Factors to consider when investing in bonds
Professional advice and, in many cases, professional management are key elements of successful financial planning. Although there is no assurance any investment strategy will be successful, our financial advisors assist investors in creating diversified fixed income portfolios designed to perform well in unpredictable market environments while addressing the investors’ specific objectives for level of income and principal preservation.
Discussed below are considerations and risks associated with investing in fixed income securities. Additional information about risks and other factors are is available at finra.org, emma.msrb.org, and investinginbonds.com. Asset allocation and diversification do not ensure a profit or protect against a loss. Investment suitability must be determined for each individual investor. Investing involves risk and investors may incur a profit or loss.
Market prices of fixed income securities may be affected by several risks, including without limitation: interest rate risk - a rise (fall) in interest rates may reduce (increase) the value of your investment, default or credit risk - the issuer’s ability to make interest and principal payments, and liquidity risk - the inability to sell bonds promptly prior to maturity with minimal loss of principal.
Interest rates. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. To analyze interest rate risk, please check modified duration and convexity which are measures of price sensitivity of a fixed-income security to changes in interest rates. Modified Duration is the approximate percentage change in price that would occur with a 1% change in interest rates. Convexity estimates the impact of interest rate changes on duration. Modified duration and convexity may be used together to approximate price volatility of fixed-income securities. Modified duration does not account for early redemption features, such as calls by the issuer. Example of sensitivity in bond price to changes in interest rates:
The following chart illustrates how a bond’s value is reduced when interest rates rise. Conversely, the value would increase when rates fall. This example assumes a 4% coupon bond, with a 4% yield at inception (priced at par or 100.00). If the market rate for like bonds went UP to 5% (a 100 basis point change), the value of the bond would decline by the amount shown under "Change in Bonds Value", with the ending price (value) listed in the final column. In this example, the 10-year bond was worth 100 cents on the dollar at puchase, but the same bond was worth 92.2 cents on the dollar after the 100 basis point change in interest rates.
|EXAMPLE BONDS MATURITY in YEARS from TODAY||Original Price (value) assumed at purchase 4% interest rate bond purchased to yield 4%||Change in Value per 100 basis points upward interest rate change*||Price (value) AFTER 100 basis point interest rate change|
Note these are examples and approximations. This example assumes non callable bonds. Callable bonds have different sensitivities when they are priced above 100.00.
*A basis point is 1/100 of 1%. A 100 basis point change would be when interest rates move 1 full percent, example moving from 4% to 5%. The change in value shown is specific to a 100 basis point rate change in similar securities. If the rate change was only 50 basis points, (or a 1/2% rate change), the value change would be roughly half of what is shown. By extension, if the rate change was 300 basis points, the change in value would be approximately 3 times what is shown.
Credit Risk or Default Risk refers to the risks that the issuer’s creditworthiness may weaken or that the issuer may possibly default and will not be able to pay interest or repay principal on its debt securities. Adverse changes in the creditworthiness of the issuer (whether or not reflected in changes to the issuer’s rating) can decrease the current market value and may result in a partial or total loss of your investment. Securities ratings provided by independent nationally recognized statistical organizations, also called Ratings Agencies, are appraisals of the financial stability of a particular issuer and its ability to pay income and return principal on your investment. Although they can assist investors in evaluating the creditworthiness of an issuer, ratings are not recommendations to buy, sell or hold a security, nor do ratings remove market risk. In addition, ratings are subject to review, revision, suspension, reduction or withdrawal at any time, and any of these changes in ratings may affect the current market value of your investment. A Rating Agency may also place an issuer under review or credit watch which may be another indicator of a future rating change. Generally, higher yields and/or lower ratings reflect higher perceived credit risk. News events relating to a particular issuer may generally impact the market price, and consequently the yield, of that issuer’s securities, even if their rating has not yet changed. Securities with the same rating can actually trade at significantly different prices. The absence of a rating may indicate that the issuer has not requested a rating evaluation, insufficient data exists on the issuer to derive a rating, or that a rating request was denied. Non-rated securities are speculative in nature and are less liquid. Raymond James trade confirmations, online accounts and monthly statements display only the ratings of those Rating Agencies to which Raymond James subscribes. For more information on ratings, please visit moodys.com, standardandpoors.com and fitchratings.com. Additionally, individual investors may request Moody’s Credit Research reports from their financial advisors.
