the fundamentals of fixed income investing

8/8/2019 The Fundamentals of Fixed Income Investing

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When it comes to makinginvestment decisions,stocks oten grabthe lions share o

our attention. Fixed-income securities

which may seem less complex or riskyareoten selected more hastily, perhaps on thesole basis o yield. But bonds are a critical anddiverse eature o the investment markets, andwell-chosen bonds should play a undamentalrole in the portolios o many investors. Iyoure considering investing in bonds, youllneed to understand what xed-income securitiesare and how they work. You will also need to

understand how to appropriately use them in aportolio designed to meet your nancial goals.

What are xed-income securities?

Bonds are loans you make to the corporationor governmental entity that issues them. Inreturn or your assets, most bonds and otherdebt securities pay a xed dollar amount ointerest at regular intervals until the date theymature, at which time their principal (acevalue) is repaid. The annual dollar amountis ound by multiplying the xed coupon

(interest) rate by the securitys ace or parvalue, usually $1,000. Thus, a bond with a 5%coupon rate will pay $50 o interest each year.

The xed-income market is diverse, cov-ering a wide maturity range (rom moneymarket instruments maturing in less than oneyear to long-term bonds maturing in 30 years

or more) and credit range (rom high-qualityU.S. Treasury securities to high-yield junkbonds, whose issuers might miss their interestpayments). Between these extremes in creditquality are mortgage- and asset-backed securitiesand investment-grade corporate bonds, whichprovide higher income and have more creditrisk than Treasuries, and tax-ree municipalbonds, whose income payments are exemptrom ederal and, in some cases, state taxes.

Features of xed-income securitiesn The Coupon Rate. Coupon rates usually varydirectly with a bonds maturity (the longerthe maturity, the higher the rate) and inverselywith the issuers creditworthiness at the time oissuance (the higher the quality, the lower therate). U.S. Treasury securities have the lowestcoupon rates because the ederal governmentas the only entity that can print moneyis thenations most creditworthy borrower.n Coupon vs. Yield. Although a bonds couponrate is usually xed, its price and yield will vary

with fuctuations in general interest rate levels,credit ratings, and demand/supply conditions.Returning to the previous example, an investorwho bought a 5% $1,000 par value bond ata price o $900 would realize a current yieldo 5.6% ($50 divided by $900 = 5.6%). I thebond had been priced at a premium to par, say$1,100, the yield to the investor would havebeen 4.5% ($50 divided by $1,100 = 4.5%).

Volume 1

Number 238

From the

T. Rowe Price

Information

Library

The Fundamentals of

Fixed-IncomeInvesting


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Table I: Change in Principal Values of Bonds

as Interest Rates Rise or Fall

Bond

Maturityin

Years RatesRise1% RatesFall1%

1 $990.57 $1,009.62

3 $973.27 $1,027.75

5 $957.88 $1,044.52

10 $926.40 $1,081.11

30 $862.35 $1,172.92

Chartassumesa5%couponand$1,000parvalueforeachbondandshowsvaluechanges

apartfromfluctuationscausedbyothermarketconditionsorfactors.

n Yield vs. Total Return. Many investors ocus

only on the current yield oered on debt secu-rities. This is a mistake because the total returnis a truer representation o the value o a xed-income investment. Total return depends onanother important componentappreciationor depreciation. For example, a bond that paida 5% coupon rate or a particular year and alsorose 1.5% in price would post a total annualreturn o 6.5%. A 1.5% price decline wouldhave reduced the total return to 3.5%.

Generally, prices o longer-maturity bonds

fuctuate more in response to changes ininterest rates than those with shorter maturi-ties. This is one o several risks associated withbond investing:n Interest Rate Risk. I interest rates rise ateryou purchase a xed-income security, thebonds price will decline. By the same token,a decline in interest rates raises bond prices,which can boost your total return. O course,these are only paper gains or losses unless thebond is sold beore it matures.

A quick way to gauge a bond or bondunds potential or price fuctuations isto look at its duration, which is a moreaccurate measure o a unds interest ratesensitivity than maturity. Multiplying theduration by the expected change in interestrates tells you approximately how much thatsecuritys price will change. For example, abond with a our-year duration means thatits price would decline about 4% or everyone-percentage-point increase in rates, and

vice versa.

n Credit Risk. Yields refect a borrowerscredit quality as well as the instrumentsmaturity. Lower-quality (noninvestment-grade or high-yield) bondsthose rated BB

or belowgenerally oer higher yields thanbetter-quality issues, but may be more volatile.The higher yield compensates you or lendingmoney to a company that is considered morelikely to deault(not make timely interest orprincipal payments). Thus, a rising yield (andalling price) on a bond may refect acompanys deteriorating nancial situationrather than any overall rise in interest ratelevels. Conversely, when a companysnancial situation improves, the yields on itsobligations should decline.

Fixed-income securities and your portfolioMary J. Miller, director o T. Rowe PricesFixed Income Division, notes: Many investorsappreciate the important role xed-incomeholdings can play in their investment portolios.They know these holdings not only generateincome, but they also can reduce the portoliosoverall volatility with only a moderate sacricein total return.


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In a well-allocated portolio, the allocation obonds, equities, and short-term investmentswill change over time depending on how longyou have to invest or your goal; visit

troweprice.com or more inormation. However,within the xed-income allotment o a well-diversied portolio, 70% might be ininvestment-grade bonds, 20% in high-yieldbonds, and 10% in international bonds.(Diversication cannot assure a prot orprotect against loss in a declining market.)

You may be able to enhance your diversica-tion and manage your business and sector riskby investing in xed-income mutual unds asopposed to individual securities. Bond unds

are a little unusual in that, unlike most bonds,they dont have either a xed coupon or matu-rity date. However, unds are ar easier to movemoney into and out o. Most xed-incomeinstruments trade in large blocks: or example,$5,000 or municipal bonds or $25,000 orGinnie Maes (GNMAs). Mutual unds allowyou to invest in a broad portolio o securitieswith a low minimum investment. They alsooer proessional research and portolio manage-ment, oten at low cost.

Beore selecting an investment, you shouldalso determine whether tax-ree municipalbonds would be more advantageous to youthan taxable bonds; see the Investing in High-Yield Municipal Bonds Insights report ormore details.


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