By Larry Lane for www.Investorzoo.com
Need to know where to invest a portion of your investment portfolio in relative safety? The investment world has a plethora of investment choices. Bonds can be an ideal investment for those seeking safety. As with all investments, the security is only as good as the company or government backing the bond. Below are some fixed income financial instruments that may fit your investment criteria.
Are you looking for a safe guaranteed investment? Certificates of deposits from an FDIC bank will provide you with a guaranteed return in the form of an interest payment every three months for the term of the CD purchased. You then get your principal back at maturity. If you have a CD at a FDIC member bank, you are guaranteed the principal and interest by the federal government. These are considered the safest investment and thus usually pay the smallest yield. Cds can start in terms of 6 months and go out to several years. The longer you agree to tie up your money with your chosen bank, the higher the return.
US Government Treasuries
Unless the US government goes bankrupt, US Treasury are a direct obligation of the United States government and are considered the gold standard as far as safety is concerned.
Treasury bills are issued in minimum denominations of $10,000 and are short term in nature; maturing in a year or less. They are sold at auction for less than their face value. The common term is “par”. When the bond becomes due, their full value is paid.
Notes are issued in minimum amounts of $1000 and mature in two to ten years. They carry a stated interest rate which is paid semiannually. Treasury notes are purchased through an auction and can be purchased at or below face value.
TIPS: Treasury Inflation Protected Securities
Commonly known as “TIPS” are securities whose principal is adjusted by changes in the Consumer Price Index. With inflation rises, the principal increases. Conversly, when there is deflation, the principal payment decreases.
The relationship between TIPS and the Consumer Price Index (CPI) affects both the sum you are paid when your TIPS matures as well as the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.The US Treasury provides TIPS Inflation Index Ratios which will allow those interested to calculate the change to principal resulting from changes in the Consumer Price Index.
How to buy TIPS
TIPS are sold directly through the Treasury, banks, brokers, and dealers. The price of a TIPS can be less than, equal to, or greater than the face value.
You can bid for TIPS in either of two ways:
•With a noncompetitive bid, you agree to accept the yield determined at the time of the auction. With this bid, you are guaranteed to receive the TIPS you want, and in the full dollar amount you wish to invest.
•With a competitive bid, you specify the yield you are willing to accept.
As a result, your bid may be:
• 1) Accepted in the full amount you want if your bid is less than the yield determined at auction.
• 2) Accepted in less than the full amount you want if your bid is equal to the high yield.
• 3) Rejected if the yield you specify is higher than the yield set at auction.
To place a competitive bid, you must use a bank, broker, or dealer.
Additional TIP information
The interest rate on a TIPS is determined at auction.
TIPS are sold in increments of $100. The minimum purchase is $100.
TIPS are issued in electronic form. You will receive a confirmation, but there is no physical bond issued.
You can hold a TIPS until it matures or sell it in the secondary market before it matures. Should inflation rise after your purchase, you may experience a loss of principal.
These are exactly like treasury notes except they mature in 10 years or more.Since Treasury securities are issued by the US government many consider treasuries risk free. This is not absolutely true. It is true that if held to maturity, you are guaranteed to receive your principal and stated interest rate. However, if you are forced to sell, you may take a loss. Should interest rates rise, your bond will be worth less than your original purchase.
Zero coupon bonds
Zero coupon bonds guarantee not only to pay you the specified interest rate on your principal; they also guarantee to pay the same rate of interest on your interest. Zero coupon bonds pay no periodic interest, instead it is automatically reinvested. “Zeros” are the best way to lock in high interest rates far into the future. If rates go up after buying your bond, you are locked into receiving below market interest rates. Again if you have to sell early, you will recognize a loss. Although you’ll receive no annual interest payments, the IRS will tax you as if you were.
“Muni bonds” are issued by city, states and governmental agencies. As with corporate bonds, bonds are rated by bond rating services. Interest rates vary according to the length of the term and rating of the government or agency. Muni bonds are free of federal income tax. They are also free of state and local incomes taxes when purchased by residences of the states in which they are issued. Muni bonds are very attractive to those in high tax brackets since they have fantastic tax advantages.
To finance their operations, corporations need to borrow money. They pay a fixed interest rate over a maturity of up to 30 years. Interest payments are made to the bond holder semi annually. At maturity, the bondholder receives their initial investment back. Interest rates vary depending on term and company. Rating services such as Moody’s and Standard and Poors grade the company based on their assessment of the company’s financial stability. Ratings range from AAA (the highest ranking) and down to F. These ratings are not perfect and are only the opinion of the respective companies. Before purchasing a corporate bond, it is extremely important that you know the health of the company they are investing in as well as the terms of the bond. In effect, you are considered the bank.
High yield or junk bonds are bonds with ratings below investment grade. Consequently, they have to offer a higher interest rate to induce investors to purchase them. One way to reduce the risk investing in junk bonds is to invest in a corporate bond mutual fund or ETF (Exchange Traded Fund) to spread the inherited risk of default.
Convertible bonds are bonds that can be exchanged for a specific number of shares of common stock. Bondholders share in the growth potential offered by the company’s stock. Convertible bonds pay lower interest rates than non convertible bonds of equal quality.
As with US Treasury bonds, you can purchase bonds of foreign governments. In many cases bonds issued by foreign governments pay a higher rate of interest rates because they must compete with more stable governments such as the United States. The dual edged sword to foreign bonds is the exchange rates. Your true return may fluctuate depending on the currency exchange rate of the government’s bond you’ve purchased.
There are several inherent risks when purchasing a bond. As we’ve discovered over the last year, anything is possible. If the company that issued the bond you’ve purchased goes bankrupt, you stand to lose entire investment. Since there is always a risk of bankruptcy, corporate bonds usually pay higher interest rates than government securities or CDs backed by the FDIC. Your bond may be “called” or redeemed before maturity. This might happen if there is a dramatic deflation and interest rates decline.
Managing your risk through mutual funds and ETFs
It is impossible to totally eliminate all risk. To diversify your bond holdings, you might want to purchase a bond mutual fund or ETF (Exchange Traded Fund). A given fund may invest in several hundred different issuant, thus decreasing the risk of default. Given the number of options available, you should be able to find an appropriate investment. If you are looking for investment choices, check popular internet sites such as Morningstar.com.
Interest rate risk During the course of holding your bond, interest can rise, thus decreasing the value of the bond you’ve purchased. If you are forced to sell early before the maturity date, you may experience a loss. Inflation and taxes will eat into your total return. With the exception of municipal bonds, the federal and state governments will tax you on your gains. However, if you are looking for an investment vehicle less volatile than the stock market, bonds may be an investment worth exploring.
Larry Lane is the editor for www.InvestorZoo.com a social networking site specializing in personal finance
The article above is information of a general nature and the information provided may not apply to your personal situation. Please consult your financial planner or licensed professional for investment advice.