Underlying ratings pertain to a security for which credit enhancement has been obtained (bond insurance, letter of credit, etc.). The underlying rating is assigned by a rating agency to such security without regard to credit enhancement or assigned to other securities of the same issuer having the same features and security structure but without the credit enhancement.
Insurance does not guarantee market value or protect against fluctuations in bond prices. The insurer is responsible for making timely payments of principal and interest if the issuer is unable to do so. The value of the insurance policy depends entirely on the insurer’s financial stability. There is always the risk that the insurer itself could declare bankruptcy or otherwise fail to meet its obligations under the insurance policy. No representation is made as to the insurer's ability to meet its financial commitments. Any guarantees such as direct government, United States Government Sponsored Enterprise, FDIC or any other insurance applies only to the face value of the investment and not to any premium paid nor does it protect the investor from market risk.
TRACE symbols are used in reporting transactions to FINRA. The first 3 letters indicate the name of obligor. It is an important indicator when measuring exposure in cases where the original issuer and current obligor are different. To view trade price information please access finra.org.
Capital structure/priority of claim. If an issuer is liquidated, stakeholders with a higher priority claim to the issuer’s assets have the potential for a greater recovery than those with lower priority. Generally, priority is as follows: (1) secured debt, (2) unsecured debt, (3) unsecured subordinated debt, (4) junior subordinated debt and trust preferred securities, (5) traditional preferred stock, and (6) common stock. Should a company liquidate or become insolvent, there is no assurance that any holders will receive compensation, regardless of priority of claim.
Purchasing Power Risk is the risk that, over time, inflation will lower the value of the returned principal. This means that an investor will be able to purchase fewer goods and services with the proceeds received at maturity. Higher inflationary pressures usually result in higher interest rates.
Reinvestment Risk. Those who lock in their returns by investing in long-term bonds might not be able to reinvest at higher rates when rates go up. However, those who buy short-term securities or callable securities may face the risk of having to reinvest at lower rates when interest rates drop.
Redemption provisions, such as calls at the issuer's option, tenders, sinking funds or extraordinary redemptions, provide the issuer an option to repay principal prior to maturity and may change the term of the investment which may affect price or yield calculations. Callable bonds may provide investors with a potential for higher yields as a means of compensation for the reinvestment risk.
Liquidity of secondary market. Although not obligated to do so, Raymond James and other broker/dealers may maintain a secondary market in securities, including brokered CDs, and the price may be more or less than the original purchase price. However, there is no assurance that an active market will develop or be maintained.
Your securities’ evaluations on monthly statements. Fixed income securities, including brokered CDs, are priced using evaluations, which may be matrix- or model-based, and do not necessarily reflect actual trades. These price evaluations suggest current estimated market values, which may be significantly higher or lower than the amount you would pay (receive) in an actual purchase (sale) of the security. These estimates, which are obtained from various sources, assume normal market conditions and are based on large volume transactions.
Commissions and other Fees – Bonds are traded on either a principal or agency basis. A trade done directly with an investor’s own firm is considered a principal trade and a markup/markdown may be included in a bond’s price. If using the firm as an agent to facilitate a trade with a different firm, an investor may pay a commission or a fee in addition to a bond’s price. Commission rates, fees and markups may vary among offerings and depend on the type of bond, the time remaining until maturity and size of the trade.
Auction Rate Securities - Auction rate securities are subject to failed auction risk. Failed auctions occur when more shares are offered for sale than there are bids to buy shares. There is no guarantee that an auction will be successful. Subsequent auctions could fail for an indefinite period of time. Your ability to sell shares depends on the auction process. Adequate demand for your shares may or may not develop. Neither the issuer, nor the broker-dealer, is obligated to take action to ensure success. In the absence of a successful auction, there is no assurance that a secondary market will develop or that shares in the security will trade at par. Shares will continue earning interest at a predetermined rate specific to each security.
