investing with bonds

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The volatility in todays financial markets is making it impossible to know where to invest and grow your money without the fear of losing your lifetime savings. Historic low interest rates are making is difficult to provide the income needed by investing in safer investments such as CDs and annuities. Investing a portion of your overall portfolio in fixed income investments should be considered as a solution to reducing volatility and providing needed income.

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  • 1.Presented by: Russell D. Francis, CPA, CFP 503-684-6116 www.pdxfis.com April 19, 2012

2. Disclaimer Portland Financial Advisors, Inc. is registered as an Investment Advisor with the State of Oregon. All information contained in these slides concerning investments is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. All statistics/prices/quotes have been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. 3. Objectives Are bonds appropriate for your portfolio? Learn about the various risks associated with bond investments Learn how different types of bonds help you reach different goals Learn about various bond trading strategies Understand the difference between individual bonds and bond funds Learn about the various methods to invest in bonds How much should I invest in bonds? Where do equities fit in? 4. Why Bonds? There's an old saying, "You make your money in stocks but keep your money in bonds." The volatility in todays financial markets is making it impossible to know where to invest and grow your money without the fear of losing your lifetime savings. Historic low interest rates are making is difficult to provide the income needed by investing in safer investments such as CDs and annuities. Investing a portion of your overall portfolio in fixed income investments should be considered as a solution to reducing volatility and providing needed income. 5. Benefits of Investing in Bonds You can align your investments with your financial goals, rather than speculating in the markets. Individual bonds can provide a steady stream of income regardless of the value of the bond, and you get all of your money back at maturity. Bonds provide diversification, smoothing out the higher volatility connected with equities. A bond portfolio can be immunized so that you receive a specific rate of return over a given time period regardless of what happens to interest rates during that time. 6. Benefits of Investing in Bonds Historical evidence shows that investment grade bonds with Aaa/AAA ratings are very safe investments. If held to maturity, there is less than a 1% probability of default based on statistics back to 1920, which includes the Great Depression. Since 1970, the record has been even better. The only investments with lower expected default rates are Treasuries, CDs and Agencies, which also offer investors lower yields. To further reduce risk, there are several bond strategies that help preserve your principal while minimizing taxes and the impact of inflation. Some bonds have distinct tax advantages for high income earners. 7. Benefits of Investing in Bonds It is important to realize that bonds can and do decline in value, but historically bonds show much less volatility than stocks, as you can see in the following table: Bond portfolios serve a number of objectives, but their main goals are principal preservation and income generation. The proportion of bonds vs. stocks in a portfolio depends on the investors risk tolerance, time horizon, and income needs. Bonds should be a larger portion of a portfolio if an investor is risk averse, or needs a steady stream of income. Name Ticker Inception Date Worst 1 Year Return 10 Year Avg. Return (as of 3/31/12). Vanguard Total Bond Market Index VBMFX 1986 -00.76 in 1999 5.51% Vanguard Total Stock Market Index VTSMX 1992 -37.04 in 2008 4.92% 8. How Bonds Work In simple terms, a bond is just a loan. If you lend out $1,000 for 10 years in return for a yearly payment of 3.75% interest, you could just as well have purchased a bond. The $1,000 of principal is the face value of the bond. The yearly interest payment is its coupon. The length of the loan, 10 years, is the bonds maturity. A bond is a loan that can be bought like any other security - it is an investment. 9. The Price of a Bond Bond prices move in the opposite direction of interest rates. When interest rates rise, bond prices will fall. This is because the interest you are earning on a bond is fixed. Lets say you purchase a new bond for $1,000 with a coupon rate of 4.0%. If interest rates go up to 4.5%, no one would want your bond paying 4.0%, so the price of your bond would be adjusted downward. If interest rates go down to 3.5%, everyone would want your bond paying 4.0%, so the price of your bond would be adjusted upward. Regardless of the price, you would still receive coupon payments of $400 annually and you would get back your $1,000 investment at maturity. 