Investments in bonds should be tailored
to your investment objectives, risk tolerance, and other personal
circumstances. Answering some fundamental questions will help
you determine the role bonds should have in your portfolio:
What are your overall
investment objectives?
Investors committed to growth are looking
for appreciation of capital with little concern for income, so
bonds will have a minimal role in their portfolios. Total return
investors want a balance of income and capital appreciation, so
bonds will be more important in their portfolios. Income investors
are looking for interest or dividend income with capital appreciation
a secondary concern, so bonds will have a significant role in
their portfolios.
What's your investment
time frame? When selecting bonds, you should consider when you
will need the principal. Typically, yield increases as the maturity
date lengthens, since you assume more risk by holding the bond
for a longer time. Investors are often tempted to purchase bonds
with long maturity dates to lock in higher yields. However, use
that strategy with care. If you purchase a long-term bond and
sell it before maturity, interest rate changes can significantly
affect the bond's market value. Although you can't control interest
rate changes, you can limit the effects of those changes by selecting
bonds with maturity dates close to when you need your principal.
What is your risk tolerance? Typically,
the higher a bond's return, the greater its risk. Thus, U.S. Treasury
securities, which are considered one of the safest bonds, typically
carry lower rates than municipal or corporate bonds. Make sure
you understand the risks involved before purchasing a specific
bond.
Are you concerned with
minimizing taxes?
Interest income from U.S. Treasury securities
is exempt from state and local income taxes, but it is subject
to federal income taxes. Interest income from municipal bonds
is exempt from federal income taxes, and typically is exempt from
state and local income taxes for residents in the issuing state.
Interest income from corporate bonds is subject to federal and
state income taxes. Investors in higher tax brackets typically
find tax exemption of interest income more valuable. Be aware
that any exemption from income taxes applies only to interest
income. Capital gains from the sale of a bond are still subject
to taxes.
What variables should
you consider before purchasing a bond?
Before you purchase a specific bond, make sure you fully understand
its features and can answer the following questions:
- What is the bond's maturity?
- What is the bond's credit rating, and
is it insured?
- Does the bond have call provisions?
- What is the coupon rate?
- What is the bond's price?
- What is the yield to maturity?
- How is the bond's interest income taxed?
Keep in mind that bonds are subject to purchasing
power risk, or the risk that its purchasing power will decrease
due to inflation; interest rate risk, or the risk that interest
rates will increase and cause the bond's value to decrease; and
default risk, or the risk that the issuer will not repay the principal
or interest on the bonds.
