BONDS MARKET

Advantages of Bonds

Have you ever heard co-workers talking around the water cooler about a hot tip on a bond? We didn't think so. Tracking bonds can be about as thrilling as watching a chess match, whereas watching stocks can have some investors as excited as NFL fans during the Superbowl. But don't let the hype (or lack thereof) mislead you. Both stocks and bonds have their pros and cons, and in this article we will explain the advantages of bonds and why you might want to include them in your portfolio.

A Safe Haven For Your Money

Those just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt, and stocks represent equity ownership.
This difference brings us to the first main advantage of bonds: in general, investing in debt is safer than investing in equity. The reason for this is the priority that debtholders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to get paid. In a worst-case scenario such as bankruptcy, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment.

In terms of safety, bonds from the U.S. government (Treasury bonds) are considered "risk-free". (There are no stocks that are considered as such.) If capital preservation - which is a fancy term for "never losing any money" - is your primary goal, then a bond from a stable government is your best investment. But keep in mind that although bonds are safer as a general rule, that doesn't mean they are all completely safe. Very risky bonds are known as junk bonds.


Slow and Steady - Predictable Returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. It's not unusual for stocks to lose 10% or more in a year, so when bonds comprise a portion of your portfolio, they can help smooth out the bumps when a recession comes around.

There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market! By owning bonds, retirees are able to predict with a greater degree of certainty how much income they'll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.

Better Than The Bank…
Sometimes bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts. As a result, if you are saving and you don't need the money in the short term, bonds will give you the greatest return without posing too much risk.

College savings are a good example of funds you want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but it's not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount they'll have to contribute to accumulate their tuition nest egg by the time college rolls around.
How Much Should You Put Towards Bonds?
There really is no easy answer to this question. Quite often you'll hear an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a person's assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20 year old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of assets in stocks and 65% in bonds and cash. That being said, guidelines are just guidelines. Determining the asset allocation of your portfolio involves many factors including your investing timeline, risk tolerance, future goals, perception of the market and income. Unfortunately, exploring the various factors affecting risk is beyond the scope of this article.

Conclusion
Hopefully, this article has cleared up some misconceptions about bonds and demonstrated when they are appropriate. The bottom line is that bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are great vehicles for saving when you don't want to put your money at risk.
The Bond Market: A Look Back
Many retail investors shun the bond market because it can be difficult to understand and it doesn't offer the same level of potential upside as the stock market. While the bond market is different from the stock market, it can't be ignored. Its size (comparable to the stock market) and depth will ensure this never happens. With the help of the book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), by Elroy Dimson, Paul Marsh and Mike Staunton, we will look at how the global bond market performed over the twentieth century and what changes we foresee for it during the twenty-first.
An Unkind Century for Bond Investors
Equity investors triumphed over bond investors during the twentieth century because the risk premium built into bonds during the 1900s was much too low to compensate investors for the forthcoming turmoil that would hit the bond market over the next century. This period saw two secular bear and bull markets in U.S. fixed income, with inflation peaking at the end of the First and Second World Wars as a result of increased government spending during those periods.

The first bull market started after World War I and lasted until after World War II. According to Dimson, Marsh and Staunton, the U.S. government kept bond yields artificially low through the inflationary period of World War II and up to 1951. It wasn't until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term U.S. bond yields then climbed to a high of nearly 15% by 1981. This was the turning point for the century's second bull market.
The countries that did show negative real returns were those most affected by the world wars. For example, Germany saw two periods in which fixed income was all but wiped out. During the worst of the two periods, 1922-23, inflation reached an unfathomable 209,000,000,000%! According to "Triumph Of The Optimists", 300 paper mills and 150 printing works with 2,000 presses worked day and night to accommodate the demand for bank notes during this period! In fact, the twentieth century had more than one incidence of hyperinflation, but none was as severe as what Germany saw in the early 1920s. (For more insight, see the Inflation tutorial.)

The graph below contrasts real government bond returns for the first and second half of the twentieth century. Notice how the countries that saw their bond markets do very poorly in the first half of the twentieth century saw a reversal in their fate in the second half:

While this illustration gives you a good feel for the government bond market, the U.S. corporate bond market, according to Dimson, Marsh and Staunton, fared better as well, and added an average 100 basis points above comparable government bonds over the twentieth century. They calculated that roughly half of this difference was related to the default premium (the premium rewarded for taking on default risk). The other half is related to defaults, downgrades and early calls.

The Bond Market Would Never Be the Same
In the 1970s, the globalization of the world markets began again in earnest. Not since the Gilded Age (1876-1914) had the world seen such globalization, and this would really start to have an impact on the bond markets in the 1980s. Until then, retail investors, mutual funds and foreign investors were not a big part of the bond market. According to Daniel Fuss' 2001 article "Fixed Income Management: Past, Present And Future", the bond market would see more development and innovation in the last two decades of the twentieth century than it had in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities and catastrophe bonds were created. Early investors in these new securities were compensated for taking on the challenge of understanding and pricing them.
Innovation in the Twenty-First Century
Entering the twenty-first century, the bond market was coming off its greatest bull market. Long-term bond yields had compressed from a high of nearly 15% in 1981 to 7% by the end of the century, leading to higher bond prices. Innovation in the bond market also increased during the last three decades of the twentieth century, and this will likely continue. Furthermore, securitization may be unstoppable, and anything and everything with future material cash flows is open to being turned into an ABS. Health care receivables, mutual fund fees and student loans, for example, are just a few of the areas being developed for the ABS marketplace.