10. The Price of a Bond Unless bonds are new issues, they rarely sell for exactly face value or par. Take a $1,000 bond with a 4% coupon that matures in the year 2014. If you manage to buy it for $800, youve effectively bought a bond with a 5% coupon, since the $40 coupon is 5% of your $800 purchase price. The current yield of the bond is 5% (the coupon rate adjusted for the current bond price). Better yet, even though you paid $800, in 2014 you will receive the full $1,000 face value. The total return, taking into account the $200 capital gain is called the yield to maturity. 11. Bond Maturity A bonds maturity refers to the specific future date on which the investors principal will be repaid. Generally, bond terms range from 1 year to 30 years. Shorter-term bonds, which generally offer lower returns, are considered comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term bonds provide greater overall returns to compensate investors for greater pricing fluctuations and other market risks. 12. Bond Yield Curve Rising Yield Curve - Buy longer-term bonds to capture the additional yield. Flat Yield Curve - Buy short-term bonds because there is no compensation for taking on the risk of longer-term bonds. Inverted Yield Curve - Buy short and intermediate term bonds. 13. Fixed Income Risk Market Price risk - The risk of bond prices going down due to rising interest rates. Interest Rate risk Fixed bond coupons not keeping up with inflation. Call risk The risk the loans (bonds) will be paid off early. Default risk (or Credit risk) The risk that the bond issuer will not be able to make scheduled payments or pay back the principal. Liquidity risk The risk that you may not be able to find a buyer if you need to sell the bond. 14. Market Price Risk The longer a bonds maturity, the higher the duration. That is, a 30 year bonds price will fluctuate more than that of a 10 year bond. This potential price volatility is referred to as market price risk. Because longer-term bonds pay higher yields, many investors purchase them without being fully aware of the risks. A 30-year bond has a duration of about 16 years, meaning the bonds price will drop 16% for every 1% increase in interest rates. Market price risk can be eliminated by holding bonds to full maturity so that you get back the face value of the bond. 15. Interest Rate Risk Bond prices will fall if interest rates rise (Market Risk). But, if rates rise substantially, you would not get the higher coupon yields paid by newer bonds. We already know market price risk can be eliminated by holding bonds to full maturity. Interest rate risk can be minimized by building a bond ladder in which some bonds mature each year so that money can be reinvested at higher coupon rates. 16. Call Risk Your loan may be paid back early, or called, forcing you to find another, possibly less lucrative place to put your money. Since a call provision offers protection to the issuer, callablebonds usually offer a higher annual return than comparable non-callablebonds to compensate the investor for the risk that the investor might have to reinvest the proceeds of a called bond at a lower interest rate. 17. Default or Credit Risk Default risk can never be completely eliminated but it is rare for high quality bonds (grade Aa/AA or better) to default, and some bonds can be insured. Diversification among types of bonds, corporate sectors, and geographic locations will also minimize risk. Historically, defaults on investment grade bonds are rare for both municipal and corporate bonds. Portfolios consisting of Aaa/AAA and Aa/AA bonds have a very low probability of default. 18. Bond Rating Grades (Quality) Credit Risk Moodys Standard & Poors Fitch Investment Grade Highest Quality Aaa AAA AAA High Quality Aa AA AA Upper Medium A A A Medium Baa BBB BBB Not Investment Grade Lower Medium Ba BB BB Lower Grade B B B Poor Grade Caa CCC CCC Speculative Ca CC CC No payments/Bankruptcy C D C In Default C D D 19. Bond Default Rates Bond Default RatesCumulative Percent (19702008) 1 Aaa/AAA indicate top-rated investment grade bonds; Aa/AA bond represent the lower part of the upper tier of investment grade. Moodys ratings for the full range of investment grade bonds are Aaa, Aa, A, and Baa; Standard & Poors and Fitch investment grade ratings are AAA, AA, A, BBB. Non-investment grade ratings are all below Baa and BBB. Source: Municipal Securities Rulemaking Board (MSRB) Rating Categories1 Moodys Standard & Poors Municipal Corporate Municipal Corporate Aaa/AAA Bonds 0.00 0.52 0.00 0.60 Aa/AA Bonds 0.06 0.52 0.00 1.50 Investment Grade 0.07 2.09 0.20 4.14 Non-Investment grade 4.29 31.37 7.37 42.35 20. Types of Bonds CDs Treasuries (Bills, Notes, Bonds) TIPs (inflation Protection) Agency Bonds (SBA, FHA, FHLB, FRMA, FNMA, GNMA) Zero Coupon Bonds Municipal Bonds (Taxable and Non-Taxable, BABs) Corporate High Yield (Junk Bonds) Step-Up Bonds Index-Linked Bonds Bond Exchange Traded Funds (ETFs) Bond Mutual Funds 21. Safety of Principal CDs are FDIC Insured by the issuing bank for $250,000 per account holder. Treasuries are backed by the full faith and credit of the U.S. government. Aaa/AAA rated bonds rarely default. Municipal bonds may be insured. Diversify among types of bonds, corporate sectors, and geographic

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