Alternative Ways to Invest in Bonds

Transcription

1 Taddei, Ludwig & Associates, Inc. Kirk Ludwig, ChFC, CFP Scot Elrod Diane McCracken, ChFC Matt Taddei, CLU, CFP 999 Fifth Ave., Suite 230 San Rafael, CA Alternative Ways to Invest in Bonds Page 1 of 5, see disclaimer on final page

2 Alternative Ways to Invest in Bonds The challenges of individual securities Even people who are experienced investors in other asset classes--stocks for example--may be less comfortable investing in individual bonds. There are many factors to consider about any given bond, and until recently bond prices have been relatively difficult for the individual investor to research and compare. Also, assembling a diversified bond portfolio may require relatively large amounts of money. Fortunately, there are several alternatives that can help you make bonds part of your overall asset allocation, even if you're reluctant to invest in individual bonds. Bond mutual funds As with any mutual fund, a bond mutual fund purchases many individual debt instruments. Each shareholder owns a tiny portion of each of the bonds in the portfolio. Funds typically pay interest income in the form of dividends. Bond funds may also produce capital gains as interest rates fall and capital losses as rates rise. Unlike the individual bonds within a bond fund, the fund itself never matures or comes due for redemption. The fund managers add new bonds to the portfolio as old ones mature or are sold. Also, default risk is generally less than with an individual bond because it's spread over many different bonds. If the issuer of one bond defaults, the performance of other bonds in the fund's portfolio might offset the loss. Bond funds may be either open-end funds or closed-end funds. Open-end funds continually offer new shares to accommodate new money as it flows into the fund and stand ready to redeem shares when the investors want to sell. Closed-end funds issue a limited number of shares and trade on stock exchanges, either at higher or lower than their net asset value (NAV), depending on investor demand for the fund. If you want to limit your bond holdings to a specific kind of bond, there's probably a fund that specializes in that type of bond. In addition, some municipal bond funds limit their holdings to bonds issued in a single state. For residents of the state that issues those bonds, income from the corresponding bond fund is free from both federal and state income tax. Finally, there are bond funds that attempt to match the results of a given bond index rather than actively trading specific bonds. Tip: Before investing in a bond mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which are outlined in the prospectus available from the fund. Read the prospectus carefully before investing. Evaluating a bond fund Many of the factors involved in evaluating an individual bond also are important when you're considering a bond mutual fund. In addition to reading the fund's prospectus before you invest, you should pay particular attention to the following information about any bond fund: Its average duration. This can help you understand how much the fund's value may fluctuate with interest rate changes. Its yield and total return. How its performance has compared to its benchmark index. Though past performance is no guarantee of future results, you should at least know how the fund compares to its peers. The type of bonds in which it invests. A bond fund may invest in a single type or maturity (e.g., intermediate-term bonds or high-yield bonds), or it may have a more diversified approach. Its expense ratio and any loads (fees) charged on the purchase or sale of shares. Page 2 of 5, see disclaimer on final page

3 Tax considerations. Depending on your tax bracket, a municipal bond fund may offer a better after-tax return than a taxable fund. Also, the dividends paid by a bond fund are taxed as ordinary interest. Even though they may be the result of capital gains from the fund manager's sale of bonds within the fund, they do not qualify as capital gains for tax purposes. Bond exchange-traded funds (ETFs) Bond exchange-traded funds (ETFs) represent shares of ownership in bond mutual funds, unit investment trusts (UITs) that invest in bonds (see below), or depositary receipts. Like a mutual fund, an ETF offers automatic diversification among many bonds. Generally, ETFs are passively-managed funds that attempt to replicate the performance of an underlying bond index. However, unlike index mutual funds, which can generally be purchased or redeemed only at an end-of-day closing price, ETFs are priced and can be bought and sold throughout the trading day. Furthermore, ETFs can be sold short (e.g., if you believe that bond prices will drop because interest rates are about to rise), bought on margin, and optioned. Stop loss and limit orders may also be placed. In addition to the questions you would ask about a mutual fund (see above), among the questions you'll want to consider with an ETF are: How do the fund's expenses compare to those of a bond index mutual fund? An ETF should have lower expenses than a comparable mutual fund. Will trading commissions and fees eat into your returns if you plan to trade frequently? Are most of the fund's distributions the result of interest income? As with a bond mutual fund, you can target a particular maturity or type of bond with an ETF. However, the more specialized the fund, the higher its expenses may be relative to other bond ETFs. Unit investment trusts (UITs) A bond unit investment trust (UIT), sometimes called a focused portfolio or a defined portfolio, buys and holds a relatively fixed portfolio of bonds or other fixed-income securities. Because the individual investments within the trust are fixed, the investor knows exactly what securities are in the portfolio, when the trust is scheduled to mature, and what level of income the trust is expected to generate. Redeemable units in the trust are sold to investors who receive an undivided interest in both the principal and the income generated by the portfolio in proportion to the amount of capital they invest. The UIT will typically buy back an investor's units, at the investor's request, at their approximate NAV. Interest payments are distributed on a predetermined date either monthly or semi-annually. Among the questions you'll want to ask about a UIT are: On what date does the UIT terminate? For a bond UIT, that date is usually the date on which the portfolio matures. Can I roll the proceeds of the trust over to another UIT? How often does the UIT make interest payments? Can I reinvest any distributions in a mutual fund or another UIT? Is the UIT insured? If the UIT is insured against failure to pay both interest and principal, it will typically offer a somewhat lower yield in exchange for the extra protection. Page 3 of 5, see disclaimer on final page