Another likely development is that derivatives will become a bigger part of institutional fixed income, with the use of such instruments as interest-rate futures, interest-rate swaps and credit default swaps. Based on issuance and liquidity, the U.S. and the Eurobond markets will maintain their dominance of the global bond market. As bond market liquidity improves, bond exchange-traded funds (ETFs) will keep on gaining market share. ETFs have the ability to demystify fixed-income investing for the retail client through their tradability and transparency (for example, Barclays iShares website contains daily data on its bond ETFs). Finally, continued strong demand for fixed income by the likes of pension funds will only help accelerate these trends over the next few decades.
Conclusion
For the most part, investing in fixed income during the past century was not an overly lucrative proposition. As a result, today's fixed-income investor should demand a higher risk premium. If this occurs, it will have important implications for asset allocation decisions. Increased demand for fixed income will only help to further innovation, which has turned this asset class from stodgy to fashionable.
The Basics of the Bond Ladder
When portfolio managers talk about strategies for success, they will often refer to risk diversification and money management. These strategies separate those investors who are successful because of knowledge and skill from those who are merely lucky. Now, don't be mistaken, luck isn't a bad thing to have, but possessing foundational skills will ultimately lead to success. In this article we'll discuss the bond ladder, a bond investing strategy that is based on a relatively simple concept that many investors (and professionals) fail to use or even understand.
A bond ladder is a strategy that attempts to minimize risks associated with fixed-income securities while managing cash flows for the individual investor. Specifically, a bond ladder, which attempts to match cash flows with the demand for cash, is a multi-maturity investment strategy that diversifies bond holdings within a portfolio. It reduces the reinvestment risk associated with rolling over maturing bonds into similar fixed-income products all at once. It also helps manage the flow of money, ensuring a steady stream of cash flows throughout the year.

In simpler terms, a bond ladder is the name given to a portfolio of bonds with different maturities. Suppose you had $50,000 to invest in bonds. By using the bond ladder approach, you could buy five different bonds each with a face value of $10,000 or even 10 different bonds each a with face value of $5,000. Each bond, however, would have a different maturity. One bond might mature in one year, another in three years and the remaining bonds might mature in five-plus years - each bond would represent a different rung on the ladder.

Why Use A Bond Ladder?
There are two main reasons to use the ladder approach. First, by staggering the maturity dates, you won't be locked into one particular bond for a long duration. A big problem with locking yourself into a bond for a long period of time is that you can't protect yourself from bull and bear bond markets. If you invested the full $50,000 into one single bond with a yield of 5% for a term of 10 years, you wouldn't be able to capitalize on increasing or decreasing interest rates.

For example, if interest rates hit a bottom five years (at maturity) after purchasing the bond, then your $50,000 would be stuck with a low interest rate if you wanted to buy another bond. By using a bond ladder, you smooth out the fluctuations in the market because you have a bond maturing every year (or thereabouts).
The second reason for using a bond ladder is that it provides investors with the ability to adjust cash flows according to their financial situation. For instance, going back to the $50,000 investment, you can guarantee a monthly income based upon the coupon payments from the laddered bonds by picking ones with different coupon dates. This is more important for retired individuals because they depend on the cash flows from investments as a source of income. If you are not dependent on the income, by having steadily maturing bonds, you will have access to relatively liquid money. If you suddenly lose your job or unexpected expenses arise, then you will have a steady source of funds to use as required.

How To Create A Bond Ladder
The ladder itself is very simple to create - just picture an actual ladder:
• Rungs - By taking the total dollar amount that you are planning to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio, or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one company defaulting on bond payments.
• Height of the ladder - The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher the average return should be in your portfolio since bond yields generally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money.
• Materials - Just like real ladders, bond ladders can be made of different materials. One straightforward approach to reducing exposure to risk is investing in different companies, but investments in products other than bonds are sometimes more advantageous depending on your needs. Debentures, government bonds, municipal bonds, Treasuries and certificates of deposit - each having different strengths and weaknesses - are all different products that you can use to make the ladder. One important thing to remember is that the products in your ladder should not be redeemable (or callable) by the issuer. This would be the equivalent to owning a ladder with collapsible rungs

Conclusion
It's been said that a bond ladder shouldn't be attempted if investors do not have enough money to fully diversify their portfolio by investing in both stocks and bonds. The money needed to start a ladder that would have at least five rungs is usually between $10,000-$20,000. If you don't have this recommended amount, purchasing products such as bond funds might be more prudent, as the charges related to the product will be offset by the benefits of diversity that they provide. In either case, make sure that all your eggs aren't in one basket, so that you can control risk exposure, have greater access to emergency funds and have the opportunity to capitalize on ever-changing market conditions.
The Basics of Municipal Bonds
If your primary investing objective is to preserve your capital while generating a tax-free income stream, municipal bonds are worth considering. Municipal bonds, or munis, are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of your original investment is returned to you.
While municipal bonds are available in both taxable and tax-exempt formats, the tax-exempt bonds tend to get the most attention because the income they generate is for most investors exempt from federal and, in many cases, state and local income taxes. Investors subject to the alternative minimum tax must include interest income from certain munis when calculating the tax, and should consult a tax professional prior to investing.

