Buying individual bonds

I’ve previously featured a guest post about the advantage to retail investors of buying municipal bond mutual funds. Retail investors can also directly buy individual municipal bonds. This is a tiny part of muniland, but I could see it growing in the future. Today, I welcome a guest post from Andrew Wels, the head of retail fixed income and vice-president for retail at E*Trade Securities. Wels writes about the advantage of buying individual bonds and “laddering” them.

Buying individual bonds
by Andrew Wels

Most financial professionals would agree that a mix of stocks and bonds is essential to a well diversified portfolio. Stocks provide growth potential, and bonds offer both regular income and return of principal upon maturity. Many individual investors are familiar with selecting stocks, but bond investing tends to be viewed as more complex.

Bond funds vs. bond ladders

A bond fund, an investment in a portfolio of individual bonds, is a popular investment vehicle for accessing the fixed-income markets. Bond funds offer diversification and some characteristics of the underlying individual bonds in which they invest. Unlike individual bonds, the interest income from a bond fund is not fixed, so there is no fixed maturity date. For the past several decades, declining interest rates have generally boosted the net asset value of bond funds. Consider the inverse: When interest rates rise, bond fund values tend to decline, exposing an investor’s principal to risk.

In a period of rising interest rates, investing in a ladder of individual bonds and holding them to maturity can help mitigate the principal risk inherent in investing in a single bond. A bond ladder is a diversified portfolio of individual bonds with staggered maturities. At each interval, a portion of the bonds in the ladder mature, and the proceeds may be reinvested at the then-prevailing interest rates, which may be higher or lower than the original rate, or used for other purposes.

Bond ladders offer the benefit of a predictable income stream derived from interest payments and periodically maturing bonds. Through bond ladders, investors can build a diversified bond portfolio that provides a mix of yield and credit quality tailored to one’s individual needs, time horizon and risk tolerance.

Muniland: the big picture (part 2)

Last week I wrote about the size of the municipal bond market and the kinds of investors who are involved in it. This week I thought it would be helpful to explain how municipal bonds are traded.

Most people understand that stocks are traded on exchanges but bonds aren’t. Although bonds could easily trade on an exchange (the New York Stock Exchange already has a setup to do just that), they currently trade “over-the-counter,” meaning that brokers contact each other and trade bonds between them.

This method of trading between dealers can happen on a phone call or fax, through the messaging system of a Bloomberg terminal or through an aggregator platform. These aggregator platforms are very common for fixed-income trading. The SEC publishes an updated list of trading platforms, which are known as “alternative trading systems” (ATS). The regulatory oversight of ATS is very limited when compared with exchange oversight, and they are not required to publish their rulebooks as exchanges are.

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