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Diversification with bonds - potential benefits and risks

In this article
  • The benefits and risks of bonds
  • Individual bonds vs. bond mutual funds
  • A bond's value varies with the market
  • Types of bonds and categories of risk

A bond is an "IOU" for money loaned by an investor to the bond's issuer. In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate known as the "coupon rate." At the end of an agreed-upon time period -- when the bond "matures" -- the issuer's objective is to repay the investor's principal.

Benefits and risks of bonds

Because bonds generally may not move in tandem with stock investments, they help provide diversification in an investor's portfolio. They also seek to provide investors with a steady income. Zero coupon bonds and Treasury bills are exceptions: The interest income is deducted from their purchase price, and the investor is expected to receive the full face value of the bond at maturity. Keep in mind that the market value of zero coupon bonds fluctuates more than the regular corporate bonds; therefore, they may not be suitable for investors with liquidity needs.

Individual bonds vs. bond mutual funds

Because individual bonds require initial investments ranging anywhere from $1,000 to $100,000, many bond investors pursue their goals through mutual funds. Providing the professional management and diversification inherent to all funds, bond mutual funds can offer a fixed-income element to balance out a portfolio of other stock and money market investments.

Investors should remember, however, that bond funds do not mature. This is critical as it means that risk to principal cannot be managed by holding these funds to maturity as with individual bonds. Also, although interest income and the principal amount invested in government bonds are guaranteed, the funds that invest in these bonds are not.

While bonds are often listed second to stocks when it comes to long-term investing benefits, their variety (and, in some cases, their tax benefits) can be suitable to many investors. Keep in mind that stocks offer growth potential, but may fluctuate more and provide less current income than other investments, such as bonds.

Discuss your goals with your financial professional and your tax advisor, and together you can decide whether bond investing is right for you.

All bonds involve market risk, interest-rate risk, and inflation risk. Some bonds also present credit risk.

Market risk -- A bond's value varies with the market

As with stocks, a bond's value will fluctuate with changing market conditions. However, there is a big difference. The fact that bonds have maturity dates makes market risk a concern only if you decide to sell the bond before the maturity date.

In practice, therefore, if you intend to hold the bond until the maturity date (when principal and interest are generally repaid to the bondholder), current fluctuations in the bond price are normal.

However, if the bond's price has fallen and you are forced to sell -- or liquidate -- a bond before it matures, then you will lose part of the principal investment as well as any future income stream.

Interest-rate risk -- An inverse relationship

This is the risk that a bond's price will fall with rising interest rates.

Interest-rate risk is common to all bonds. When interest rates rise in the economy, a bond's price will usually drop, and vice versa.

In general, bond investments have historically been more stable than their stock counterparts. Moreover, because bond investors may be concerned primarily with receiving income (instead of capital appreciation) from their bonds, they may not be as concerned with fluctuating bond prices. Many bond investors will hold their bonds until maturity, intending to receive their principal investment.

Credit risk -- why bonds are rated

Some bonds hold "credit risk," or the risk that the bond issuer will go into default before your bond reaches maturity. In that case, you may lose some or all of the principal amount invested and any outstanding income that is due. Bonds are often rated by Moody's and Standard & Poor's (S&P). Ratings run from Aaa (Moody's) or AAA (S&P) through D, based on the issuer's creditworthiness. Aaa and AAA are the highest credit ratings. Despite their negative name, "junk bonds," so called because of their lower credit ratings, are more formally known as "high-yield bonds" and are generally appropriate for investors who can withstand price volatility in search of higher yield potential. Keep in mind that high-yield bonds are subject to greater risk of loss of principal and interest, including default risk, than higher rated bonds.

Inflation risk -- The downside of fixed income

This is the risk that a bond's total return will not outpace inflation. Because the "coupon" or interest payment is fixed until maturity, an inflationary environment will cause these payments to lose value relative to other investments.

The four major types of bonds

Bonds come in a variety of forms, each bringing different benefits, risks, and tax considerations to an investor's portfolio. Most bonds fall into one of four general categories: corporate, government, government agency, and municipal.

Corporate bonds

Issued by corporations, these bonds seek to provide an investor with a steady stream of income at a generally higher rate than other bonds.

Risk Considerations: Other than market and interest-rate risk, the primary risk associated with this type of bond is credit risk. Another risk with some corporate bonds is that the bond could be "called" by the issuer, who then repays the principal before the maturity date; the debt is paid ahead of time, and the investor may not be able to reinvest it at the same income stream.

Tax Considerations: All interest earned on a corporate bond will be taxed as ordinary income at your usual income tax rate. If you choose to sell a bond for profit, this "capital appreciation" will be taxed as a capital gain.

Government bonds

Government bonds are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government. They include intermediate- and long-term Treasury bonds. Intermediate-term bonds mature in three to ten years, whereas long-term bonds generally mature in periods of up to 30 years.

Risk Considerations: Perhaps the safest of all bond investments, these bonds are generally considered to have the lowest level of credit risk because they are guaranteed by the U.S. government. However, this guarantee does not eliminate market risk, which is the risk that a security's value will move in tandem with its overall market. A government bond also presents some inflation risk -- the risk of its comparatively lower return not keeping pace with inflation. As a result, an investment could actually lose value over time.

Tax Considerations: Treasuries are fully taxable at the federal level but are exempt from state and local taxes.

Government agency bonds

These bonds are indirect debt obligations of the U.S. government issued by federal agencies and government-sponsored entities. Examples of such organizations are the Federal National Mortgage Association (FNMA, or "Fannie Mae"), the Government National Mortgage Association (GNMA, or "Ginnie Mae"), and the Student Loan Marketing Association (SLMA, or "Sallie Mae").

Risk Considerations: Next to Treasury bonds, agency and entity bonds are often considered to be among the safest bonds in terms of credit risk. Because these bonds are not directly issued by the U.S. government, they are not backed by its full faith and credit. In addition to the risks inherent in government bonds, agency bonds run the risk of going into default. Because of this added risk, however, these bonds generally offer the potential for higher yields than government bonds.

Tax Considerations: These bonds are fully taxable at the federal level and, in some cases, at the state and local levels as well.

Municipal bonds

Municipal bonds, or "munis," are issued by a U.S. state, county, city, town, village, or local authority to raise funds for general use or particular public works projects.

Risk Considerations: Munis fall somewhere in the middle of the credit risk spectrum. The risk of default can vary depending on the creditworthiness of the issuer and the type of debt obligation.

Tax Considerations: Perhaps the biggest advantage of most munis is their tax-exempt income status. Income accrues tax free at the federal level and, in most cases, at the state and local levels as well. However, investors may be subject to the Alternative Minimum Tax for certain private activity bonds. Capital gains, on the other hand, are fully taxable.

© 2016 DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. 

Please always consider the charges, risk, expenses, and investment objectives carefully before purchasing any financial product, including mutual funds or variable annuities. For a prospectus containing this and other information, please contact a financial professional. Read it carefully before you invest or send money.

This article is provided for your informational purposes only.

Please be advised that this materials is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transactions(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent advisor.

AXA Equitable Life Insurance Company (NY, NY) Securities offered through AXA Advisors, LLC (member FINRA, SIPC). AXA Equitable and AXA Advisors are affiliated and do provide legal or tax advice.

GE 115052 (09/2016)