Two Varieties
Municipal bonds come in two varieties: general obligation bonds and revenue bonds. General obligation bonds, issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.
Risk Factors
While buying municipals bonds is most often viewed as a conservative investment strategy, it is not risk-free. Hare are the risk factors:
Credit Risk
If the issuer is unable to meets its financial obligations, it may fail to make scheduled interest payments and/or be unable to repay the principal upon maturity. To assist in the evaluation of an issuer's creditworthiness, ratings agencies such as Moody's Investors Service and Standard & Poor's analyze a bond issuer's ability to meet its debt obligations, and issue ratings from 'Aaa' or 'AAA' for the most creditworthy issuers to 'Ca', 'C', 'D', 'DDD', 'DD' or 'D' for those in default. Bonds rated 'BBB', 'Baa' or better are generally considered appropriate investments when capital preservation is the primary objective. To reduce investor concern, many municipal bonds are backed by insurance policies guaranteeing repayment in the event of default.

Interest-Rate Risk
The interest rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds.

Tax-Bracket Changes
Because municipal bonds generate tax-free income, they generally pay lower interest rates than taxable bonds. Investors who anticipate a significant drop in their marginal income-tax rate may be better served by the higher yield available from taxable bonds.

Call Risk
Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date. The investor's capital is returned with a premium added in exchange for the early debt retirement. While you get your entire initial investment plus some back if the bond is called, your income stream ends earlier than you were expecting it to.

Market Risk
The underlying price of a particular bond changes in response to market conditions. When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive. Investors who want the higher yield may be willing to pay a premium to get it. Likewise, if interest rates rise, newly issued bonds will pay a higher yield than existing issues. Investors who buy the older issues are likely to do so only if they get it at a discount. If you buy a bond and hold it until maturity, market risk is not a factor because your principal investment will be returned in full at maturity. Should you choose to sell prior to the maturity date, your gain or loss will be dictated by market conditions, and the appropriate tax consequences for capital gains or losses will apply.

Buying Strategies
The most basic strategy for investing in municipal bonds is to purchase a bond with an attractive interest rate, or yield, and hold the bond until it matures. The next level of sophistication involves the creation of a municipal bond ladder. A ladder consists of a series of bonds, each with a different interest rate and maturity date. As each rung on the ladder matures, the principal is reinvested into a new bond. Both of these strategies are categorized as passive strategies because the bonds are bought and held until maturity.

Investors seeking to generate both income and capital appreciation from their bond portfolio may choose an active portfolio management approach whereby bonds are bought and sold instead of held to maturity. This approach seeks to generate income from yields and capital gains from selling at a premium.

Are Municipal Bonds Right For You?
Investing in municipal bonds can have a long-term impact on your income stream and your portfolio. To learn more about the benefits of municipal bonds, contact an investment professional or thoroughly research them yourself before investing your money.
Avoid Tricky Tax Issues on Municipal Bonds
Municipal bonds, or munis, have proved to be a great vehicle for states and municipalities, which can receive financing at a low cost, and for investors, who can find better after-tax returns for their bond portfolios. Despite these advantage, however, investors must be aware of certain issues surrounding the munis they purchase, lest they be surprised by a tax bill from their "tax-free" investments.
Municipal Bonds Can Be Subject to Capital Gains Tax
When buying muni bonds on the secondary market, investors must be aware that bonds purchased at a discount (less than par value), will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to the coupon payments, but only the principal of the bond.
Without knowing that the gain is subject to capital gains tax, an investor could end up paying $96.22 for a bond that is only worth $95.62. So, when looking at a muni bond offered for sale on the secondary market, the investor must look at the price of the bond, not just the yield to maturity, to determine whether tax consequences will affect the return. (To learn more, see Where can I get bond market quotes?)

The bad news is, while discount bonds are taxed, bonds purchased at a premium do not work in a similar manner; they cannot offset capital gains by providing capital losses.This tax rule runs contrary to that of most investments, including other types of bonds, because the IRS treats tax-free instruments differently than their taxable cousins. Thus, when analyzing yields for muni bonds offered on the secondary market, for par or premium bonds the yield-to-maturity figure is usually sufficient to determine an expected return, but for discount bonds, one must also factor in the negative tax implications that can arise from capital gains.

The "De Minimis" Rule
One of the most confusing concepts related to muni bonds is the de minimis tax rule.This nugget of tax law states that if you purchase a bond at a discount and the discount is equal to or greater than a quarter point per year until maturity, then the gain you realize at redemption of the bond (par value minus purchase price) will be taxed as ordinary income, not as capital gains. For those in the top tax bracket this could mean the difference between paying 15% and 35% on the gain.

Bond Required Rate of Return Coupon Rate Cash Flow at End of Year 1 (Coupon) Cash Flow at End of Year 2 (Coupon + Principal - Tax) Net Present Value
Some Municipal Bonds are Federally Taxable
The federal government does not tax most activities of states and municipalities, giving most muni bonds tax-exempt status, but some activities do not fall under this tax exemption. Thus, coupon payments for muni bonds sold to fund those activities are federally taxed. One common example is a bond issued to fund a state's pension plan obligation. When this type of bond is for sale, brokers selling the bond should readily know whether it is taxable.
Another, more harrowing example of taxable munis is those that are issued as tax free, then later become taxable if and when the IRS determines the proceeds are being used for purposes that do not fall under tax-exempt status. This is very rare, but when it happens, it leaves a lot of very unhappy investors; their coupon payments are taxed as ordinary income and, if they choose to sell the bond, the price they receive will be lower because buyers would require a higher yield on a taxable bond.