Brokered Certificates of Deposit (CDs) purchased through a securities broker and held in a brokerage account are considered deposits with the issuing institution and are insured by the Federal Deposit Insurance Corporation (FDIC), an independent agency of the U.S. Government. FDIC deposits are insured up to $250,000 per issuer (including principal and interest) for deposits held in different ownership categories, including single accounts, joint accounts, trust accounts, IRAs, and certain other retirement accounts. The deposit insurance coverage limits refer to the total of all deposits that an account holder has in the same ownership categories at each FDIC-insured institution. For more information, please visit fdic.gov. Brokered CDs are redeemable at par upon death of beneficial owner. If you purchased this CD at a premium to par, the premium is not FDIC-insured. Each insured institution is assigned an FDIC certificate number which appears on trade confirmations and statements. The FDIC certificate number is important because mergers and acquisitions may lead to the consolidation of multiple institutions under the same certificate number, thereby reducing your insurance coverage if you held deposits at each of the consolidating institutions. 'Certificate of Deposit Disclosure Statement’ is available at raymondjames.com/liquid.htm or upon request from your financial advisor. Additional information is available from the FDIC at ww.fdic.gov/deposit/deposits/index.html and from the Securities and Exchange Commission at sec.gov/investor/pubs/certific.htm.
Corporate Bonds are debt obligations issued by U.S. and foreign companies, most of which are unsecured promises to repay the principal at a predetermined future date, although some may be secured by a lien on certain corporate assets. In most instances, the issuing company also agrees to pay interest to investors. As bonds are obligations of the issuer to pay back borrowed funds, they generally have priority to pay interest prior to any dividend distributions on the issuer’s stock.
Estate Protection Feature (survivor’s option).Certain bonds include a feature which allows the estate of the beneficial holder to return the bond to the issuer at face (par) value in the event of the beneficial holder’s death, regardless of the price at which the security is trading at that time. If this security has a zero coupon, then it will be redeemed at the accreted value. As certain limitations may apply such as holding periods or annual limitations, please refer to each individual issuer’s prospectus, offering circular or disclosure document. Brokered CDs also generally include an estate protection feature.
Foreign bonds are subject to additional risks, including without limitation, liquidity, currency fluctuations, differing accounting standards, political and economic instability, and differing tax laws.
GSE securities are issued by government-sponsored enterprises (GSEs). Payment of principal and interest is solely the obligation of the issuer. These securities, also known as agency securities, are not guaranteed by the U.S. government and are subject to market risk if sold prior to maturity. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are currently under the Federal Housing Finance Agency's (FHFA) conservatorship. Ginnie Mae (GNMA) is a government corporation and its securities are backed by the full faith and credit of the United States Government; however, they are subject to market risk if sold prior to maturity.
High-yield bonds are not suitable for all investors. The risk of default may increase due to changes in the issuer's credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of a portfolio.
Mortgage-backed securities and Collateralized Mortgage Obligations (CMOs) are priced based on an average life which includes prepayment assumptions that may or may not be met and changes in prepayments may significantly affect yield and average life. The actual maturity date may be shorter than stated. For more information, please review FINRA’s Investor’s Guide to Mortgage Securities and CMOs at finra.org. Mortgage-backed securities are generally regarded as higher yielding investments with relative safety of principal when issued by one of the Government Sponsored Enterprises (GSEs). However, the potential reward of higher yields is dependent on the predictability of timing the return of principal contingent upon the cash flows from the underlying mortgage pools, as homeowners have the option of prepaying their principal at any time.
Tax-Exempt Municipal Bonds are issued by state and local governments as well as other governmental entities to fund projects such as building highways, hospitals, schools, and sewer systems. Interest on these bonds is generally exempt from federal taxation and may also be free of state and local taxes for investors residing in the state and/or locality where the bonds were issued. However, bonds may be subject to federal alternative minimum tax (AMT), and profits and losses on bonds may be subject to capital gains tax treatment. Municipal securities may lose their tax-exempt status if certain legal requirements are not met, or if tax laws change.
