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Five tips for bond investors

Consider ladders, premium bonds, and intermediate-bond funds as rate policies change.

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After more than three decades of generally falling interest rates—and five-plus years of living in a zero-Fed-Funds-rate environment—the winds of change are blowing in the bond market.

Investors have choices to navigate the shifting environment—from professionally-managed diversified funds to managed accounts, ETFs, or individual bond strategies. But if you have chosen to manage an individual bond portfolio yourself, it may make sense to reconsider positioning and review holdings. Here are five tips for bond buyers in today’s markets.

The winds of change.

The Fed has pushed rates lower for more than five years with a combination of low-rate policy and bond-buying programs that are meant to stimulate the economy. The resulting low-interest rate environment has caused many investors to adopt new strategies. Some have become extremely risk averse, parking large amounts of money in cash. Others have accepted more risk than they might have in the past to try to generate income.

But it may be time to take another look at those positions. The Fed has been reducing its program of bond purchases and, if the economy cooperates, expects to completely finish later this year. At the same time, some members of the central bank have said they expect to raise rates at some point next year. In general, when rates rise, bond prices fall, though not all bonds will react the same way. That means it is a good time to reevaluate the risks in a fixed income portfolio.

For one thing, high yield, leveraged loans, international bonds and lower-quality corporate bonds have all seen their interest rates move closer to those offered by the highest-quality government bonds—a phenomenon known as “spread compression.” This means that investors aren’t getting paid as much to take on risk.

A low starting point for rates could also have implications if rates do rise. Higher-yielding bonds have traditionally done better than higher quality bonds when rates rise— the additional income the bonds kick off has helped to offset price decreases. In this coming cycle, that cushioning effect may be less significant than it has been in the past because the spreads are already so narrow.

“Investors need to be aware of the reduced reward offered in exchange for risk,” says Roger Young, senior vice president of fixed income at Fidelity Capital Markets. “Now may be the time to be more cautious.”

Here are five tips for bond buyers in today's markets.

1. Take a look at ladders.

While no one knows the future path of rates, Young says these conditions may argue for a bond ladder. A ladder is created by buying a series of bonds that mature periodically in a series of rungs moving out into the future. If rates do rise in response to a stronger economy or changes in Fed policy, ladders may give investors the opportunity to put some money to work at higher rates, without the risk of trying to time rate changes exactly.

2. Consider intermediate-term bonds.

Young says investors may want to consider a diversified intermediate-term bond fund. Since the beginning of 2014, the yield curve has flattened in part because yields for longer-dated bonds have fallen as demand for longer Treasuries from pension funds and other institutions has outweighed supply. At the same time, yields on two-year Treasuries have been rising as expectations for a Fed rate hike in 2015 become more widespread in the marketplace.

Typically, this kind of flattening of the yield curve—where the shortest-dated bonds have moved up in price but the longest-dated bonds have not changed much—occurs as the economy gains strength and inflation worries appear to be high enough that monetary officials may raise short-term rates, but that doesn’t seem to be the case this time. “You could argue that part of the Fed’s desire to stop QE and raise rates may be driven by the desire to normalize monetary policy,” says Young. “The end result of this attempt at normalization probably means only small incremental rate increases—data dependent—and, if inflation remains tame, the intermediate part of the market looks more stable and attractive to me.”

3. Think about premium bonds.

Premium bonds represent another possible approach to navigate today's rate environment. Premium bonds pay higher rates than new-issue bonds of similar quality. Investors have to pay more than the face value of the bond to get them, but the higher interest rates provide some advantages if you think rates may rise.

Higher income can be desirable for current expenses, but the increased cash flow also provides the opportunity to reinvest as rates go higher. That can increase the yield of a bond portfolio overall and can also reduce the sensitivity of the bond’s price to rate changes. On the other hand, in a falling rate environment the increased need to reinvest can result in lower rates. So your market view matters. Another risk of a premium bond comes if the bond is called at par. In that event, an investor would experience a capital loss.

4. Do your research before buying.

Investors need to know what they own. While this adage is true anytime, it may be particularly important for investors who have grown more comfortable with risk in their portfolios in recent years. Investors tend to make the same mistakes when choosing bonds. They allow yield to drive their investment decision, they often don’t read fundamental research on the company or issuer before investing, and they depend too heavily on ratings from a nationally recognized statistical rating organization (NRSRO) such as Moody’s, Standard & Poor’s, or Fitch.

