Why bother with bonds?

Sept. 1, 2000
Jitters over interest rates and Federal Reserve Board concerns make investing in the bond market a real challenge these days. Here are answers to the most common questions I am asked about bonds.

Hugh F. Doherty, DDS, CFP

Jitters over interest rates and Federal Reserve Board concerns make investing in the bond market a real challenge these days. Here are answers to the most common questions I am asked about bonds.

Since stocks have rewarded investors, why bother with bonds?

Stock returns are abnormally high and won`t continue forever. Bonds add stability to your portfolio when the market is in turmoil. The mid-April correction gave investors a painful taste of what a falling market can do to their returns - and peace of mind. A 5.5 percent tax-free yield on municipal bonds looks very, very good when stocks lose 25 to 50 percent of their value.

Why does the credit quality of a bond matter?

It indicates the likelihood of investors getting back their principal. The best-known credit rating agencies are Standard & Poor`s and Moody`s Investors Service.

With bonds, as well as with stocks, there is a trade-off between risk and return. Issuers with the highest credit ratings pay the lowest interest rates, and those with the lowest credit ratings have to pay more to convince investors to take the extra risk.

Note: Only a few companies qualify for the top credit rating (AAA by Standard & Poor`s and Aaa for Moody`s). Investors can look up ratings on the Web at www.standard andpoors.com or www.moodys.com.

What`s better - individual bonds or bond funds?

For people with at least $100,000 to invest, such as retirees who depend upon a steady stream of income, individual bonds are wonderful. That amount allows you to own various types of bonds - with different maturities. Once you purchase a bond, you lock in its interest rate and know that if you hold the bond until maturity, you will get back your principal plus regular semiannual interest payments, unless the borrower defaults.

The only bonds smaller investors can buy are U.S. Treasury securities, which come in denominations as small as $1,000. You can buy most individual municipals and corporate bonds with as little as $5,000.

A bond fund, by contrast, has no finite maturity or set rate of return. The portfolio manager is constantly adding or dropping bonds, as market conditions dictate. The yield and price of shares on a bond fund vary, sometimes significantly, from one month to the next. If you don`t have enough money to assemble a bond portfolio on your own, a bond fund is terrific. Bond funds also can pay income monthly rather than semiannually.

How should I pick an individual corporate bond?

Look for familiar companies that operate businesses you understand. Look for a maturity that suits your needs and an interest rate that seems reasonable for current conditions.

What is laddering?

It is a process whereby you plan to have the necessary funds available at a predetermined date of maturity. Parents who are saving for their children`s college educations want to invest in bonds that mature just before each tuition payment is due.

What should I know before purchasing a bond?

Bonds are sold net - with the commission built in. There can be enormous differences in pricing, so always try to get prices from at least two different brokerage firms before you buy. U.S. Treasury Bonds can be purchased directly with no fees at (800) 943-6864 or www.ustreas.gov.

Next, find out if the bond is callable. That means if interest rates drop in the future, the bond can be redeemed by the issuer before the maturity date. That would be bad news for the investor who is counting on the bond to provide steady income and might have to reinvest the proceeds at a lower interest rate.

Hugh F. Doherty, DDS, CFP, is a Certified Financial Planner, national lecturer, financial adviser to the health-care profession, and CEO of Doctor`s Financial Network. For further information on lectures, study club workshops, or consultations, you can fax to (732) 449-3229, send e-mail to [email protected], call (800) 544-9653, or visit www.dr.hughdoherty.com.

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