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Personal Financial Planning

Notes Bond Investment Strategies

The way you invest in bonds for the short-term or the long-term depends on your investment
goals and time frames, the amount of risk you are willing to take and your tax status.
When considering a bond investment strategy, remember the importance of diversification. As
a general rule, it’s never a good idea to put all your assets and all your risk in a single asset class
or investment. You will want to diversify the risks within your bond investments by creating a
portfolio of several bonds, each with different characteristics. Choosing bonds from different
issuers protects you from the possibility that any one issuer will be unable to meet its obligations
to pay interest and principal. Choosing bonds of different types (government, agency, corporate,
municipal, mortgage-backed securities, etc.) creates protection from the possibility of losses in
any particular market sector. Choosing bonds of different maturities helps you manage interest
rate risk.

With that in mind, consider these various objectives and strategies for achieving them.

Preserving Principal and Earning Interest

If keeping your money intact and earning interest is your goal, consider a “buy and hold”
strategy. When you invest in a bond and hold it to maturity, you will get interest payments,
usually twice a year, and receive the face value of the bond at maturity. If the bond you choose
is selling at a premium because its coupon is higher than the prevailing interest rates, keep in
mind that the amount you receive at maturity will be less than the amount you pay for the bond.
When you buy and hold, you need not be too concerned about the impact of interest rates on a
bond’s price or market value. If interest rates rise, and the market value of your bond falls, you
will not feel any effect unless you change your strategy and try to sell the bond. Holding on to
the bond means you will not be able to invest that principal at the higher market rates, however.

If the bond you choose is callable, you have taken the risk of having your principal returned to
you before maturity. Bonds are typically “called,” or redeemed early by their issuer, when
interest rates are falling, which means you will be forced to invest your returned principal at
lower prevailing rates.

Notes When investing to buy and hold, be sure to consider:
1. The coupon interest rate of the bond (multiply this by the par or face value of the
bond to determine the dollar amount of your annual interest payments)
2. The yield-to-maturity or yield-to-call. Higher yields can mean higher risks.
3. The credit quality of the issuer. A bond with a lower credit rating might offer a
higher yield, but it also carries a greater risk that the issuer will not be able to keep
its promises.
Maximizing Income

If your goal is to maximize your interest income, you will usually get higher coupons on
longer-term bonds. With more time to maturity, longer-term bonds are more vulnerable to
changes in interest rates. If you are a buy-and-hold investor, however, these changes will not
affect you unless you change your strategy and decide to sell your bonds.

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