12 Things Every Bond Investor Should Know
How CPAs can help their investor-clients.
January 24, 2011
Due to skyrocketing government deficits and the likelihood of rising interest rates, there’s been a recent wave of media warnings about the possibility of loss and default in the municipal bond class of investments.
My opinion about whether or not losses in this sector will occur is not what this article is about. Rather, the purpose of this article is to provide a few general and simplified items your clients investing in government or corporate bonds should know:
Know thy investment. Starting with the most basic, remember: when investing in a bond, an investor is essentially loaning money to a business or a government entity for a specified period of time, during which time they receive interest payments on their investment (otherwise known as “yield” or “return”).
Understand the risk. There are two key elements that determine the risk of a bond: credit quality and the length of time it will take for your client to receive their money back (otherwise known as the “maturity date”). Here, common sense prevails: the longer your client loans an entity their money, the greater the risk they won’t get their initial investment back and therefore, the higher return commonly associated with longer term bonds when compared with their shorter term counterparts.
Credit counts. Companies such as Moody’s and Standard and Poor’s (S&P) rate bonds. Generally speaking, the more “As” your clients see, the better the chances the entity won’t go out of business (often referred to as default).
There’s no free lunch. To attract investors, an entity with a lower credit rating most often offers higher returns than similar bonds with higher credit quality. If all goes well and the entity doesn’t default, your client may do well but needless to say, the higher the return, the greater the chance something can go wrong.
Bond values fluctuate. Suppose your client loaned an entity $10,000 and received a five-percent yield in return, this would result in receiving $500 per year. But suppose after the investment is made, the rates for the same bond increases to seven percent. In this case, a new investor in the marketplace loaning the entity $10,000 would receive $700 per year. Now let’s suppose your client wanted to sell their five-percent bond for which they paid $10,000 … What investor would pay $10,000 to get $500 in interest payments when the prevailing rate had a $700 return per year? No one knowingly would. Therefore, to compensate for this, the value of the bond your client wants to sell would have to be reduced to make it more competitive in the marketplace.
Don’t panic. I sometimes see newer bond investors panic when the value of their bond goes down. But remember that as long as your clients hold their bond until maturity (and the entity doesn’t default), your clients will get their money back and (in the above example) continue receiving their $500 annual interest payments along the way. With that in mind, the general rule of thumb is that if a bond goes down in value, your clients should not panic and sell it. Instead, they should research the reason the bond went down in value and consider holding it until maturity so that a loss is not recognized.
Funds can’t get dates. An individual bond has a maturity date; the fantastic date when as long as the entity holding your client’s money doesn’t default, they know when they will be receiving their initial investment. On the flip side, bond funds don’t have maturity dates. In other words, if the value of the fund goes down, there’s no known date in which your clients will know by which date they’re getting their money back.
Diversify. If the above comment makes it seem as though individual bonds are an obvious better way to invest, such isn’t always the case. When loaning money to one entity (as is the case with an individual bond), a client generally has more risk than when loaning their money to many entities (as is the case when one invests in a bond fund that invests in many bonds).
Understand Duration.Investing in bond funds? Your clients should really understand something called duration. The duration of a fund indicates the change in value a fund should experience for every one-percent movement in interest rates. For example, suppose bonds in a particular fund have an average duration of three years. In this case, for each one-percent movement in interest rates, the fund’s value should generally move three percent in the opposite direction of the rate change itself (for reasons summarized in number five above). In the perceived likelihood interest rates in this country soon start to rise (and therefore the value of bonds should generally fall), these days, it’s especially important to know the duration of one’s fund by doing some research in places such as www.morningstar.com.
Taxable or tax free? Generally speaking, your clients will get some tax relief when loaning their money to a government entity whereas investing in a corporate entity will expose the earnings to tax. As such, many investors often gravitate towards tax-free government bonds and shy away from taxable ones, but remember that after an analysis, the after-tax earnings might still exceed the tax-free earnings offered by many government bonds.
Look for the sales. When investing in an individual bond, it is often better to “buy at a discount” rather than at a “premium” due to one simple fact: at maturity, those clients buying a bond at a discount will receive back more than the amount initially invested.
And most importantly:
Don’t take any of the above to heart. As one can likely determine by now, analyzing bonds can be a tricky endeavor. While the above can provide some helpful insight, no brief article can truly provide one with all the facts necessary to efficiently evaluate bonds, especially when factoring in a client’s personal needs and goals. It’s for this reason this final point is of paramount importance to keep in mind.
During these days when there’re many warnings about various bond investments, hopefully some of the above will help your clients better understand the general nature of this popular class of investments.
Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.
The AICPA’s Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. All members of the AICPA are eligible to join the PFP section. If you want an in-depth CPE course on investment planning, consider the new Investments course offered in partnership with The American College.The Personal Financial Specialist (PFS) credentialis exclusively available to CPAs who want to demonstrate their expertise in this subject matter.
For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.