Generally, taxable munis are still exempt from state and local taxes, so investors in states with high income taxes may find that they get a better after-tax return than with other fixed income investments that are fully taxable at all levels, such as corporate bonds or certificates of deposit.

The Alternative Minimum Tax
Although it is relatively uncommon, some muni bonds are federally taxed if the holder is subject to alternative minimum tax (AMT). If you are unsure of whether a specific muni is subject to AMT, be sure to consult the broker before purchasing it. An example of the type of muni that is subject to AMT is that used for a particular municipal improvement, but is not backed by the credit of a state or municipality, but rather that of a corporation (such as an airline backing an airport improvement bond).

Conclusion
While munis are an attractive investment for many due to the tax savings, it is vital that you understand potential tax liabilities surrounding a purchase. If not, you might be surprised with an unexpected tax bill.

Profit From Mortgage Debt With MBS
In its May 2006 edition of Research Quarterly, the Bond Market Association estimated that mortgage debt represents $6.1 trillion of the $25.9 trillion bond market. As more people buy their first homes, move into bigger spaces, or purchase vacation homes, this borrowing is bound to expand. This situation creates an opportunity for astute investors, who can use mortgaged-backed securities (MBS) to own a piece of this debt. In this article, we'll show you how you can use MBS to complement your other fixed-income assets.

How They Are Formed
MBS are debt obligations purchased from banks, mortgage companies, credit unions and other financial institutions and then assembled into pools by a governmental, quasi-governmental, or private entity. These entities then sell the securities to investors. This process is illustrated below:
Real estate buyers borrow from financial institutions.

Types of MBS

Pass-Through
The pass-through or participation certificate represents direct ownership in a pool of mortgages. You will get a pro-rata share of all principal and interest payments made into the pool as the issuer receives monthly payments from borrowers.

The mortgage pool will usually have a five-to-30-year maturity. However, the cash flow can change from month to month depending on how many mortgages are paid off early - this is where the prepayment risk lies.

When current interest rates decline, borrowers might refinance and prepay their loans. Investors then must try to find yields similar to their original investments in a lower, current-interest rate environment.

Conversely, investors can face interest rate risks when current interest rates go up. Borrowers will stay with their loans, leaving investors stuck with the lower yields in a rising current-interest rate environment.

Collateralized Mortgage Obligations (CMO)
Collaterized mortgage obligations (CMOs) are pools of pass-through mortgages.
Individual Investors

There are several types of CMOs that are designed to reduce investors' prepayment risk, but the three most common are:

1. Sequential Pay CMOs
In a sequential pay CMO, CMO issuers will distribute cash flow to bondholders from a series of classes, called tranches. Each tranche holds mortgage-backed securities with similar maturity and cash flow patterns. Each tranche is different from the others within the CMO. For example, a CMO might have four tranches with mortgages that average two, five, seven and 20 years each.

When the mortgage payments come in, the CMO issuer will first pay the stated coupon interest rate to the bondholders in each tranche. Scheduled and unscheduled principal payments will go first to the investors in the first tranches. Once they are paid off, investors in later tranches will receive principal payments.

The concept is to transfer the prepayment risk from one tranche to another. Some CMOs may have 50 or more interdependent tranches. Therefore, you should understand the characteristics of the other tranches in the CMO before you invest. There are two types:

Planned Amortization Class (PAC) Tranche
PAC tranches use the sinking fund concept to help investors reduce prepayment risk and receive a more stable cash flow. A companion bond is established to absorb excess principal as mortgages are paid off early. Then, with income from two sources (the PAC and the companion bond) investors have a better chance of receiving payments over the original maturity schedule.

Z-Tranche
Z-tranches are also known as accrual bonds or accretion bond tranches. During the accrual period, interest is not paid to investors. Instead, the principal increases at a compound rate. This eliminates investors' risk of having to reinvest at lower yields if current market rates decline.

After prior tranches are paid off, Z-tranche holders will receive coupon payments based on the bond's higher principal balance. Plus, they'll get any principal prepayments from the underlying mortgages.

Because the interest credited during the accrual period is taxable - even though investors don't actually receive it - Z-tranches may be better suited for tax-deferred accounts.

2. Stripped Mortgage Securities
Strips are MBS that pay investors principal only (PO) or interest only (IO). Strips are created from MBS, or they may be tranches in a CMO.
Principal Only (PO)
Investors pay a deeply-discounted price for the PO and receive principal payments from the underlying mortgages.

The market value of a PO can fluctuate widely based on current interest rates. As interest rates drop, prepayments can increase, and the PO's value might rise. On the other hand, when current rates go up and prepayments decline, the PO could drop in value.

Interest Only (IO)
An IO strictly pays interest that is based on the amount of outstanding principal. As the mortgages amortize and prepayments reduce the principal balance, the IO's cash flow declines.

The IO's value fluctuates opposite a PO's in that as current interest rates drop and prepayments increase, the income can go down. And when current interest rates rise, investors are more likely to receive interest payments over a longer period of time, thereby increasing the IO's market value.

Safety Ratings
Fitch Ratings provides credit ratings as well as coupon rates and maturity dates for MBS.

MBS Issuers
You can buy MBS from several different issuers:

Independent Firms
Investment banks, financial institutions and homebuilders issue private-label, mortgage-backed securities. Their creditworthiness and safety rating may be much lower than those of government agencies and government-sponsored enterprises.

