The bond marketplace can be confusing. Unlike the stock market, there’s no central exchange for all bonds, some areas are less active than others, and information on individual bonds can be difficult to find. So here are four tips on buying individual bonds, to help you find useful information and potential opportunities, and to avoid common pitfalls.
1. A bond’s yield can signal opportunity—as well as risk.
One of the misconceptions among bond investors is that yield equals return—and the higher the yield the better. But yield isn’t a bond’s return, and a higher yield can also be a sign of higher risk.
There are three common measures of a bond’s yield: nominal yield, current yield, and yield to maturity (see table below for brief explanations). Yield to maturity (YTM) is the closest measure of a bond’s yield, because it captures coupon payments over the course of the bond’s life, as well as its purchase price, reinvestment of interest, and principal received at maturity.
In addition, the yield on certain types of bonds is measured differently:
Zero-coupon bonds don’t pay interest. They are purchased at a steep discount to par. Their yield to maturity is the difference between their purchase price and the face value of the bond.
Callable bonds give the issuer the right to redeem the bond before its maturity date, which would unexpectedly give back a large cash flow to investors. These bonds are typically redeemed by the issuer in a low-rate environment, thus increasing an investor’s reinvestment risk, because the returned principal might have to be reinvested at lower rates. An investor who owns callable bonds will typically see two yield calculations: YTM and yield to call (YTC), or the yield calculated to the next call date instead of to maturity.
Muni bonds are exempt from federal taxes, so it’s important to also look at their tax-equivalent yield. Consideration should also be given to whether the munis being weighed have their interest payments subject to the alternative minimum tax, as this could affect whether they will help you achieve your goal of minimizing taxes and maximizing returns.
Using yield to assess risk
Since yield calculations are similar across the bond universe, you can also use yield to assess risk. A common rule of thumb is that the higher the yield, the higher the risk, all else being equal. The high yields of some bonds may be pricing in the possibility of a change in credit quality, a downturn in the economy, or an issuer’s inability to meet its future obligations. Conversely, safer investments, like U.S. Treasuries, offer lower yields.
2. Diversification can help reduce a portfolio’s volatility.
Because bonds generally provide regular income and are less volatile than stocks, they can act as a cushion against the stock market’s unpredictable ups and downs. Bonds generally don’t move in the same direction as stocks (see chart below). Bonds tend to zig when stocks zag. The chart provided shows the performance—total return, not yield—on the eight major types of bonds, from 2000 through 2010.
How does diversification help? Returns of different kinds of bonds tend to move in different patterns. As a result, holding a mix of bond types may help you increase your fixed-income portfolio’s return potential over time without significantly increasing its risk. Diversification does not ensure a profit or guarantee against loss; its main purpose is to minimize the volatility in your portfolio. The chart below illustrates the performance of various bond-market sectors in recent years.
Investors may gain exposure to various types of bonds using bond funds or ETFs, or by building their own bond portfolio based on these types of bonds or a combination of bonds and bond funds. In general, funds provide professional management, diversification, institutional pricing, and daily liquidity. Individual bonds provide a fixed maturity date, declining price volatility closer to maturity, return of par value—assuming no default—and fixed coupons or cash flows. Defined maturity bond funds also combine the diversification of mutual funds and the fixed maturity date of an individual bond.
3. Do your research before buying.
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 to make their decisions. In part, that has been because most information in the bond market—pricing and financial information—was difficult to obtain. More recently, pricing and analysis have become more readily available.
When buying corporate bonds
Many investors rely on rating agencies when assessing corporate bonds, so consider:
- How current is the rating?
- What has been 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. For example, you may consider looking at recent independent research on the listed stock of the bond's issuer or use Equity Summary Score, which is an accuracy-weighted sentiment of the opinions of independent research providers.
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
Investors should read the official statement and other disclosure information found in the Municipal Securities Rulemaking Board’s EMMA (Electronic Municipal Market Access system). Unlike corporations, which are required to file financials quarterly, municipalities are required to file only yearly, but they aren’t closely regulated. For example, California provides daily and weekly financial data on the state. However, many cities, hospitals, and other public borrowers don't make financial records accessible.
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.) Since most muni bond insurers aren’t writing policies, one could argue that the underlying credit of an issue is more important. In other words, the issuer’s ability to pay is more important than whether it has insurance.
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.
4. Consider liquidity, which varies among bonds.
On any given day, 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.
Most corporations issue debt in one or several maturities. For example, a company might issue $1 billion split between a 5-year and a 10-year issue. But most companies don’t issue long-term debt on a regular basis, like the U.S. Treasury does. There is one exception: the CorporateNotes Program, through which a group of issuers comes to market weekly to issue set maturities. Also, commercial paper is issued daily, but it is very short term.
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.) Unfortunately, trading activity in municipal bonds is the weakest, because municipalities have a greater number of issuers and issues than corporate bonds.
So, there can be more to investing in a bond or bond fund than you might have expected. It is also important to make sure you own bonds appropriate for your time frame, tolerance for risk, and investment goal. Our four tips should give you a framework, and the tools listed below can help. If you have questions or prefer professional help, our fixed-income representatives are available.
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.