Brushing Up On Bonds

After years of uninspiring returns, bond yields are finally on the rise. This has happened because the Federal Reserve is about to embark upon a cycle of interest rate hikes.

In response, some investment grade corporate bonds have seen yields on 5- and 10-year bonds rise to over 5%. For a fixed income investor, this is starting to become an attractive proposition for the first time in several years. That yield is still short of current inflation rates, but that gap should close as interest rates start to rise.

Thus, it may be a good time to brush up on your knowledge of fixed income securities.

What are Fixed Income Securities?

Fixed income securities offer the purchaser a fixed income rate, typically until some maturity date. The issuer of the fixed income security uses these securities to raise money for day-to-day operations and finance large projects.

Common types of fixed income securities are government and corporate bonds, certificates of deposit (CDs), and preferred stock.

We are going to delve deeper into bonds, which are the most popular type of fixed-income security. The concept is straightforward. The issuer is borrowing money from you, and they pay you an interest rate that is correlated with the perceived credit risk.

Who Needs Fixed Income?

Fixed income securities are appropriate for anyone that relies on investment income for any purpose, and who must minimize risks to capital. This is distinct from those who are attempting to build their wealth over time, in which case they would want to invest in more aggressive securities.

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Retirees typically count themselves as fixed income investors. However, most people, retired or not, should shift their portfolio toward more fixed income choices as they approach their retirement years. It could take years to recover from a major bear stock market, but you can significantly reduce risk in your portfolio as you approach retirement by increasing the percentage devoted to fixed income options.

What are the Risks?

Even though the risks of fixed income securities are low compared to stocks, they are not risk-free. The single biggest risk is that your yields fail to keep up with inflation.

For example, at present the annual inflation rate in the U.S. is running at about 8%. This means that on average, you will have to pay 8% more each year for the goods and services you purchase.

Now, consider the yield from various fixed income offerings. Most CDs and bonds with the highest credit ratings will yield far less than 8%. If your retirement savings are invested in such securities, the value of your savings will decline over time.

However, it is possible to buy bonds today that yield 8%. That brings me to the second area of risk. High-yielding bonds like this fall into two classes. The first consists of companies with a higher credit risk, and thus a lower credit rating.

The reason these bonds yield more money is that the investor is assuming a higher risk of default, which means the possibility of losing their entire investment. That’s a nightmare scenario for a fixed income investor and a good reason to avoid these “junk bonds.”

To put the credit risk in perspective, here are the credit rating descriptions from the “Big Three” credit rating agencies — Fitch Ratings, Moody’s and S&P — of all bond categories considered “investment grade.”

Presently, you will not find any investment-grade bonds yielding as high as 8%, but the gap between inflation rates and investment-grade bonds should close as interest rates rise.

A second risk comes in the form of bonds that are “callable.” This means that the issuer can redeem them at a specific price and on a specific date.

Let’s say a bond at $25 yielded 6% when it was issued. That means annual interest rate payments of $1.50 (6% of $25) for each bond you own. But let’s say interest rates have risen, and the bond is now being traded at $28. You can buy this bond for $28 and receive an effective interest rate of 5.36% ($1.50/$28.00).

However, if that bond is currently callable, you could see it redeemed at any time for $25. You risk losing the $3.00 premium you paid for the bond if it is redeemed before the interest payments justify paying that premium. That’s why you don’t buy callable bonds (or preferred shares) above their call price if they can be immediately called.

A final risk is that interest rates will rise. In that case, you would still receive the same interest payments from your bond, but the value at which you could resell the bond will decline. This may not be an issue if you don’t plan to resell the bond, but a rise in interest rates can also reflect rising inflation. You may find some erosion of your buying power over time.

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Bonds are sold as new issues or in the secondary market from your broker. You can also buy U.S. Treasury securities directly from the U.S. government at

That covers the most basic information about bonds. Given the prospect of rising interest rates, you should really get up to speed on this investment option. Your retirement may depend on it.

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