Federal Home Loan Mortgage Corporation (Freddie Mac)
Freddie Mac is a federally-regulated, government-sponsored enterprise that purchases mortgages from lenders across the country. It then repackages them into securities that can be sold to investors in a wide variety of forms.

Freddie Macs are not backed by the U.S government, but the corporation has special authority to borrow from the U.S. Treasury.

Federal National Mortgage Association (Fannie Mae)
Fannie Mae is a shareholder-owned company that is actively traded (symbol FNM) on the New York Stock Exchange and is part of the S&P 500 Index. It receives no government funding or backing.

As far as safety goes, Fannie Maes are backed by the corporation's financial health and not by the U.S. government. (For more information, check out the Fannie Mae website.)

Government National Mortgage Association (Ginnie Mae)
Ginnie Maes are the only MBS that are backed by the full faith and credit of the U.S. government. They mainly consist of loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration.

Mutual Funds
If you like the idea of profiting from an increase in the growth of mortgages but are not up to researching all the different types of MBS, you might be more comfortable with mortgage mutual funds. There are funds that invest in only one type of MBS, such as Ginnie Maes, while there are others that incorporate various types of MBS within their other government bond holdings.

Besides greater diversification of loans, mutual funds can reinvest all returns of principal in other MBS. This lets investors receive yields that change with current rates and will reduce prepayment and interest rate risks.

In Conclusion
MBS can offer federal government backing, a monthly income and a fixed rate of interest. The downside, however, is that the term can be uncertain and they might not increase in value like other bonds when current interest rates drop. Also don't forget that you could get a piece of your principal returned with every monthly payment. Consequently, at maturity there may not be any principal remaining for you to reinvest.

High Yield, Or Just High Risk?
It may surprise you to know that some of the top companies in the Fortune 500 have had debt obligations that were below investment grade - otherwise known as "junk bonds". For example, in 2005, automotive icons Ford and General Motors both fell into junk bond status for the first time in either company's history. Many investors would not pass up the opportunity to buy common stock in these companies, so why do so many avoid these companies' bonds like the plague? It may have something to do with price fluctuation and with the fear that past abuses, like those of Michael Milken - the controversial financial innovator also known as "The Junk Bond King" - might be repeated.

Although they are considered a risky investment, junk bonds may not deserve the negative reputation that still clings to them. In fact, the addition of these high-yield bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation. Here we explain what high-yield bonds are, what makes them risky and why you may want to incorporate these bonds into your investing strategy.
Why the Bad Reputation?
During the 1980s, Michael Milken - then an executive at investment bank Drexel Burnham Lambert Inc - gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in corporate finance and mergers and acquisitions, which in turn fueled the leveraged buyout boom. Milken made millions of dollars for himself and his Wall Street firm by specializing in bonds issued by "fallen angels" - companies that experienced financial difficulty which caused the price of their debt, and subsequently their credit rating, to fall.

In 1989, Rudy Giuliani (then the U.S Attorney General of New York) charged Milken under the RICO Act with 98 counts of racketeering and fraud. Milken was indicted by a federal jury. After a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements. Today, many on Wall Street will attest that the negative outlook on junk bonds still persists because of the questionable practices of Milken and other high-flying financiers like him.

Defining High-Yield Investments
Generally, high-yield bonds are defined as debt obligations with a bond rating of Ba or lower according to Moody's, or BB or lower on the Standard & Poor's scale. (To learn more, see What Is A Corporate Credit Rating?) In addition to being popularly known as "junk bonds", they are also referred to as "below-investment grade". These bonds are available to investors as individual issues or through high-yield mutual fund investments. For the average investor, high-yield mutual funds are the best way to invest in junk bonds, as these funds were formed to diversify a pool of junk bonds and reduce the risk of investing in financially struggling companies.

Advantages of High-Yield Bonds
Many good companies run into financial difficulty at various stages of their existence. One bad year for profits or a tragic chain of events may cause a company's debt obligations to be downgraded to a level below investment grade. Because of these additional risks, high-yield investments have generally produced better returns than higher quality, or investment grade, bonds. If you are looking to get a higher yield within your fixed-income portfolio, keep in mind that high-yield bonds have typically produced larger returns than CDs, government bonds and highly-rated corporate issues.

High-yield bonds do not correlate exactly with either investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they're less vulnerable to interest rate shifts, especially at lower levels of credit quality. And, as Susan Weiner explains in an article in Financial Planning Magazine, they are similar to stocks in relying on economic strength. Because of this low correlation, adding high-yield bonds to your portfolio can be a good way to reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.

Another factor that makes high-yield investments appealing is the flexibility that managers are given to explore different investment opportunities that will generate higher returns and increase interest payments. Finally, many investors are unaware of the fact that debt securities have an advantage over equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first during the liquidation process, then preferred stockholders, and lastly common stockholders. This added safety can prove valuable in protecting your portfolio from significant losses, thereby improving its long-term performance.

The New High Yield
If you're looking for some big yield premiums, then emerging market debt securities may be a good addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts because they have a much smaller market, yet they account for about 30% of global high-yield markets. Since the U.S. represents only 50% of global high-yield markets, those investors who stay domestic are missing out on a broad range of opportunities in the global markets.

What else could you be purchasing when investing in high-yield funds? One new addition is leveraged bank loans, which are often defined as credits priced 125 basis points or more over the London Interbank Offer Rate (LIBOR). These are essentially loans that have a higher rate of interest to reflect a higher risk posed by the borrower. Some managers like to include convertible bonds of companies whose stock price has declined so much that the conversion option is practically worthless. These investments are commonly known as "busted convertibles" and are purchased at a discount since the market price of the common stock associated with the convertible has fallen sharply.

