(PUB) Investing 2015

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BONDS 101 – PART I I Balancing Trade-Offs

lies the silver lining to a rising interest- rate environment: You get the opportu- nity to invest in better (higher) yielding options as your bonds mature. Reinvestment risk means that your future level of income is less certain. So when you choose a short maturity bond (or bond fund) over one with a longer maturity, you are exchanging a more stable price for a less stable level of income over time. Conversely, with the long maturity bond, your price is more variable, but your income is more consistent. You can get a good sense of the trade-off between price risk and income risk in the charts below showing the month-end price (with capital gain dis- tributions added back in) and the distrib- uted monthly income of Short-Term Treasury and Long-Term Treasury over the past 15 years. Short-Term Treasury’s price was much more consis- tent, trading between $10.02 and $11.00 over the past 15 years, while Long-Term Treasury’s price ranged from $10.20 to $14.19. Both funds saw their income decline over this 15-year stretch from a similar level of about $0.05 per share, but Long-Term Treasury’s distributions only fell to $0.03 a share, while Short- Term Treasury’s fell nearly to zero, and experienced more ups and downs along the way. So, when choosing between a short and a long-maturity bond (or bond

maturity bond funds, as we’ll see in a moment.) But price is only one piece of the bond equation—what about the income your bonds generate? A risk that often goes

LAST MONTH we discussed the basics of bonds—what a bond is, how bond prices and yields relate to one another, and the difference between maturity

and duration as well as yield and interest rates. If you need a refresher, go ahead and pull out last month’s issue. (If you’ve misplaced it, you can download a copy at www. AdviserOnline.com.) Having dealt with the mechanics, let’s dive in a bit deeper and talk

unnoticed but has a big impact on bond investors is reinvestment risk , or the risk that, when your bond matures and your principal is returned to you, the options avail- able for reinvesting the money pay a lower yield. For bond investors, this

occurs when interest rates are on the decline. Suppose you buy a bond that matures in two years and yields 4%. After two years, the borrower returns the money you lent, and you want to invest in another two-year bond. But now interest rates have declined and two-year bonds yield 2%. That’s rein- vestment risk. You would have been better off at your initial purchase by buying a bond with a longer maturity. Of course, hindsight is always 20-20, and the fact that you can make an error when you buy a bond is why we talk about risk in the first place. Bond investors seem to love it when interest rates are falling, because the prices on their bonds rise, as they’ve done for more than 30 years. But they should be disappointed when it comes time to reinvest that money. Therein

about some of the risks associated with investing in bonds and bond funds. That knowledge base will allow us to take a rational and well-educated look at the chicken-little headlines and articles, such as Barron’s recent cover story “Trouble Ahead for Bond Funds.” That story (and others like it) play on investors’ fears rather than provide a sober analysis of bonds, bond funds and how to use them in the current econom- ic and market environment. There are a lot of holes in the article, but here’s the big piece those stories completely miss: Investors should actually welcome ris- ing interest rates. Let me explain. Short or Long Maturity? Let’s pick up where we left off last month talking about maturities. A key decision bond investors must make is how long they are willing to lend their money before they’re paid back. Bond funds don’t have maturity dates, but this question translates to your choice of funds focused on bonds with short, intermediate or long-term maturities. As we discussed last month, inter- est-rate risk is the impact of rising and falling interest rates on bond prices, and the longer a bond’s maturity, the greater that impact will be. In other words, a Treasury bond that matures in five years will have a more stable price than a Treasury that matures in 20 years. (The same logic applies to short versus long

Stable Prices…

…Or Stable Income Short-Term Treasury Long-Term Treasury $0.07

$10.0 $10.5 $11.0 $11.5 $12.0 $12.5 $13.0 $13.5 $14.0 $14.5 Fund Price

Short-Term Treasury Long-Term Treasury

$0.06

$0.05

$0.04

$0.03

$0.02

Monthly Income Per Share

$0.01

$0.00

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