4 Buying on margin Though many investors associate the process of buying on margin with stocks, you also can buy bonds on margin, financing part of the purchase with credit your broker lends to you through your margin account. The broker then holds the bonds you purchased as collateral until you pay back the loan, plus interest. When you sell your bonds, you use the proceeds to pay off that loan; what remains is your profit (or loss) on the transaction. When you buy on margin, you leverage your investment by using somebody else's money. Bonds that can be bought on margin include municipal bonds, federal government bills, notes, and bonds, investment-grade corporate bonds, and bonds that can be converted into marginable securities (convertibles). Buying bonds on margin works in basically the same way as with stocks. You must meet your broker's initial margin requirement, which typically requires that you put into your margin account a percentage of the purchase price. Initial margin requirements are one key difference between bonds and stocks. Depending on the type of bond and its relative security, your broker may have lower margin requirements for bonds than for stocks. For example, to buy a corporate bond or a stock, you typically must put up at least 50 percent of the purchase price and often more; however, you may be able to buy Treasury securities on margin by investing a much lower percentage of your own money. That means that with a given amount of money, you can potentially control more bonds than you could stocks. Caution: Leverage magnifies the results of your investment decisions; it can lead to profits or losses that are greater than if you had invested your own money. It is a more aggressive strategy than non-leveraged investing. The ability to use greater leverage with certain bonds also means greater risk. Tip: As long as the interest the bond pays covers the interest you owe on the margin loan, even if bond prices drop, you could always simply hold the bond until maturity and redeem it at its full face value. However, you might still be required to add cash or other securities to the account to meet a margin call. You must meet certain financial tests to qualify for a margin account, but if the transaction works in your favor, you can repay your broker for the loan (plus interest). To profit, your rate of return on the bonds purchased with the margin loan--including both interest and any change in value--needs to exceed the interest owed to the broker plus trading commissions. You may want to look at the extent to which interest paid on the bonds might offset the interest you'll pay on the loan from your broker. You'll also want to think about whether you believe interest rates are likely to rise or fall in the future; that will affect the prices of your bonds and therefore your return. The interest you pay on a margin loan used to buy securities may be deductible, and there may be other tax consequences associated with a margin account. The Federal Reserve Board, the SEC, the National Association of Securities Dealers, Inc., and the New York Stock Exchange impose many rules on margin accounts; individual brokers may also impose their own (stricter) rules and margin requirements. If an investor's margin account falls below the broker's maintenance requirement, the broker may make a margin call, and the investor must either deposit more cash or securities into the account or sell some securities. Otherwise, the broker may sell any of the securities in the account to increase the holdings to at least the broker's margin requirement for maintaining the account. Caution: A margin account agreement typically gives your broker the right to loan out securities in your margin account to other investors without notifying you. The first also can force the sale of securities or assets in your account(s), or sell your securities or assets in the account without contacting you (though many will attempt to do so as a courtesy). The brokerage firm can increase its "house" maintenance margin requirements at any time and is not required to provide you advance written notice. In the event of a margin call you are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet the margin call. Also, you are not entitled to an extension of time on a margin call. Finally, you can lose more funds than you deposit in the margin account. Page 4 of 5, see disclaimer on final page

5 Registered Representative Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC.Investment Advisor Representative, Taddei, Ludwig & Associates, Inc., a Registered Investment Advisor. Cambridge and Taddei, Ludwig and Associates Inc. are not affiliated. Taddei, Ludwig & Associates Inc., 999 Fifth Avenue Suite 230 San Rafael, California Taddei, Ludwig & Associates, Inc. Kirk Ludwig, ChFC, CFP Scot Elrod Diane McCracken, ChFC Matt Taddei, CLU, CFP 999 Fifth Ave., Suite 230 San Rafael, CA scot@tlafinancial.com Page 5 of 5 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2012