeelthatitisimportanttoeducateourclientsaboutthepotentialrisksandbene'itsofbondinvesting.However,havingsaidthat,wecertainlydon’tplantoabandon'ixedincomeinvestmentsshouldinterestratesincrease.Rather,weplantocontinuetomonitormarketsandseekouttheopportunitiesthatrisinginterestratesmaysendourway.
As$inancialguidesforourclients,weworkhardtoachieveresultswhilechartingacoursethroughshiftingeconomicconditions.Wealsowanttoofferourselvesasaresourcetoyou,yourfamily,andyourfriends.Wearehappytoanswerquestionsaboutyourcurrent4inancialsituationandfuturegoals,andweoffercomplimentaryconsultationsatanytime.Shouldyouhaveanyquestionsaboutbondinvestingormarketmovements,pleasereachout.Wewouldbedelightedtobeofservice.
Sincerely,
Christian Urbina
ChristianUrbina
President &CIO
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Footnotes,disclosuresandsources:SecuritiesofferedthroughCapitalGuardian,LLC,memberFINRA/SIPC.InvestmentAdvisoryServicesofferedthroughCapitalGuardianWealthManagement,anSECregisteredInvestmentAdvisor.SecuritiesProductsarenotFDICinsured,arenotbankguaranteed,andmaylosevalue.
Opinions,estimates,forecastsandstatementsof.inancialmarkettrendsthatarebasedoncurrentmarketconditionsconstituteourjudgmentandaresubjecttochangewithoutnotice.
Thismaterialisforinformationpurposesonlyandisnotintendedasanofferorsolicitationwithrespecttothepurchaseorsaleofanysecurity.
Investinginvolvesriskincludingthepotentiallossofprincipal.Noinvestmentstrategycanguaranteeapro9itorprotectagainstlossinperiodsofdecliningvalues.
Fixedincomeinvestmentsaresubjecttovariousrisksincludingchangesininterestrates,creditquality,in7lationrisk,marketvaluations,prepayments,corporateevents,taxrami1icationsandotherfactors.
Opinionsexpressedarenotintendedasinvestmentadviceortopredictfutureperformance.
Pastperformancedoesnotguaranteefutureresults.
Consultyour+inancialprofessionalbeforemakinganyinvestmentdecision.
Opinionsexpressedaresubjecttochangewithoutnoticeandarenotintendedasinvestmentadviceortopredictfutureperformance.Allinformationisbelievedtobefromreliablesources;however,wemakenorepresentationastoitscompletenessoraccuracy.Pleaseconsultyour+inancialadvisorforfurtherinformation.
Investmentsinstocksinvolverisksincludinglossofentireprincipal.
Whilemanysecuritiesaimtoprovidestabledividends,dividendpaymentsaredependentonvariousfactorssuchasmarketconditionsandarenotguaranteed.Italsomaybediscontinuedormodi4iedatanytime.ThesearetheviewsofPlatinumAdvisorMarketingStrategies,LLC,andnotnecessarilythoseofthenamedrepresentative,BrokerdealerorInvestmentAdvisor,andshouldnotbeconstruedasinvestmentadvice.NeitherthenamedrepresentativenorthenamedBrokerdealerorInvestmentAdvisorgivestaxorlegaladvice.Allinformationisbelievedtobefromreliablesources;however,wemakenorepresentationastoitscompletenessoraccuracy.Pleaseconsultyour2inancialadvisorforfurtherinformation.
Byclickingonthelinks,youwillleaveourserver,astheyarelocatedonanotherserver.Wehavenotindependentlyveri7iedtheinformationavailablethroughthislink.Thelinkisprovidedtoyouasamatterofinterest.
