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A bond is a debt security, similar to an I.O.U.  When an investor purchases a bond, the investor is lending money to a government, municipality, corporation, federal agency or other entity known as an issuer (the entity obligated to pay principal and interest on a bond it issues).  In return for that money, the issuer provides the investor with a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.

Among the types of bonds available for investment are: U.S. government securities, municipal bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign government bonds.  When purchasing bonds, investors become creditors of the issuer and, therefore, have priority a claim on the issuer’s assets in the event of bankruptcy.  Bonds can be also called bills, notes, debt securities, or debt obligations.

Why bonds?

At Elm Tree Capital, we believe that bonds are core element of any financial plan to invest and grow wealth and can play an important role in a well-diversified portfolio.  Bonds may provide predictable income and, most importantly, principal protection commensurate to the underlying credit rating.   Additionally, bonds tend to be a key component of an investor's overall asset allocation and may help minimize overall volatility.

There is a wide variety of individual bonds to choose from in creating a portfolio that matches an investor's investment needs and expectations.

Who invests in bonds?

Bonds can benefit an investor’s portfolio in a variety of ways.  For retirees, investing in high rated bonds with a laddering strategy may provide a predictable income stream and safety of capital.  For other investors, bonds can help meet future obligations, such as vacations, college funding or the purchase of a house.

How much to allocate to bonds?

Bond allocation depends on many factors, including an investor’s time horizon, risk tolerance, need for income and future goals.  In most cases, as investors’ age, they grow more dependent on income from their portfolios and become more risk averse. Bonds can help ease specific concerns that arise when investors move from one stage of their financial journey to the next.

What is Bond Laddering?

Bond laddering is portfolio management strategy and model for investing in fixed income that involves purchasing multiple bonds, each with different maturity dates, in order to achieve the following goals:

  • Decrease interest rate risk by holding both short-term and long-term bonds, thereby spreading risk along the interest rate curve.  If rates are rising, as one bond matures the funds can be re-invested into higher yield bonds.
  • Decrease re-investment risk because as one bond in the ladder matures, the cash is re-invested, but it only represents a portion of the total portfolio. Even if prevailing rates at the time of re-investment are lower than the previous bond was returning, the smaller amount of reinvestment dollars mitigates the risk of investing a lot of cash at a low return.
  • Maintain steady cash flows to encourage regular saving for investors looking for an income-producing portfolio.

How to Invest in Individual Bonds?

Most individual bonds are bought and sold in the over-the-counter (OTC) market, although some corporate bonds are also listed on the New York Stock Exchange. The OTC market comprises securities firms and banks that trade bonds; brokers or agents, who buy and sell bonds on behalf of customers in response to specific requests; and dealers, who keep an inventory of bonds to buy and sell.

New bond issues can be purchased in the primary market (when it is first issued), typically through an investment advisor that provides the investor the offering document, official statement or prospectus.   Bonds can also be bought and sold bonds in the secondary market, after they have already been in issued in the primary market.B

Bonds in the OTC market are usually sold in $5,000 denominations. In the secondary market for outstanding bonds, prices are quoted as if the bond were traded in $100 increments. Thus, a bond quoted at 98 refers to a bond priced at $98 per $100 of face value, which equates to buying a bond with a face value of $5,000 for $4,900 (or at a two percent discount).

Bond Credit Ratings and Risks >