Category: Investment

Rating Bonds

US Savings Bonds. Savings bonds are debt securities issued by the U.S. Department of the Treasury. They are issued in Series EE or Series I.Before you add bonds to your portfolio, you should understand how they work and what variations exist among them. Just as importantly, you need to identify the risks that come with owning bonds and how you can protect yourself from them.

Bond Basics

Bonds are essentially IOUs, issued by federal, state, and municipal governments as well as by corporations and governmental agencies. They are intended to raise revenue for a wide variety of activities. For example, governments issue bonds to finance the construction of infrastructure projects, such as roads, bridges, airports, public housing, and schools. Corporations may use the proceeds of bonds to pay for the construction of new manufacturing facilities, research and development, or to expand into new markets.

Bond investors essentially loan money to the bond’s issuer. In return, they receive interest payments at specified intervals plus a promise that the issuer will return the bond principal to investors when the bond’s term ends on its maturity date.1

Interest Rate Risk

Bonds are not a risk-free investment. Rising interest rates may reduce the desirability of the bonds you own because there is an inverse relationship between bond prices and yield. If you opt to sell a bond before it matures because interest rates on newly issued bonds have gone up, you will most likely have to accept a lower price than you paid for it.

The Importance of Credit Quality

Credit risk — or the risk that a bond issuer will fail to make promised interest and principal payments — is another important consideration. Bonds issued by companies or entities that are financially healthy are not as risky as bonds from issuers that are less financially sound. Bonds with low credit ratings offer higher yields to compensate for added risk to your portfolio.

Rating Agencies

Rating services assess municipal bonds, all types of corporate bonds, and international bonds. U.S. Treasury bonds are not rated. Before rating a bond, analysts assess various factors that could affect the issuer’s willingness and ability to meet its obligations to bondholders. For example, they examine other debt the company carries and how fast the company’s revenues and profits are growing. They take a holistic approach in that they also review the state of the economy and the financial health of other companies in the same business. In the case of municipal bond issuers, they examine and compare municipalities of a similar size and similar budget.

Credit ratings influence the interest rate an issuer must pay in order to sell its bonds. However, credit ratings are opinions about credit risk. Even though credit ratings are forward looking in that they assess the impact of foreseeable future events and can be useful to investors, they are not a guarantee that an investment will pay out or that an issuer will not default. While investors may use credit ratings in making investment decisions, they are not indicators of investment worth nor are they buy, sell, or hold recommendations. You can learn more about the rating systems of the two major services, Standard & Poor’s and Moody’s, on their websites.

This information is not meant as tailored investment or tax advice. Before building a portfolio that includes bonds, you may find it helpful to discuss your strategy with a financial professional.

1Bonds can gain or lose value based on economic conditions and market events. Principal is not guaranteed.

Understanding Total Return

Hands of a young Asian businessman Man putting coins into piggy bank and holding money side by side to save expenses A savings plan that provides enough of his income for payments.A mutual fund’s performance — its total return — can be either positive or negative. In other words, a fund either made or lost money for a measured time period. There are three separate elements that contribute to total return: the distribution of fund income (interest and dividends received on the fund’s investments); the distribution of capital gains; and the rise or fall in the price of fund shares. A fuller understanding of these three elements can help you make more informed decisions as an investor.

Fund Income

Bond issuers, such as corporations and the U.S. government, pay interest on the money loaned to them by the investors that buy the bonds. If you buy a government bond, for example, you know how much interest the bond will pay you over the life of the bond. Bonds are also known as “fixed-income” investments because you can anticipate your earnings.

If you own shares in a bond fund rather than an individual bond, you will share in the interest earned by the bonds in the fund. However, if you own your bond fund through an employer’s retirement plan, you do not actually receive your share of the interest income in cash. Instead, your share of the interest is reinvested in the fund and is used to buy additional shares for your account.

If you own shares in a stock fund, you may receive a distribution of dividends the fund received on its various stock holdings. Your share of the dividends paid to a stock fund you own through an employer’s retirement plan is reinvested in that fund and used to buy additional shares.

Capital Gains Distributions

When fund managers sell an investment that has increased in price, the fund will have a capital gain. Funds, of course, have losers as well as winners. When a fund sells an investment for less than it paid for it, the fund suffers a loss. Most mutual funds distribute capital gains (minus capital losses) to their shareholders at the end of the year. If you own funds through a retirement account, then the capital gains distributions are reinvested in additional fund shares.

Rise or Fall in Fund Share Prices

The market prices of stocks and bonds rarely remain static — they typically rise and fall each trading day. Thus, the share price of a fund depends on the current value of the investments it holds in its portfolio, after deduction of expenses and liabilities. As an investor, it’s important to understand that until you sell your shares in a fund, any gain or loss in their value is only a gain or loss on paper.

Total Return and Fund Performance

There are several ways to measure fund performance, and total return plays a part in each method.

  • Average annual total return: One way to measure the performance of a mutual fund is to look at its average annual total return for different periods of time. A comparison of a fund’s return to a benchmark will show how the fund has performed relative to an index.
  • Cumulative total return: Looking at a fund’s cumulative total return shows how much a fund has earned over a specific period.
  • Year-by-year returns: It can be helpful to compare a fund’s performance from one year to the next. If you notice a wide variation year to year, the fund is most likely a highly volatile one.

You should consider the fund’s investment objectives, charges, expenses, and risks carefully before you invest. The fund’s prospectus, which can be obtained from your financial representative, contains this and other information about the fund. Read the prospectus carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.

Prices of fixed income securities may fluctuate due to interest rate changes. Investors may lose money if bonds are sold before maturity.

Stock investing involves a high degree of risk. Stock prices fluctuate and investors may lose money.