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The right bond for any purpose

By David Luhman on Sat, 05/09/2009 - 23:34

The right bond for any purpose

Viewing bonds by their maturity

So I hope I've given you an overview of bonds, and the number one enemy of bonds, inflation. I hope you've also seen that debtor governments have a bias towards tolerating inflation because it reduces their debt burden.

But let's take a closer look at the various types of bonds and see how you can use them in your everyday investing.

Perhaps the simplest way to look at bonds is by their maturities. Bonds usually are classified into cash equivalents, short-term, intermediate-term and long-term bonds.

Cash equivalents

Cash equivalents are US Treasury bills which mature in 90 days, short-term certificates of deposits, or so-called commercial paper issued by large companies.

Cash equivalents normally mature in 120 days or less, and face little interest rate risk. The interest rate risk is low because even if interest rates zoom up, your investment will soon be returned and you can reinvest at the higher interest rate.

Short-term bonds

Short-term bonds are said to mature in two to three years. Short-term bonds generally yield more than cash equivalents, and the interest rate risk is higher as well.

If interest rates shoot up, you'll have to wait two to three years to reinvest at the higher rates. Of course you always can sell your short-term bonds in the open market, but if interest rates already have risen, you'll have to sell your short-term bonds at a slight loss.

Intermediate-term bonds

Intermediate-term bonds can be thought of as those bonds that will mature in five to seven years. They usually yield a little more than short-term bonds, and of course face higher interest rate risk.

Long-term bonds

Finally, long-term bonds can be thought of as those bonds that will mature in 15 to 20 years or more. The so-called "long bond" in the US Treasury market is watched closely, and has a maturity of 30 years.

Long-term bonds generally pay a little higher interest than intermediate-term bonds, but the interest rate risk for long-term bonds is high.

If you like to speculate on interest rate moves, you should buy or sell long-term bonds. The investment climate of the late 1970s and early 1980s was a great example of the risks and potential rewards of investing in long-term bonds.

The Jimmy Carter Memorial Inflation and long bonds

During the "Jimmy Carter memorial inflation" long-term bond investors had negative returns from 1977 through 1981. However, after the appointment of Paul Volcker as chairman of the US Federal Reserve, the US became more serious about fighting inflation.

Although most investors suffered losses in long-term bonds in the late 1970s, those who bet that lower interest rates were coming were richly rewarded in 1982 when the long-term bond market posted a total return of 40 percent in one year.

Most of this return was in the form of capital gains realized through a sharp drop in interest rates. Remember that long-term bonds are sensitive to changes in interest rates.

Potential for gains by timing the bond market

With all this talk about capital gains or losses in the bond market, you might be thinking, "Well, here's an easy way to make lots of money in the bond market. Just buy long-term bonds when interest rates are falling, reap the capital gains, and then sell before interest rates rise again."

You could make money if you can time the market. The operative word here is "if".

Virtually no one beats the bond market

Although there is some evidence that a few people are able to beat market averages in stocks, there is little evidence that anyone can win in the bond market. Independent rating services that monitor bond market forecasters show that almost no one beats a simple buy and hold strategy in the bond market.

It's easy to see why. The US Treasury market is easily the deepest, most liquid, and most watched market for any security in the world. In this market, it's extremely doubtful that you know something that others don't.

Of course there is something to be said about being a contrarian, but studies show that most people who try to time the bond market actually do worse than those who use a buy and hold strategy. After accounting for trading commissions, taxes, and the expense of a bond guru's high-priced newsletter, it's doubtful you can beat the market. Resist the temptation.

Most of a bond's return comes from initial yield

Still, don't get carried away with all this talk about potential capital gains, even when investing in volatile long-term bonds. Over time, the total annual return you'll get on a bond investment is approximately equal to the current yield of your bond. In fact, over 80 percent of the total return on a bond is explained by the current yield of the bond.

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