To help diversify their investments even further, many fund managers are given the flexibility to include high-yielding common stocks, preferred stocks and warrants in their portfolios, despite the fact that they are considered equity products. For portfolio managers looking to tailor duration and short the market, credit default swaps offer a credit derivative that allows one counter-party to be long a third-party credit risk and the other counter-party to be short the credit risk. In essence, one party is buying insurance and the other party is selling insurance against the default of the third party.

Risks of High-Yield Investing
High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. Fortunately for investors, default rates are currently around 2% (as of Aug 2005), which is near historic lows. However, you should be aware that default rates for high-yield mutual funds are flawed. The figures can be manipulated easily by managers because they are given the flexibility to dump bonds before they actually default and get downgraded and to replace them with new bonds.

How would you be able to assess more accurately the default rate of a high-yield fund? You could look at what has happened to the fund's total return during past downturns. If the fund's turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently. You could also look at the fund's average credit quality as an indicator; this would show you if the majority of the bonds being held are just below investment-grade quality at 'BB' or 'B' (Standard & Poor's rating). If the average is 'CCC' or 'CC', then the fund is highly speculative ('D' indicates default).

Another pitfall to high-yield investing is that a poor economy and rising interest rates can worsen yields. If you've ever invested in bonds in the past, you're probably familiar with the inverse relationship between bond prices and interest rates: "as interest rates go up, bond prices will go down". Junk bonds tend to follow long-term interest rates more closely; these rates have recently stabilized, thus keeping investors' principal investment intact.
During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over the portfolio (buying and selling to replace the current holdings), which will lead to higher turnover percentages and, ultimately, add additional fund expenses that are paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks such as the weakening of foreign economies, changes in currency rates and various political risks.

Conclusion
Before you invest in high-yield securities, you should be aware of the risks involved. If, after doing your research, you still feel these investments suit your situation, then you may want to add them to your portfolio. The potential to provide attractive levels of income and the ability to reduce overall portfolio volatility are both good reasons to consider high-yield investments.
Retail Notes Make Bond Investing Easier
You may know that bonds are one way to get income from your investments. You may also know they can help you diversify your portfolio since they often move in the opposite direction of stocks. Yet some people might stay away from bonds because they don't understand how these investments work, or the pricing structure turned them off to the idea. Here go over why bond investing may be confusing, how using bond funds as a solution can present problems and, finally, how retail notes offer an alternative.
Bonds Can Be Confusing
With accrued interest, markups, commissions and changing prices, bond investing is not always easy. In 2003, the National Association of Security Dealers (NASD) issued the results of a 55-question investor-literacy survey. The results of survey showed that just 71% of the participants understood the concept of a bond and only 39% knew the inverse relationship between bond prices and interest rates. These numbers may explain why some people avoid bonds.

Diversifying Is Not Always Easy
If you don't understand bond pricing, using bonds to diversify may be difficult to achieve. The typical face value of a corporate bond is $1,000, but if you buy one on the secondary market, you may pay more or less than that amount. The price depends on several factors including prevailing interest rates and credit ratings. Grasping these complex factors can present a roadblock in the attempt to using bonds strategically. (If, however, you would like to start learning, check out Bond Basics and Advanced Bond Concepts.)

As such, to gain some diversification using bonds, many investors invest in bond mutual funds. You can start with a small amount and receive diversification; however, the trouble is that you don't know exactly what income you'll receive while you own the fund (because you own units of a basket of bonds rather than the actual bonds, which you would own if you bought the bonds yourself). And there are ongoing fees that you pay to the fund company to manage your investment.

When interest rates are falling, it is easy to ignore these fees because the value of the fund's shares goes up (remember bond prices and interest rates have an inverse relationship). But when interest rates rise, expenses could consume a larger portion of your returns. Plus a bond fund has no maturity date, so there is no point in time when you are assured of getting back your original investment (as you are when you own a bond directly).

Finally, bond funds also present a potential tax problem. Many owners of taxable bond funds aren't very happy when they get their Form 1099 from their funds. At this time these shareholders realize that they do not have complete control over when they must take capital gains (short or long term) and how they can get hit with taxes even if they haven't sold any of their shares.

For instance, when interest rates start to rise, the bond fund's share value can drop. This might cause other fundholders to panic and sell. Fund managers then need the cash to meet the redemptions, so they have to sell bonds that may have appreciated, and must pass that growth to each shareholder, even if the money is reinvested in additional fund shares. Thus, shareholders who stayed in the fund end up with a distribution that they didn't even want, but they still have to pay the associated tax on that distribution. And to make bad matters worse, they might have to pay tax while their fund's value is falling.

Retail Notes Offer Another Option
There is another choice for income-seeking investors that is easy to understand and inexpensive to buy. Retail notes are fixed-income securities that you can purchase directly from the issuer at par in $1,000 increments with no accrued interest or added markups. They are fixed-rate subordinated, unsecured obligations of the issuing company. The notes and accompanying interest payments are backed by the full faith and credit of the issuer and are either callable or noncallable. The callable notes usually provide higher yields and include call protection for a set time (for further reading on callable securities, see Call Features: Don't Get Caught Off Guard). Once you buy the notes, you will receive regular fixed-interest payments (monthly, quarterly or semi-annually) until maturity.

The notes are offered weekly by a limited number of issuers, many of whom are top-rated, well-known international corporations. The offers are valid for one week and include a series of coupon rates, maturities, interest-payment frequencies, call dates and credit ratings. Issuers, however, have the right to change or cancel an offering without notice. You can invest in these securities through a broker who can provide you with the weekly postings.

These notes are suitable for fully taxable accounts, or you can put them in your IRA, where the interest income accumulates tax deferred. And investors who want to create an income (bond) ladder can purchase retail notes with different maturity dates and interest-payment schedules.

Even though there might be a secondary market for retail notes, they are meant to be held until maturity. Therefore, they are not suitable if you are looking to trade them for the capital gains (but this is the kind of fixed-income strategy that presents the complexities we discussed above). But like other fixed-income investments, the market value of retail notes can fluctuate until maturity.

Finally, most retail notes have a unique survivor's option. This feature gives your estate the ability to return the notes back to the issuer at par value. Therefore, just in case the note is worth less than par value when you die, your heirs can still return the notes for par value.

Conclusion
If you are looking to include or increase the amount of fixed assets in your portfolio, retail notes can make your investing easier. They are simple to understand, can be purchased for a moderate amount, and provide a stable income for their life.

Call Features: Don't Get Caught Off Guard

Callable bonds - because they carry the risk of being cashed in early - often have a higher coupon rate. Although this may make callable bonds more attractive, call provisions can come as a shock. Even though the issuer might pay you a bonus when the bond is called, you might still end up losing money. Plus, you might not be able to reinvest the cash at a similar rate of return, which can disrupt your portfolio. Here we look at how a call can cause losses, what to look for in a callable bond and how to prepare for the possibility of your bond being called.
How You Can Lose Money
Let's look at an example to see how a call provision can cause a loss. Say you are considering a 20-year bond with a $1,000 face value that was issued seven years ago and has a 10% coupon rate with a call provision in the 10th year. At the same time, because of dropping interest rates, a bond of similar quality that is just coming on the market may pay only 5% a year. You decide to buy the higher-yielding bond, whose purchase price is $1,200 (the premium is a result of the higher yield). This results in an 8.33% annual yield ($100/$1,200).

Suppose that three years go by, and you're happily collecting the higher interest rate. Then the borrower decides to retire the bond. If the call premium is one year's interest, 10%, you'll get a check for the bond's face amount ($1,000) plus the premium ($100). In relation to the purchase price of $1,200, you lost $100 in the transaction. And once the bond is called, your loss is locked in.

Municipals Not Immune
Now you may think that this problem may occur only to investors who buy high-yielding corporate junk bonds. Wrong.

In Feb 2005, New York City began calling in $430 million of its AAA-rated bonds. Their goal was to reduce interest expenses by replacing old bonds that paid 6-8% with new ones paying 3-5%. It was estimated that this move caused these seemingly high-quality bonds to lose $50 million in total market value. And for those individual bond owners who had bought the bonds at a premium, the loss was 15% or more of their investment.

What to Look For
When you are buying a bond on the secondary market, it's important you understand any call features, which your broker is required to disclose in writing when transacting a bond. Usually call provisions can be inspected in the issue's indenture.

When analyzing callable bonds, there isn't necessarily one bond that is more or less likely to be called than another of similar quality. The main factor that causes an issuer to call its bonds is interest rates (we look at this more below). There is one feature, however, that you want to look for in a callable bond: call protection. This means there's a period during which the bond cannot be called, allowing you to enjoy the coupons regardless of interest rate movements.

Before buying a callable bond, it's also important to make sure that it in fact offers a higher potential yield. Find bonds that are non-callable and compare their yields to callable ones. However, locating bonds without call features might not be easy. According to Thomson Financial, about 78% of new municipal bonds sold in 2004 are callable.

Finally, don't get confused by the term 'escrow to maturity'. This is not a guarantee that the bond will not be redeemed early. This term simply means that a sufficient amount of funds, usually in the form of direct U.S. government obligations, to pay the bond's principal and interest through the maturity date is held in escrow. Any existing features for calling in bonds prior to maturity may still apply.

Don't Wait until Interest Payments Stop
If you own a callable bond, remain constantly aware of its status so that, if it gets called, you can immediately decide how to invest the proceeds. To find out if your bond has been called, you will need the issuer's' name or the bond's CUSIP number. Then you can check with your broker or online at: http://www.moodys.com/ (the service is free but requires registration).

Be Prepared
As we mentioned above, the main reason a bond is called is a drop in interest rates. At such a time, issuers evaluate their outstanding loans, including bonds, and consider ways to cut costs. If they feel it is advantageous for them to retire their current bonds and secure a lower rate by issuing new bonds, they may call their bonds. If your callable bond pays at least 1% more than newer issues of identical quality, it is likely a call could be forthcoming in the near future.

At such a time, you as a bondholder should examine your portfolio to prepare for the possibly of losing that high-yielding asset. First look at your bond's trading price. Is it considerably more than you paid for it? If so, it may be best to sell it before it is called. Even though you pay the capital-gains tax, you still make a profit.

Of course, you can prepare for a call only before it happens. Some bonds are freely callable, meaning they can be redeemed anytime. But if your bond has call protection, check from what date the issuer can call the bond. Once that date passes, the bond is not only at risk of being called at any time but its premium may start to decrease and the issuer might not pay any more interest. You can find this information in the bond's indenture. Most likely there will be a schedule stating the bond's potential call dates and its call premium.

