Types Of Bonds And Investment Techniques

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Types Of Bonds

Convertible bonds are special types of corporate bonds. A convertible bond allows the holder to exchange the bond for a stated number of shares of the issuer’s stock. The conversion feature is used as a benefit to make these bonds more attractive to investors because it provides additional upside potential. If the value of the company’s stock rises enough, the bond’s market price will begin to track the value of the shares to which it can be converted.

Municipal bonds, called “munis” for short, are attractive because of their tax treatment. In general, interest from municipal bonds is exempt not only from federal income tax but also from state and local income tax in the states and cities where they are issued.

Reflecting their tax-free treatment, municipal bonds typically pay lower interest rates.

Callable bonds give the issuer the right to repay the principal of the bond to the investor prior to maturity. They would typically elect this option (a call) when interest rates have fallen, giving them the opportunity to refinance their debt at lower rates. A call forces the bondholder to reinvest at the lower prevailing rates, making a call unattractive to investors. To compensate for this, many callable bonds include a call penalty, which is an additional payment of interest made at the time the bond is called.

Zero coupon bonds do not make periodic interest payments. Instead, they are sold at a deep discount to their face value. For example, a zero coupon bond with a par value of $1,000 at its maturity date in 20 years and priced to yield 5 percent could be purchased for $372.43. While zero coupon bonds eliminate reinvestment risk, they are more sensitive to movements in interest rates which makes the price of a zero coupon bond more volatile than a coupon bond.

Other than municipal securities that can accumulate tax-free, there can be a tax drawback to some zero coupon bonds. The IRS taxes the interest each year as it accrues, even though it has not actually been received by the investor. Many investors do not like the idea of paying federal income tax on money they have not yet received. Holding zero coupon bonds inside a tax-advantaged retirement plan, such as an Individual Retirement Account (IRA), is one way to avoid paying tax on this "phantom income."

Bond Investment Techniques

Diversification reduces risk with stock investing and can reduce the risk of investing in bonds as well. A fully diversified bond portfolio might include U.S. Treasury, municipal and corporate bonds. These bonds might be further diversified by owning bonds with varying maturity dates.

A truly diversified portfolio will go even further, holding municipal bonds issued in different geographic regions of the country and corporate bonds from a variety of industries. One can even invest in bonds issued by foreign governments and companies, which may entail additional risk.

Building such a diversified bond portfolio may require a large amount of assets, time and expertise which is why many people use mutual funds for their bond investments.

Laddering is used to reduce interest rate risk. Investors build a bond ladder by buying a series of bonds with varying maturity dates, such as U.S. Treasury bonds, corporate bonds or municipal bonds. For example, an investor with $40,000 might invest $10,000 each in bonds that mature in 5, 10, 15 and 20 years. When the 5-year bond matures, the investor reinvests the proceeds in a 20-year bond, restoring the ladder to its original structure.

Laddering has two key benefits.

• If an investor has a future need for money, the ladder can be structured so that a bond is maturing when they need the funds rather than selling them earlier and facing the risk that their market value has declined due to rising interest rates.
• Because long-term bonds are more volatile than short-term bonds, the variety of maturities reduces this risk as well.