Title: The Use of Bonds in Financial Planning: How to Structure an Investment Portfolio to Meet Long-Term Needs
Abstract: Bonds traditionally have been the province of institutional investors. However, as individuals seek to diversify their portfolios and add an element of certainty to future investment returns, bonds have become increasingly popular. This article examines bond characteristics, pricing, investment risk and ways to protect against that risk--information that can be extremely useful to CPAs and their clients in structuring investment portfolios designed to meet long-term needs. BOND CHARACTERISTICS Bonds are fixed-income securities. The bond contract (indenture) calls for payment of principal (par value) at maturity and periodic interest payments during the bond term. Interest payments are determined by multiplying the bond's par (face) value by the interest rate (coupon rate) called for in the contract. Generally, interest payments are made semiannually, and bond terms run from one to several years. Bond prices are based on the amount and timing of future cash flows from the bond and the current market rate of interest. Future cash flows include interest during the bond term and return of par value at maturity (or sales proceeds if the bond is sold before maturity). Bond prices generally are based on the assumption the bond will be held to maturity. The bond price is the present value of interest payments plus the present value of the return of par at maturity, determined using the current market interest rate. If the market rate is greater than the coupon rate, the bond will trade below par (at a discount). If the market rate is less than the coupon rate, the bond will trade above par (at a premium). If the coupon and market rates are equal, the bond will trade at par. There is an inverse relationship between changes in the market rate and bond prices: As the market rate increases, the bond's price decreases, and as the market rate decreases, the bond's price increases. Exhibit 1, at left, shows how bonds are priced and how market rate changes affect prices. BOND RISK To judge whether a bond is a good investment, investors must consider the risk characteristics of the entity issuing the bond (default risk) and the risk of a change in interest rates (interest rate risk). Default risk and types of bonds. Different entities issue bonds at different levels of default risk. Generally, the higher the default risk, the greater the rate of return. Lowest-risk bonds are issued by the U.S. Treasury. Since principal and interest on such bonds are guaranteed by the U. S. government, these bonds have essentially no default risk. States, municipalities and other political subdivisions issue general obligation bonds, which-although backed by the issuer's full faith and credit-have an increased level of default risk. Municipalities also issue revenue bonds, which are serviced by income from specific revenue-producing projects such as toll bridges. Revenue bonds often carry a higher risk than general obligation bonds since their repayment depends on the project's success. Interest received on municipal bonds is free of federal income tax. Nongovernment entities also issue bonds (debentures). These bonds' default risk depends on the issuer's ability to service the debt, which in turn depends on the issuer's financial condition and the business risks it faces. Default risk can be lowered by adding covenants to the bond indenture. Covenants provide safeguards to bondholders by restricting business activities. Interest rate risk. Interest rate risk, the risk the market rate will change, is inherent in all bonds. If interest rates change while bonds are held, the actual return on the investment will differ from the expected yield. The two components of interest rate risk are * Reinvestment risk. Reinvestment risk occurs when interest payments during the bond term cannot be reinvested at the market rate. Exhibit 2, page 48, illustrates this risk. In example 1, interest is reinvested at the market rate and the bond is held to maturity. …
Publication Year: 1992
Publication Date: 1992-05-01
Language: en
Type: article
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Cited By Count: 2
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