Understanding bonds and their risks

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A bond is an "IOU" for money loaned by an investor to the bond's issuer. In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate known as the "coupon rate." At the end of an agreed-upon time period when the bond "matures" the issuer repays the investor's principal.

Benefits and risks of bonds

Because bonds tend not to move in tandem with stock investments, they help provide diversification in an investor's portfolio. They also provide investors with a steady income stream, usually at a higher rate than money market investmentsFootnote 1. Zero-coupon bonds and Treasury bills are exceptions: The interest income is deducted from their purchase price and the investor then receives the full face value of the bond at maturity.
All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested. To help measure credit risk, many bonds are rated by independent entities such as Moody's and Standard & Poor's (S&P). Ratings run from Aaa (Moody's) or AAA (S&P) through D (for default), based on the rater's appraisal of the issuer's creditworthiness. Aaa (Moody's) and AAA (S&P) are the highest credit ratings. Ratings better than BBB (S&P) and Baa (Moody's) are considered to be "investment grade."
Bonds that are rated below investment grade (that is, BB or lower by S&P, Ba or lower by Moody's) are sometimes called "junk" bonds.Footnote 2 They may be appropriate for investors who can withstand higher price volatility and default risk while seeking increased investment cash flow potential.
Like stocks, all bonds can present the risk of price fluctuation (or "market risk") to an investor who is unable to hold them until the maturity date (when the original principal amount is repaid to the bondholder). If an investor is forced to sell or liquidate a bond before it matures, and the bond's price has fallen, he or she will lose part of the principal investment as well as the future income stream.

An inverse relationship: Interest rate risk

Another risk common to all bonds is interest-rate risk. In normal circumstances, when market interest rate levels rise, existing bonds' market values usually drop (and vice versa), although past performance does not assure future results. However, interest rate risk's effect on market value may be a relatively minor factor for income-oriented, buy-and-hold investment strategies. That's because bondholders are generally entitled to receive the full principal value of their bonds at maturity, regardless of any short-term changes in market value that might have been caused by fluctuations in market interest rates.
Most bonds fall into one of four general categories
  • Corporate
  • Government
  • Government Agency
  • Municipal

Types of bonds

Bonds come in a variety of forms, each bringing different benefits, risks, and tax considerations to an investor's portfolio. Most bonds fall into four general categories: corporate, government, government agency, and municipal.
    Issued by corporations, these bonds may provide an investor with a steady stream of income
  • Risk Considerations: The primary risks associated with corporate bonds are credit risk, interest rate risk, and market risk. In addition, some corporate bonds can be called for redemption by the issuer and have their principal repaid prior to the maturity date. When bonds are called in a declining interest environment, investors may not be able to obtain new bonds that offer the same yield.
  • Tax Considerations: Interest earned on a corporate bond is generally taxed as ordinary income at your applicable federal and state income tax rates. If you sell or redeem a bond for more than you paid, the difference would be taxed as a capital gain.
    Government bonds are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government. They include intermediate- and long-term Treasury bonds. Intermediate-term bonds mature in three to 10 years, whereas long-term bonds generally mature in 10 to 30 years.
  • Risk Considerations: Among the lowest risk of all bond investments, these bonds have low credit risk because they are backed by the full faith and credit of the U.S. government. A government bond does present market risk if sold prior to maturity, and also carries some inflation risk — the risk that its comparatively lower return will not keep pace with inflation.
  • Tax Considerations: Treasury bond interest is fully taxable at the federal level but it is exempt from state and local taxes. Gains on sale or redemption are also taxable.
    These bonds are indirect debt obligations of the U.S. government issued by federal agencies and government-sponsored entities. Examples of such organizations are the Federal National Mortgage Association (FNMA or "Fannie Mae") and the Government National Mortgage Association (GNMA or "Ginnie Mae").
  • Risk Considerations: Agency and entity bonds are widely seen as having low credit risk due to their association with government-chartered entities. But because these bonds are not directly issued by the U.S. government, they are not necessarily backed by its full faith and credit. In addition to the risks inherent in government bonds, agency bonds run the risk of going into default, although such an occurrence is generally considered unlikely. Because of this added risk, however, these bonds generally offer higher yields than government bonds.
  • Tax Considerations: These bonds are fully taxable at the federal level and, in some cases, at the state and local levels as well. Gains on sale or redemption are also taxable.
    Municipal bonds, or "munis," are issued by a U.S. state, county, city, town, village, or local authority to raise funds for general use or particular public works projects
  • Risk Considerations: Munis fall somewhere in the middle of the credit risk spectrum. The risk of default can vary depending on the creditworthiness of the issuer and the type of debt obligation.
  • Tax Considerations: Perhaps the biggest advantage of most munis is their ability to offer income potential that may be income tax exempt. Gains on sale or redemption are taxable. Income from some municipal bonds may be subject to the alternative minimum tax.
Know the risks associated with bonds
  • Credit Risk — The risk that a bond's issuer will go into default before a bond reaches maturity
  • Market Risk — The risk that a bond's value will fluctuate with changing market conditions
  • Interest Rate Risk — The risk that a bond's price will fall with rising interest rates
  • Inflation Risk — The risk that a bond's total return will not outpace inflation

Individual bonds vs. bond mutual funds

Individual bonds are typically issued with unit values ranging from $1,000 to $100,000 apiece. As a result, many bond investors find it impractical to assemble and manage a diversified bond portfolio. One alternative to individual bond investment is bond mutual funds. Using pooled investment resources, mutual fund managers can create a diversified bond portfolio for investors. Shares of these funds offer investors the opportunity to add a fixed-income element to balance out a portfolio of other investments.
Of course, diversification generally cannot assure a profit or protect against a loss, and investments in mutual funds carry specific costs such as management fees and operating expenses (expressed as the annual expense ratio). Sometimes mutual funds also incur sales commissions or redemption fees.
The wide variety of bonds may make them potentially suitable in many investment scenarios. Discuss your goals with your financial professional, and together you can decide whether bond investing is right for you.

Footnote 1 An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share it is possible to lose money by investing in the fund.

Footnote 2 Investments in high-yield bonds (sometimes referred to as "junk" bonds) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer's ability to make principal and interest payments.

Diversification does not ensure a profit or protect against loss in a declining market.

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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.