Finally, you can employ certain bond strategies to help you protect your portfolio from call risk. Laddering, for example, is the practice of buying bonds with different maturity dates. If you have a laddered portfolio and some of your bonds are called, your other bonds with many years left until maturity may still be new enough to be under call protection. And your bonds nearer maturity won't be called because the costs of calling the issue wouldn't be worth it for the company. While only some bonds are at risk of being called, your overall portfolio remains stable.

Summary
There is no way to prevent a call. But with some planning, you can ease the pain before it happens to your bond. Make sure you understand the call features of a bond before you buy it, and look for bonds with call protection. This could give you some time to evaluate your holding if interest rates experience a decline. Finally, to determine whether a callable bond actually offers you a higher yield, always compare it to the yields of similar bonds that not callable.
Bond ETFs: A Viable Alternative
While some electronic bond trading is available to retail investors, the entire bond market remains an over-the-counter market. Unlike stock trading - for which automation has leveled the playing field for retail and institutional investors - the bond market lacks liquidity and price transparency except for the most liquid of bonds. For the self-directed bond investor, for whom it may make little sense to invest in expensive actively managed bond funds, exchange-traded funds (ETFs) which track bond indices may offer a good alternative.

Overview Of Bond ETFs
While similar to other ETFs (see Introduction To Exchange-Traded Funds), bond ETFs are unique in the world of fixed income because, as they are traded on stock exchanges, the current and historical prices of bond ETFs are available to all investors. Historically, this kind of price transparency for bonds has been available only to institutional investors.

The challenge for the architect of a bond ETF is to ensure that it closely tracks its respective index in a cost-effective manner despite the lack of liquidity in the bond market. Most bonds are held until maturity, so an active secondary market is typically not available for them. This makes it difficult to ensure a bond ETF encompasses enough liquid bonds to track an index. This challenge is bigger for corporate bonds than for government bonds.

The suppliers of bond ETFs get around the liquidity problem by using representative sampling, which simply means tracking only a sufficient number of bonds to represent an index. The bonds used in the representative sample tend to be the largest and most liquid in the index. For example, the Lehman Aggregate Bond Index contains more than 6,000 bonds, but the Barclays iShare Lehman Aggregate Bond Fund (AGG) contains only a little over 100 of those bonds.

And, given the liquidity of government bonds, tracking errors will be less of a problem with ETFs that represent government bond indices.

Bond ETFs pay out interest through a monthly dividend, while any capital gains are paid out through an annual dividend. For tax purposes these dividends are treated as either income or capital gains. (However, the tax efficiency of bond ETFs is not a big factor because capital gains do not play as big of a part in bond returns as they do in stock returns.)

Finally, bond ETFs are available on a global basis. Barclays Global Investors, for example, has created ETFs that are available in the U.S., Europe and Canada.

Bond ETFs Versus Bond Ladders
The liquidity and transparency of an ETF offers advantages over a passively held bond ladder. Bond ETFs offer instant diversification and a constant duration, which means an investor needs to make only one trade to get a fixed-income portfolio up and running. A bond ladder, which requires buying individual bonds, does not offer this luxury.
One disadvantage of bond ETFs is that they charge an ongoing management fee. While lower spreads on trading bond ETFs help offset this somewhat, the issue will still prevail with a buy-and-hold strategy over the longer term. The initial trading spread advantage of bond ETFs is eroded over time by the annual management fee.

The second disadvantage is that there is no flexibility to create something unique for a portfolio. For example, if an investor is looking for a high degree of income or no immediate income at all, bond ETFs may not be the product for him or her.

Bond ETFs Versus Index Bond Funds
Bond ETFs and index bond funds cover similar indices, use similar optimization strategies and have similar performance. Bond ETFs, however, are the better alternative for those looking for more flexible trading and better transparency. The make-up of the underlying portfolio for a bond ETF is available daily online, but this type of information for index bond funds is available only on a semi-annual basis. Furthermore, on top of being able to trade bond ETFs throughout the day, active traders can enjoy the ability to use margin, sell short and trade options on these securities.

The main disadvantage of bond ETFs is the trading commissions they generate. Therefore, they make more sense for larger and less frequent trades. However, ETFs don't pose this disadvantage for investors who purchase their index bond funds through a third party (such as an online broker), which also charges a fee for the fund trade.

Summary
The bond ETF is an exciting new addition to the bond market, offering an excellent alternative to self-directed investors who, looking for ease of trading and increased price transparency, want to practice indexing or active bond trading. However, bond ETFs are suitable for particular strategies. If, for instance, you are looking to create a specific income stream, bond ETFs may not be for you. Be sure to compare your alternatives before investing.

Asset Allocation within Fixed Income
Outperforming your average bond fund on a risk-adjusted basis is not a particularly difficult task for the savvy retail investor. Investing in bond funds is a flawed exercise--particularly in a low interest rate environment. High management fees on bond funds offset much of their active management and diversification benefits. Fixed-income fund managers tend to strive for performance that tracks a respective index rather than portfolio optimization. For example, the overall market capitalization of the U.S. fixed-income market is the basis for the most popular fixed-income index--the Lehman U.S. Aggregate.

How can it be so easy to beat Wall Street's best at their game? Let's take a look at how diversifying across the different classes is the basis of successful fixed-income investing, and how the individual investor can use this premise to gain an advantage over fund managers.