In part, that has been because pricing, financial information and other data in the bond market—was difficult to obtain. But that is changing. “Today the bond market has become more transparent than ever before and investors have access to more information today than they ever have,” says Young.

When buying corporate bonds: Many investors rely on rating agencies when assessing corporate bonds, so consider how current is the rating, and the ratings trend for the issuer or bond. If a rating is old or if there is no pattern of upgrade or downgrade, you might need to do more homework before buying the bond.

You can gain perspective on the financial situation of a company using Fidelity’s RatingsXpress Credit Research from S&P. It gives you the rationale for S&P's rating grade, an overview of the fundamentals of the company and its standing in the industry, as well as S&P's outlook for the company. You can access the research report by searching for a bond in the Research Center, selecting the bond, and finding the research report in the right hand column of the page. (Log-in required.)

Finally, look at your bond’s yield compared with its benchmark or against similarly rated peers available in Fixed Income & Bond Markets research. For example, for a corporate bond, you might use a benchmark index of AA-rated bonds.1 If the bond’s yield is close to an A-rated benchmark, the bond market may be indicating that the bond’s credit is misrepresented, and that the bond could become subject to a downgrade.

When buying muni bonds: Muni investors should take advantage of the research available from Fidelity and the Municipal Securities Rulemaking Board's EMMA (Electronic Municipal Market Access system). You may want to compare bonds of similar credit quality and type; for instance, an A-rated revenue bond versus other A-rated revenue bonds. EMMA's price discovery tool also allows you to access the official information including recent financial data and ratings. Then, using the trade activity function, you can review all the recent trading activity in a given bond and compare it to other bonds of similar quality.

In looking at muni ratings, note whether or not the bond is insured. This information can be found in a bond’s offering details on Fidelity.com. But you may not want to put too much weight on the insurer. Since the insurer’s ability to pay is not certain, one could argue that the underlying credit of an issue is more important. Insurance does not always strengthen the bond's repayment potential.

Finally, consider new issues, because the financial information is fresh, their ratings are up to date, and they typically offer institutional pricing, meaning there is no markup or concession fee.

5. Take liquidity into account.

A company’s stock or a U.S. Treasury bond can trade as many as 20 times in just a few seconds. An active corporate bond might get 20 trades in several hours. Some muni bonds might take several years to get 20 trades.

Trade volume is important because if you own a bond and need to sell, you have to find a buyer. A bond that has little trading volume might be hard to sell. If you are forced to sell, you may have to be willing to accept a very low price in order to find a buyer—causing you to suffer a loss.

Recent trading activity can be a clue to how active and liquid a bond might be in the marketplace. You can obtain access to pricing on municipal bonds, agencies, and corporate bonds when researching an individual bond using our Fixed Income & Bond Market information. Note: Trading activity in municipal bonds is the weakest, because municipalities have a greater number of issuers and issues than corporate bonds..

In conclusion

The bond market has changed a lot in recent years, but there is more change to come. It is important to make sure you own bonds that are appropriate for your time frame, tolerance for risk, and investment goal, and to consider your outlook for the market. Our four tips should give you a framework, and the tools listed below can help. If you have questions or prefer professional help, call one of our fixed income representatives.

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Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Past performance is no guarantee of future results.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
The information presented above reflects the opinions of the speakers as of August 8, 2014. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility by maturity is not possible.
Interest income earned from tax-exempt municipal securities is generally exempt from federal income tax, and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. In addition, you may be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. Market discount arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the official statement for the relevant offering for additional tax and other considerations.
The municipal market can be adversely affected by tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax advisor regarding your specific situation.
A bond ladder, depending on the types and amounts of securities within it, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of your portfolio value. You must perform your own evaluation as to whether a bond ladder and the securities held within it are consistent with your investment objectives, risk tolerance, and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a representative.
Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss.
Issuers can redeem callable bonds prior to maturity. This typically occurs when interest rates decline and issuers have incentive to refinance their debt at lower prevailing levels of interest rates. When this occurs, investors typically find that the reinvestment choices the market presents have lower yields for commensurate levels of risk. Investors should read a bond’s prospectus to understand its call risk.
1. Credit ratings can also speak to the credit quality of an individual debt issue, such as a corporate note, a municipal bond, or a mortgage-backed security, and the relative likelihood that the issue may default.
"AAA"—Extremely strong capacity to meet financial commitments—highest Rating.
"AA"—Very strong capacity to meet financial commitments.
"A"—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
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