Taxable Municipal Bonds are issued by state and local governments as well as other governmental entities to fund redevelopment districts, stadiums, pensions and utilities. Interest or other investment return is included in gross income for federal income tax purposes and may also be subject to state and local income tax. A municipal security may be issued on a taxable basis because the intended use of proceeds does not meet federal tax law requirements for the exclusion from gross income, because certain other federal tax law requirements are not met, or because the issue qualifies for a tax credit or subsidy.
Investors interested in regular updates about individual municipal securities can sign up on EMMA (emma.msrb.org.) to receive e-mail alerts when disclosure documents are posted on the website. Investors who track particular bonds identified by their unique “CUSIP” numbers can receive an e-mail notification from EMMA if a new disclosure document is posted for that security. These documents can include annual and other periodic financial filings, operating data and other types of material events. To sign up for an alert, enter a nine-digit CUSIP number into the “Muni Search” function of EMMA.
New Issues. For more complete information about new issues, including charges and expenses, obtain a prospectus or municipal official statement from your Financial Advisor. Alternatively you can access this information on sec.gov/edgar.shtml or emma.msrb.org. Please read it carefully before you invest or send money.
Original Issue Discount (OID) securities are issued at a price less than the stated redemption price at maturity. OID may be deemed interest income and may be reportable for tax purposes as it accrues whether or not you receive any interest payments from the issuer during the year. Please consult with your tax advisor regarding specific OID tax treatment.
Preferred Securities are comparable to fixed income investments as their income payments are generally fixed over the term of the investment and will react similarly to other debt investments to changes in market conditions. Preferred securities present a greater risk because they are generally subordinate to debt in liquidation priority. Preferred securities are quoted on either a current yield basis, or a yield-to-call basis if trading at a premium. For preferred securities that pay dividends, the dividend is paid at the discretion of the board of directors and holders generally do not have voting rights. Preferred dividends may be cumulative or non-cumulative. Some preferred securities may have a deferred interest feature, which allows the issuer, in certain circumstances, to defer payments between 5 to 10 years or longer depending on the security. The deferred income will generally accumulate, and may be considered as ordinary income for the year in which it is accrued, even though the holder of the security receives no payment until the issuer reinstates interest payments. If deferred, the ability of the issuer to reinstate interest payments is subject to the creditworthiness of the issuer. Additionally, preferred securities generally carry no change of control provisions.
Step-up Coupon Securities increase their coupon payments over a period of time according to a predetermined schedule. Coupon adjustments may not reflect changes in interest rates. When investing in a step-rate security, you may be accepting lower yields initially than comparable fixed-rate securities in return for the potential of receiving higher yields over the life of the investment. However, there is a greater likelihood that the issuer will call these bonds when prevailing interest rates are lower than the current coupon. This may affect the yield on the security.
U.S. Treasury securities are issued and guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are guaranteed as to the timely payment of principal and interest; however, these securities are subject to market risk if sold prior to maturity.
Variable interest rate bonds, which are also referred to as "floater" or "adjustable" rate bonds, pay interest at rates which vary over time and are tied to other interest rates such as those paid on U.S. Treasury bills, a representative benchmark, interest rate index, or combination of indices. Interest payments may fluctuate. Variable rate bonds provide the holder with additional interest income if the underlying rates rise or with reduced interest income if the rate falls.
Zero coupon bonds may have higher price fluctuations since there are no regular interest payments.
Raymond James may, from time to time, have a position in the securities mentioned and may buy or sell such securities in the course of our regular business. Investors are advised to review alternatives with their financial advisors prior to making an investment decision.
This information herein was obtained from sources which we believe reliable, but the accuracy of which cannot be guaranteed. No representation is made that it is accurate or complete, that any returns indicated will be achieved, or that you should rely on it to make an investment decision. Changes to assumptions may materially impact returns. Past performance is not indicative of future results.