Educational Programming Video
The Value Line Mutual Fund Survey
Program 19: Financial Planning Part 8
In the last several sessions, we discussed investment profiles. In this session we'll continue to discuss some of the different types of bond funds and cash investments that Value Line's asset allocation formula recommends.
Bonds are long-term debt obligations. Those who invest in a bond generally receive monthly or quarterly interest payments, plus the return of their principle when the bond reaches maturity. There are a number of different categories of bonds: Corporate, High Yield, Municipal, Government notes, Mortgage, and International.
Corporate bonds are those debt obligations issued by non-government, for-profit organizations. Corporate bonds are rated on several different quality scales. Value Line uses the Standard and Poor's scale which runs from AAA, the highest-grade bond, to C and below. Corporate bonds are considered investment grade, or high quality, if their S&P score is above BB. For more information on these scores you should consult an introductory book about bonds. For now, though, it is enough to understand that the higher the letter, the higher the bond's quality, and, the more of any given letter the better the score. So, AAA is better than A, but both are better than BBB.
High-Yield bonds are those bonds that have quality ratings of BB or lower. These bonds are commonly referred to as junk bonds. These are debt obligations of smaller or higher risk companies. Very often the bond ratings are low because there is a chance that the bond will not be paid off. If that were the case, the bondholder would lose all his or her money. High-yield bonds are risky investments and their value can move up and down swiftly.
Municipal bonds are graded along the same scale, but are not usually broken out by high quality or low quality. Basically, a municipal bond is a bond that a local town, city, or state has issued. Some municipalities are more financially sound then others, and, as such, get higher bond ratings. At times you will hear a bond described as insured. The principal and interest payments of these bonds are literally insuredif the issuer cannot pay, an insurance company will. You may also hear of bonds that are pre funded or pre paid. Again, this is just like what it sounds. The issuer of these bonds has put aside money with which to pay these bonds, and there is little concern that these municipal bonds will not be paid off.
Government notes are bonds issued and backed by the United States government. The most commonly referred to government bonds are Treasuries, which are debt obligations issued by the U.S. Department of the Treasury. U.S. government bonds are all of the highest quality (AAA). The only risk that investors face when buying a bond issued by the federal government is that interest rates will fluctuate.
Mortgage issues are collections of mortgages that are bundled together to form one large bond. These bonds are backed by the future payments of the mortgage holders. Their value is hypothetically backed by the properties for which the mortgages have been created. In reality, though, buying one of these bonds will not result in you owning a piece of property. There are several different ways that a mortgage bond can make its way to market. The most common and highest quality way is through government-sponsored agencies, such as the Federal Home Loan Corporation or Freddie Mac. These bonds can also be created by non-government entities. Unlike agency bonds, bonds issued by non-government organizations have no explicit or implicit guarantee.
International bonds are those bonds issued by foreign governments or non-U.S. based companies. The quality of these bonds varies a great deal. Bonds issued in emerging markets (less developed countries) are normally of lower quality than those issued in financially sound countries. With regard to foreign corporate debt, the same rules that apply to U.S. companies applysome are better than others.
There is also another group of bonds that is, essentially, equivalent to cash. These are bonds that will come due within 12 months. Essentially, money market funds invest in these types of bonds. While on the subject of cash, for many investors a bank account or Certificate of Deposit will do just fine. Both of these are backed by the U.S. Government, while money market funds, though offered by banks, are not.
To keep things simple, Value Line recommends that investors have representation in domestic bond funds, high yield bond funds, and foreign bond funds. Any of the above mentioned funds could be used to satisfy these three categories. For those in high tax brackets, municipal bond funds might be the best bet for both the domestic and high yield component. Foreign bond funds can also take on various forms. The more aggressive investor could highlight funds that invest in emerging-market debt, while more conservative investors might choose high-quality European bond funds. With regard to cash, more aggressive investors could purchase an ultra short-term bond fund, while conservative types should stick with bank accounts and CDs.
That wraps up our discussion of bonds and cash. Next session, we'll discuss some different types of investors and create portfolio allocations that might be right for each.