Equity vs. Debt
When it comes to investing, you can be either an owner or a lender. If you own stock (or shares of a mutual fund that invest in stocks), you are a shareholder and literally own a part of a company. The company has no obligation to pay you back by redeeming your shares, and the value of your shares will rise or fall with the fluctuation of the market.
On the other hand, when you buy bonds, you are acting as a lender. That is, you are “lending” your money to an entity (e.g., company, state, municipality, or the U.S. government) for its promise to pay, which takes the form of periodic interest and a return on your principal. The borrower does have an obligation to you (the bondholder), to repay. However, it is possible for the borrower to default on this obligation to pay interest and principal.
Bond Basics
One of the most common questions posed by potential bond investors is, “What is bond yield?” Yield is the investor’s original return on investment. When most people mention yield, they are referring to current yield (i.e., the current annual interest income divided by the initial price paid for the investment). Perhaps a better measure for investors is yield to maturity (YTM), which is the bond’s rate of return if it is held until its maturity date. YTM provides the most complete measurement of performance, taking into account the present value of future payments.
There are several factors that can affect the yield. However, one of the more important considerations is credit risk. This is the risk that a bond issuer will go into default before a bond reaches maturity. Lower quality issues tend to pay higher yields to compensate for added risk. In addition, for bonds carrying similar credit ratings, it is typical that the longer the time until maturity, the higher the yield tends to be.
Bond investments are also subject to interest rate risk, so that when interest rates rise, the price of bonds can decrease and the investor can lose principal value.
What About Bond Funds?
Like stocks, successfully investing in bonds requires a great deal of knowledge and experience. For this reason, bond mutual funds can be a good way to incorporate bonds into your portfolio. A bond fund is run by professional money managers who use their knowledge and experience to purchase a variety of bonds that are consistent with the fund’s stated objectives. However, unlike individual bonds, a bond fund has no obligation to pay a stated interest rate or return your principal. As an investor, you should be aware that investment returns in principal values of bond mutual funds will fluctuate due to market conditions. Therefore, when shares are redeemed, they may be worth more or less than their original cost.
Many investors who understand bond yield may still have a difficult time accurately comparing the performance of bond funds when fund companies calculate and advertise yields in different ways. Fortunately, the Securities and Exchange Commission (SEC) has established an industry standard for computing yield in mutual fund advertisement and sales literature. The standard creates a fixed-yield quote requirement for bond mutual funds, making it easier for investors to decide which bond funds are most suitable for their individual investment portfolios. In addition, a funds prospectus, which can be obtained from a financial professional, can be consulted for a complete list and description of its holdings, as well as information on risks, fees, expenses, and other information. Always read the prospectus and consider the charges, risks, expenses, and investment objectives carefully before investing.
Before You Decide…
Bonds can be a valuable addition to your portfolio because of their ability to help maintain principal and provide income. However, the percentage of your portfolio you choose to invest in bonds should be determined by your overall goals and objectives. Despite the allure of potentially higher returns from equities, bonds may still deserve some of your investment attention.
Bernard Long and H. Lee Weith offer securities and investment advisory services through AXA Advisors, LLC, in Columbia, Md., a member of FINRA, SIPC; and annuity and insurance products through AXA Network, LLC, and its subsidiaries. You can contact them at Bernard.Long@axa-advisors.com (410-309-3639) and Herbert.Weith@axa-advisors.com (410-309-3605).