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How to help generate predictable income

Owning bonds, bond funds, and CDs to maturity may lessen worries about rising rates.

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When interest rates moved quickly higher last year, some investors headed for the exits, with more money flowing out of bond mutual funds than into them for the first time in many years. But even while bond funds saw outflows, money was moving into individual bonds. One reason: An individual bond, CD, or fund with a defined maturity may help an investor manage the risk of price losses from rising rates.

The reason is simple: Higher rates cause bond prices to fall, and that means the value of investments may dip. But, if you can hold a bond, CD, or defined-maturity fund to maturity and the issuer completes its repayment, you will collect your interest and principal, regardless of what happened to prices in the interim.

For long-term investors, falling bond prices in the near term may not matter much, because bond funds tend to benefit from rising rates given enough time. But for investors who may need to access their money at a specific time in the future, investment products with a defined maturity may offer some appeal. Investors who hold to maturity can expect a more predictable return relative to investing in a traditional bond fund, though both are subject to the usual risks of bond investing.

One risk among many

Investing in defined maturity funds and individual bonds does not remove price swings—an investor may realize losses if he or she sells before the maturity date. With individual bond ownership, the risks of selling could also include liquidity risk, which could increase losses.

In addition, all the other risks that go with bond investing still exist, including the risk that an issuer may not complete its payments, or that inflation will eat into returns.

“The ability to determine the maturity of your bond portfolio may give you a bit more control over when you get your income and may help limit how much changes in the rate environment impact your financial plans,” says Richard Carter, vice president of fixed income products and services. “This predictability of return can be an important feature for investors who are looking for income on a specific schedule, and for whom access to principal before maturity isn’t important.”

Here are three ways to invest for a well-defined time horizon.

Cash-flow matching—individual bonds

If you know when you need interest or the principal back from your investment and can invest enough to achieve diversification and manage transaction costs, individual bonds provide an investment option that can be tailored to your plan and time frame. If you are saving to buy a second home at retirement, for instance, you might invest in zero-coupon bonds that will reach maturity when you expect to stop working. The bonds may fluctuate in price along the way, but if you can hold them to maturity and the issuer does not default, you should be able to plan on predictable returns from your investment.

A key to this strategy is liquidity. Keep in mind that holding individual bonds doesn’t protect the investor from price changes caused by interest-rate fluctuations if the bonds are sold prior to maturity. So, you should have enough money besides the bonds to cover your other income needs.

While control over maturity may be appealing, the decision to buy individual bonds should not be based on a desire to control maturity alone. Buying individual bonds means you have control over the credit quality of your portfolio, down to the specific issuer; that provides flexibility but it also means you have to manage your own portfolio diversification and credit research.

“An investor concerned with rising rates may be willing to accept more credit risk now, at least with shorter-dated bonds, on the assumption that rising rates are coming from a strengthening economy,” says Carter. “At the same time, we must remember that default risk has been trending lower for a while, and that default probability does move in cycles. The end of cheap money could mark the turning point for the refinancing opportunities for riskier credits, sending credit distress and default rates higher. So if you are buying individual bonds, you should be careful about how much credit risk you are taking on."

A bond ladder

A ladder of individual bonds or CDs may make sense for an investor looking to manage the risk of rising rates without a clear end date or over a longer period of time. A ladder strategy involves buying bonds maturing in intervals, or “rungs,” for example, two, four, six, eight, and 10 years, and holding them until maturity. As each rung of bonds comes due, the investor retrieves part of their overall principal. The chart to the right shows a hypothetical example of a CD ladder where, assuming the investor remains within the $250,000 FDIC insurance limit, the credit risk would be zero. Fidelity suggests that no more than 5% of one’s bond portfolio be placed in a specific issuer name. So it is possible to construct a ladder using Fidelity’s online or rep-assisted bond ladder tools that contain multiple different issuers per rung in order to help diversify against credit risk.

When investors get their principal back, they can choose to use the money to cover a spending need. Alternatively, they might choose to reinvest the money into a ladder. If the money is reinvested at higher prevailing rates, the overall income on their portfolio will go up. If rates have moved lower, reinvesting might cause a drop in future income. The key is that maturing bonds deliver cash flow at defined points in time, which may be a useful feature for investors looking to build a portfolio for income.

