Strategies for investing in individual bonds
Points to know
- Ladders, barbells, and swaps are some of the trading strategies you can use for buying and selling bonds.
- Callable bonds can be redeemed by the issuer before the maturity date, exposing you to interest rate risk.
Climbing the ladder, exercising with barbells & more
Here's a list of the commonly used strategies, how they work, and their advantages and disadvantages.
How it works
When you consider constructing a bond ladder, picture a real ladder.
Say your ladder has bonds that mature in 2, 4, 6, 8, and 10 years. When the first bond matures in 2 years, you reinvest the money in a bond with a 10-year maturity, maintaining the ladder you've constructed.
- Takes the guesswork out of interest rate swings.
- Offers a consistent interest revenue stream.
- Provides ongoing turnover and the opportunity to invest again.
- Offers diversification of maturities and returns.
- Can potentially lower expenses.
- Is a conservative strategy that doesn't maximize your returns.
- May not be the best strategy for anyone with small amounts of money to invest (usually below $50,000 per issue, considering expenses).
- May lead to bonds being called if maturities are longer than 10 years. (Understand the call features of any fixed-income security you buy.)
How it works
This time, picture a barbell. Your heavy concentrations of investments comprise the ends of the barbell, with lesser amounts, if any, in the middle.
Since this strategy includes a lot of short-term bonds, you'll need to continually trade maturing bonds for new ones.
- Captures high yields from longer maturities and uses lower maturities to help minimize interest rate risk.
- Offers diversification.
- Provides liquidity and flexibility to handle emergencies.
- Tends to shortchange a middle-of-the-road strategy by minimizing exposure to intermediate-term bonds.
- Requires consistent monitoring of short-term investments to replace those that are maturing.
- Is vulnerable to loss of principal on the long-term investments when interest rates rise.
A bond swap is simply selling one bond and immediately using the proceeds to buy another.
How it works
You decide to sell a bond at a loss and use the proceeds to buy a better-performing bond. You can write off the losses on the sale but potentially get a better return on the purchase.
- Can reduce your tax liability.
- May get you a higher rate of return.
- Offers portfolio diversification.
- Allows you to act in anticipation of interest rate changes.
- Can improve the credit quality of your portfolio.
- Wash sales
Your swap could create a "wash sale" if you're not careful. That is, the IRS won't recognize any tax loss generated if you sell and repurchase the same or a substantially identical investment within 30 days before or after the trade or settlement date.
- Tax implications
You'll need to understand the differences in the tax treatment of short-term capital gains and losses and long-term capital gains and losses. These differences can affect how you apply the losses and your tax rate on the profits.
GOOD TO KNOW!
Want an idea of the income you'd receive on a hypothetical investment? Or how much you'd need to invest to get a potential income? Our investment income calculator can estimate the yield, potential income, or amount for a hypothetical investment.
Your bond's been called. Now what?
If you invested in a bond with a high interest rate—and a "call feature"—you might not enjoy that rate until the bond matures. That's because the bond issuer could choose to pay back your principal before the stated maturity date.
The risk of callable bonds
What's good for you isn't necessarily good for the bond issuer.
When interest rates fall, the issuer is likely to want to refinance the debt at a lower rate and call the bond.
Meanwhile, you're very happy with the higher rate that callable bonds customarily pay. Now you have to reinvest the money in an interest rate environment that doesn't pay as much.
How to protect your investment
Protecting your investment starts before you buy a bond:
- Know if your bond is callable.
- Find out if it has call protection—a time frame during which the bond can't be called, assuring you'll receive the interest rate for at least that period regardless of what's going on in the markets.
- Try to find bonds that are non-callable and compare their yields to callable bonds.
If you have a callable bond, keep up with interest rates and have a plan to invest the proceeds if the bond is called.
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Investments in bonds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates; credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline; and inflation risk, which is the possibility that increases in the cost of living will reduce or eliminate the returns on a particular investment.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
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