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.
When investing to buy and hold, be sure to consider:

  • 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.

Maximizing Income

If your goal is to maximize your interest income, you will usually get higher coupons on longer-term 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: BBB or lower from Standard & Poor’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, Barbells and Immunization strategies

Just as with equities, bonds are subject to risk. Likewise, bond investors share the desire to maximize their return given a level of risk
Buy-and-hold investors can manage interest rate risk by utilizing the following Bond portfolio strategies:

Laddered Portfolio: A laddered bond portfolio is a strategy used to reduce reinvestment risk and interest rate risk by investing in a portfolio of bonds with staggered maturities. The bonds would mature in different years, thus maturing in different interest rate environments. If rates rise, the value of the portfolio may fall but any new bond put into the porfolio may provide greater cash flow dur to rising rates. This type of strategy also enables an investor to match cash flows with planned expenditures.

Barbell Strategy: A barbell strategy offers another means of balancing risk in a bond portfolio. The barbell strategy places heavy weights on very long maturities and very short maturities with a little or no position in intermediate-term maturities. An advantage is that this strategy can be completed with fewer bonds. A disadvantage is that the investor may be unable to match maturities with cash needs as effectively.

Immunization strategy: This strategy aims to eliminate interest rate risk in a fixed income portfolio. Immunization involves selecting a portfolio of bonds such that interest rate movements results in bond price fluctuations and cash flow for reinvestment that offset one another. Duration measures the point in time when these two risks offset each other.

If an investor purchaes a bond and sells it when it reaches its duration, any loss in the bond value caused by an increase in interest rates should be offset by the increase in the reinvestment earning of interest payments. Similarly, if interest rates decline, the loss in the reinvested earnings should be offset by the increase in the value of the bonds. By matching the duration of the bond to the investment horizon, interest rate and reinvestment risk can be offset.

Smoothing Out the Performance of Stock Investments

Because stock market returns are usually more volatile 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 strategies.

Saving for a Definite Future Goal: Zeros and Bullet strategies

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.
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.

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.

Total Return Strategy

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.
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.

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.

Ladders, barbells, bullets and immunization strategies can all be implemented with municipal securities for a tax-advantaged approach best achieved outside of a qualified, tax-deferred retirement or college savings account.

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.

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.