Is the Time Right for Bonds? Bond Market Investing

This ERATE Blog Post has been featured by WSJ.com

 

by Nancy Osborne, COO of ERATE

Now that the stock market has hit shaky ground, investors are looking for a safer haven to park their money. In July of 2007, the market briefly closed above 14,000 only to slide back down 1,000 point within a month. In the flight to quality that normally follows a downturn in the market, investors have begun turning to more secure holdings such as bonds. With the Federal Reserve having initiated the process of moving short-term rates lower in response to a slowing economy that was pushed in that direction by the fallout resulting from the sub-prime loan debacle, bonds are once again in the spotlight. Even if a recession is some how averted, the economy is likely to continue trending lower in both 2008 and 2009. As the housing market unravels, letting more air out of the tires, consumers will feel less confident in their spending ability. The disposable and discretionary spending of consumers is on course to experience a considerable pull back, thus dragging the overall economy down with it.

The bond market is where debt issued by federal, state and local governments, as well as large corporations, is traded. The prevailing climate for interest rates is typically the key indicator for the bond market. When interest rates move higher, the value and therefore the price of bonds already issued at lower interest rates drops and conversely as interest rates move lower, those bonds previously issued on the market increase in value and therefore in price. Interest rates influence the demand for bonds and on the supply side the number of new bond issues coming onto the market has the defining impact as the market attempts to digest these new issues and supply and demand work to establish price.

An advantage of bonds is that they tend to move in a direction opposite that of stocks and are therefore a good way to balance and manage the risk of maintaining equity holdings. Bonds also pay out a stream of income over time and are a relatively safe and reliable investment which produces a steady return. Currently the five and ten year issues may offer the best over all return, however a good way to invest in bonds is through bonds mutual funds. Consider a highly rated muni-bond fund which is typically a five to ten year general obligation bond issued by a municipality to finance a targeted project. Muni-bonds are insured as a requirement to support the bond and to back its safety and most are rated by the general rating agencies such as Moody's or S&P in an effort to reflect the solvency of the municipality having issued them. The critical selling point of muni-bonds is that their gain is generally tax-free which adds significantly to their yield.

An exciting new development in the world of muni-bonds, they are now tracked by exchange traded funds (ETFs) making them an even more attractive investment as bare-bones expense ratios are the hallmark of ETFs. The national average for an expense ratio on a tax free bond fund is about 1.02%. Compare that to the 0.25% expense ratio of some the muni-bond ETFs and you will reap the benefits of investing in the lower expense ratio fund, increasing your overall return. The tax free element of muni-bonds works to increase the tax equivalent yield by 1%-2% if you are in the 28% tax bracket as an example. This combination of lower expense ratios, along with their tax-free status, make muni-bonds an investment worth taking a serious look at.

Note that a key case regarding municipal bonds is currently being decided by the U.S. Supreme Court. The case originated in the state of Kentucky and will likely determine whether municipal bonds purchased by an investor who resides in a state other than the state where the municipal bonds were issued are indeed tax free. However the municipal bonds issued by and purchased within your state of legal residence are not at issue.

Always consult with your tax or financial and legal advisor regarding your own individual circumstances before taking any action which could have a significant impact on your personal taxes or finances.