“Over the past year, Fed policy has anchored short-term rates for now, while longer-maturity bonds have seen yields rise, leading to a steep yield curve,” according to Carter. “That increases the appeal of a ladder for investors worried about rates, because it can provide an investor access to some of those higher yields while still providing some protection from rising rates, thanks to the bonds or CDs that will mature in the next two to six years.” (See the chart to the right.)

Defined-maturity funds

Defined-maturity funds (or similar ETF products) offer a way to combine some of the benefits of professionally managed funds with some of the control that individual bonds provide. While most bond funds provide diversification, professional management, liquidity, and credit surveillance, they cannot easily be customized to a specific time horizon, unlike individual bonds and bond ladders, where the maturity and payment dates are very explicit. This could result in a potential timing mismatch that could expose investors to market risk. Individual bonds, on the other hand, can be tailored to fit investors’ specific needs, but security selection may be difficult for the average investor, and the transaction costs can be significant. Defined-maturity funds seek to bridge the gap between individual bonds and bond funds, by offering the professional management and diversification of bond funds with the defined maturity of an individual bond.

General attribute Investment product
  Bond fund DMF Individual Bond
Professional
management

Within the fund's
maturity range
Diversification Possible, with
multiple bonds
Institutional
transaction costs
No ongoing
management fees

Ladders may
incur ongoing costs
Daily liquidity
At current NAV

At current NAV
 
Varies
Maturity/end date
Declining price
volatility toward
maturity
Return of
par value
Fixed coupons
Individual bonds carry the risk of default. The attributes above refer to fixed-rate, noncallable bonds.

Bottom line

Investors in conventional bond funds may see the net asset values of their investments change when rates move. The same price changes impact individual bonds and defined-maturity bond funds, but, by holding these investments to maturity, investors may be able to lessen the impact of these price changes on their investment goals.

Learn more

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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.
Information provided in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The views and opinions expressed by the speakers are their own as of April 23, 2014, and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions. Fidelity Investments disclaims any liability for any direct or incidental loss incurred by applying any of the information in this article. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing these investments by making this article available to its customers.
The municipal market is volatile and can be significantly affected by adverse tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Unlike individual debt securities, which typically pay principal at maturity, the value of an investment in the fund will fluctuate.
As the fund approaches its liquidation date, the fund’s securities will mature, and the fund may reinvest the proceeds in money market securities with lower yields than the securities previously held by the fund. Although money market funds seek to maintain a stable NAV of $1 per share, this is not guaranteed, and they may in fact lose money. The amount of the fund’s income distributions will vary over time, and the breakdown of returns between fund distributions and liquidation proceeds will not be predictable at the time of investment. You may experience a gain or loss for tax purposes. Although the price volatility of the funds is designed to decline as they approach their defined end date, shareholders who sell the funds before this date could experience more price (NAV) uncertainty.
Additional considerations for investors in municipal bonds: Some municipal bonds may not be tax-advantaged, depending on the issuer and your state of residence. Some bonds in a portfolio may also be purchased at a premium, which may result in realized losses. Keep in mind that certain municipal bonds may be difficult to sell (since a particular bond issuer may be unable to make interest or principal payments) or may be in default, in which case such bonds may have little or no value. In other cases, the interest on municipal bonds may be determined to be taxable after purchase. Bond ladders focused on California municipal bonds are more susceptible to political, economic, and regulatory factors, including budget deficits and an eroding tax base.

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 avoiding losses caused by price volatility by holding them until maturity is not possible.

The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.

Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Your ability to sell a CD on the secondary market is subject to market conditions. If your CD has a step rate, the interest rate of your CD may be higher or lower than prevailing market rates. The initial rate on a step rate CD is not the yield to maturity. If your CD has a call provision, which many step rate CDs do, please be aware the decision to call the CD is at the issuer's sole discretion. Also, if the issuer calls the CD, you may be confronted with a less favorable interest rate at which to reinvest your funds. Fidelity makes no judgment as to the credit worthiness of the issuing institution.

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