An investor’s decision to buy a particular bond or series of bonds is typically dependent on an assessment of one’s investment goal, time horizon and the amount of risk that one is willing to take.

Your length of time and risk tolerance metrics will ultimately guide the type of strategy you wish to employ to achieve your investment goal or objective. The investor, for instance, whose investment goal is one of capital growth and has an investment horizon of say twenty years, that is, the length of time until the funds will be needed, may have a moderate risk profile and will tend to invest in long-dated high-credit quality bonds (investment grade bonds). Contrastingly, an investor with a higher risk appetite, shorter investment horizon may opt to buy short-dated lower-credit quality bonds (non-investment grade or junk bonds) in order to maximise interest income.

In considering a bond investment strategy, it’s also noteworthy to consider the importance of diversification, as it is generally not a good idea to have all your investments concentrated in a single risk or asset class.

You will want to diversify the risks within your bond investments by creating a portfolio of several bonds, each with different characteristics. Investing in bonds from different issuers, for instance, protects you from the possibility that any one issuer will be unable to meet its obligations to pay interest and principal.

Buying bonds of different types (sovereign, corporate, municipal, asset-backed securities, etc) creates protection from the possibility of losses in any particular market segment, and choosing bonds of different maturities will help to manage interest rate risks.

Consider below two investment objectives, and strategies for achieving them.

PRESERVATION OF PRINCIPAL AND EARNING INTEREST

If your investment objective is to preserve your principal investment and earn interest, consider a “buy and hold” strategy.

A “buy and hold” strategy is one where a bond is purchased and held to maturity, and the investor receives periodic coupon payments over the life of the bond and full repayment of principal at maturity, provided the issuer does not default on the bond.

However, if the bond is purchased at a premium (because coupon rate is higher than the prevailing interest rates) you will receive at maturity less than the amount you pay for the bond, while if the bond is purchased at a discount (coupon rate is less than prevailing market rate) you will get more than you pay for the bond, at maturity.

When you buy and hold bonds to maturity, 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. However, holding on to the bond means you will not be able to invest at higher market rates.

“Buy and hold” strategies work best with high-credit quality bonds which minimise the risks of issuer defaults and longer-dated bonds which should offer higher coupon rates (and yields) than shorter-dated bonds.

MAXIMISING RETURNS

Using bonds to invest for total return, or a combination of capital appreciation (growth) and income, requires a more active trading strategy than the passive “buy and hold” strategy and a view on the direction of interest rates on other market variables.

Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather than holding the bond to maturity. Bond prices fall when interest rates are rising and rise when interest rates fall.

The capital gains from bond sales are added to interest income to boost the overall return on the bond for the period held.

For instance, a five-year 8% coupon bond purchased at a price of $100.00 and sold at a price of $107.00 a year later would produce a total return of 15 per cent for the year, that is (coupon of $8.00 + capital gains of $7) divided by initial investment of $100.00 and then converting to percentage.

In contrast, a ‘buy and hold” strategy in the same bond would only have yielded 8% return (coupon rate) after a year.

An investor can also purchase units in a bond fund to maximise returns. Some bond funds have total return as their investment objective, offering investors the opportunity to benefit from bond market movements while leaving the day-to-day investment decisions to professional portfolio managers.

An investor can also consider investing in a bond mutual fund to achieve automatic diversification of their bond investments for less than it would cost to construct a portfolio of individual bonds.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm