Objectives, not price, key in bond investing

by Timothy M. Reese

for the Business Journal

Would you purchase a car based solely on its price? If you want to get the most value for your money, you probably wouldn't. You'd likely include many factors in your decision, such as, What is the car's reputation for quality? What kind of gas mileage does it get? How long will it last? What features does it offer?

Similarly, you shouldn't purchase bonds based solely on their rates of return, also called yields. If you do, you may not be choosing bonds that best meet your needs. Before shopping for bonds, make sure you:

Clarify your bond investment objectives. Most investors purchase bonds for one of three reasons: To preserve principal (the initial amount invested), to earn current income, or to achieve total return (the combination of interest payments and appreciation in the bond's price).

If principal priority is your objective, you place the safety of your accumulated wealth above other investing goals, such as income or growth.

If you seek current income, you want to generate a reliable income stream from your accumulated wealth.

And if you're looking for total return from your bond investments, you want to earn the best possible return on your bond investments in terms of both the interest income you receive and any potential gains you can achieve from selling your bonds.

Determine your risk tolerance. Your risk tolerance is an important consideration when building a bond portfolio. Your financial consultant can help you determine your bond investing risk tolerance by considering how you relate to the two major types of risk associated with bonds: credit risk and market risk.

Credit risk is a direct reflection of a bond issuer's ability to make timely interest and principal payments on its bond, even during adverse economic conditions. As with other types of investing, bond investors can be conservative, aggressive or speculative.

Many municipal and corporate bond issuers pay Moody's Investors Service, Standard & Poor's or other bond-rating services to assign credit ratings to their bonds. These ratings represent Moody's and S&P's independent assessments of the issuer's creditworthiness. You can evaluate a bond's credit risk by reviewing its rating.

You should know that bonds issued by the the U.S. government and U.S. government-sponsored agencies are not rated, but market participants attribute the highest rating to them.

Market risk reflects the reality that all bonds, even those with the highest credit ratings, can fluctuate in price before they reach maturity. A bond's price will fluctuate as its market yield rises and falls in response to changes in general economic conditions and the fortunes of the bond's issuer.

The further out in time a bond's maturity date is, and the lower its current interest rate, the more its price will fluctuate for a given yield change. You should realize that you only encounter market risk if you sell a bond before it matures. Risk and return generally go hand in hand. The greater a bond's credit risk, the higher the yield tends to be.

Once you've established your investment objective and risk tolerance, your financial consultant can help you identify different styles of bonds that are available with features that make sense for your needs.

(Timothy M. Reese is vice president of investments with A.G. Edwards & Sons, member SIPC.)