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Fixed Income and Bond ETFs Could Reduce Your Portfolio’s Volatility
Posted By Ron On August 19, 2011 @ 1:00 AM In Investing | Comments Disabled
Depending on which side of the equation you’re on, bonds can be either a loan or debt. Bonds essentially are loans that investors make to corporations and governments. They are also known as fixed-income investments because the corporation or government that borrows the money and issues the bond typically pays the bond investor (the lender) a fixed amount of interest over a pre-defined period of time.
At the end of the term, the corporation of government pays back the original investment (the principal) to the investor. All bonds have a face value (the price of the bond), and a coupon, which is the annual rate of the interest the bond pays. For example, an investor who buys a bond with a face value of $1,000 and a coupon of 4% will pay $1,000 for the bond and receive $40 in interest payments each year for the length of the term.
Because investors get back their original investment, there is a reduced amount of risk involved in bond investing. Subsequently, the amount of interest represented by the coupon rate is generally lower than the historical returns generated by equity (stock) investing.
So, bond investors will always get the prevailing rate that’s demanded by the market. Bonds with high coupon rates have higher prices, negating that higher rate and bonds with low coupon rates have lower prices, padding that lower rate.
Investors buy bonds in order to build portfolios that suit their ideal asset allocation according to their risk tolerance . Bonds tend to have a low correlation with stocks — that is, when stocks fall, bonds tend to rise. So owning bonds can help provide a hedge or a “safety cushion” in the event of a downturn in the stock market. In addition, bonds provide a steady stream of income at rates considerably higher than the historical average dividend yield of stocks — about 5 percent annually for bonds compared to just 1.5 percent or so for stocks.
Think of it this way: if the prevailing interest rate is 3 percent but a bond has a rate of 12 percent, wouldn’t more investors want that bond? What happens when more people want something that is scarce? You guessed it – that item increases in price – and bonds are no different.
On the flip side, should the prevailing rate be 8 percent but an individual bond has a coupon rate of only 4 percent, that bond will be sold at a discount to entice buyers to purchase it. After all, why buy a 4 percent investment when you could buy an 8 percent investment? – because you can buy it at a discount to make up the interest you wouldn’t get.
Bond exchange traded funds (ETFs) track indexes made up of individual bonds. Bond ETFs don’t have a face value or a coupon rate because those components are tied up into the bond’s share price. The bond ETF’s share price is determined by the prices (face values) of the individual bonds in the index that the ETF tracks. Consequently, when the prices of those bonds in the ETF rise, the ETF’s share price also rises. When the bond prices fall, the share price falls. Instead of a coupon rate, bond ETFs have a yield or interest payment that equals the average rate of the bonds in the index tracked by the ETF. Though the interest payment on an individual bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF shift. But, these interest rates change only in small amounts.
Investors by bond ETFs for the same reason they buy bond mutual funds — to avoid the hassle and expense of buying a collection of individual bonds. Though bond ETFs tend to have lower expense ratios than most bond mutual funds, the selection of bond ETFs is somewhat limited though there are hundreds of bond mutual funds. Still, there are a number of options for bond ETF investors who want exposure to the overall bond market conveniently and at a low cost.
Any online broker can help you buy bonds, bond ETFs, or bond mutual funds. Here are a few to consider.
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