The use of bonds in financial planning: how to structure an investment portfolio to meet long-term needs.

Bonds traditionally have been the province of institutional investors. However, as individuals seek to diversify their portfolios and add an element of certainty to future investment returns, bonds have become increasingly popular. This article examines bond characteristics, pricing, investment risk and ways to protect against that risk--information that can be extremely useful to CPAs and their clients in structuring investment portfolios designed to meet long-term needs.

BOND CHARACTERISTICS Bonds are fixed-income securities. The bond contract (indenture) calls for payment of principal (par value) at maturity and periodic interest payments during the bond term. Interest payments are determined by multiplying the bond's par (face) value by the interest rate (coupon rate) called for in the contract. Generally, interest payments are made semiannually, and bond terms run from one to several years.

Bond prices are based on the amount and timing of future cash flows from the bond and the current market rate of interest. Future cash flows include interest during the bond term and return of par value at maturity (or sales proceeds if the bond is sold before maturity).

Bond prices generally are based on the assumption the bond will be held to maturity. The bond price is the present value of interest payments plus the present value of the return of par at maturity, determined using the current market interest rate. If the market rate is greater than the coupon rate, the bond will trade below par (at a discount). If the market rate is less than the coupon rate, the bond will trade above par (at a premium). If the coupon and market rates are equal, the bond will trade at par. There is an inverse relationship between changes in the market rate and bond prices: As the market rate increases, the bond's price decreases, and as the market rate decreases, the bond's price increases. Exhibit 1, at left, shows how bonds are priced and how market rate changes affect prices.

BOND RISK

To judge whether a bond is a good investment, investors must consider the risk characteristics of the entity issuing the bond (default risk) and the risk of a change in interest rates (interest rate risk).

Default risk and types of bonds. Different entities issue bonds at different levels of default risk. Generally, the higher the default risk, the greater the rate of return. Lowest-risk bonds are issued by the U.S. Treasury. Since principal and interest on such bonds are guaranteed by the U. S. government, these bonds have essentially no default risk.

States, municipalities and other political subdivisions issue general obligation bonds, which-although backed by the issuer's full faith and credit-have an increased level of default risk. Municipalities also issue revenue bonds, which are serviced by income from specific revenue-producing projects such as toll bridges. Revenue bonds often carry a higher risk than general obligation bonds since their repayment depends on the project's success. Interest received on municipal bonds is free of federal income tax.

Nongovernment entities also issue bonds (debentures). These bonds' default risk depends on the issuer's ability to service the debt, which in turn depends on the issuer's financial condition and the business risks it faces. Default risk can be lowered by adding covenants to the bond indenture. Covenants provide safeguards to bondholders by restricting business activities.

Interest rate risk. Interest rate risk, the risk the market rate will change, is inherent in all bonds. If interest rates change while bonds are held, the actual return on the investment will differ from the expected yield. The two components of interest rate risk are

* Reinvestment risk. Reinvestment risk occurs when interest payments during the bond term cannot be reinvested at the market rate. Exhibit 2, page 48, illustrates this risk. In example 1, interest is reinvested at the market rate and the bond is held to maturity. Thus, the investment returns the implied yield.

In example 2, however, interest receipts are reinvested at 9% instead of 12%. This results in interest payments having a lower future value. As such, the bond investment's future value is lower than that implied by the market rate at purchase, and the return on the investment is lower than the expected 12%.

If rates rise during the bond term, the future value of the bond investment will be greater than the yield implied by the purchase price. The higher the coupon rate and the longer the period of time until maturity, the greater the impact of changes in the reinvestment rate on both future value and yield.

In both of exhibit 2's examples, the future value of the principal is equal to the bond's par value ($10,000), because the bond was held to maturity. Not all bonds, however, are held to maturity and if they are not, investors experience price risk.

* Price risk. Price risk occurs when bonds are sold on the open market. Price is determined by the market interest rate at the time of sale. Since a bond's price changes when interest rates change, investors may not receive par value upon sale. In other words, when bonds are sold before maturity, the investor's final proceeds and the return on the investment may differ from those expected at the time the bonds were purchased. Exhibit 3, above, illustrates price risk.

The assumptions in exhibit 3 are the same as those in example 2, exhibit 2, except the bonds are 20-year bonds and are sold at the end of the 10th year. In exhibit 3, the proceeds are determined by discounting future cash flows at the market rate. Since the coupon rate is higher than the market rate, the bond sells at a premium. This results in a yield of less than 12%, but the yield is greater than that in example 2, exhibit 2, because the amount received for the bonds is greater than par, lessening the effect of the lower return on reinvested interest.

As exhibit 3 illustrates, the two components of interest rate risk move in opposite directions. A decrease in the market interest rate has a negative reinvestment risk and a positive price risk. This implies the future value of reinvested interest payments will decrease due to a decreased reinvestment rate, but it also implies the bond's sales price will increase. The opposite is true if interest rates increase while the bond is held. An investor can avoid interest rate risk altogether by using the two components to offset each other. By eliminating interest rate risk, investors can immunize the bond against future interest rate changes.

BOND IMMUNIZATION 

A bond investment is immunized when reinvestment and price risks completely offset each other, leaving the investment's future value unchanged regardless of changes in the market rate. An investment is immunized when the bond's duration equals the desired investment horizon.

Bond duration. Duration is the weighted average time from investment in the bond until receipt of cash flows from the investment. The investment horizon is the length of time an investor wishes to hold the bond. Exhibit 4, page 50, gives the formula for computing duration and an example of how it is determined.

The bonds in exhibit 4 have a 12% coupon rate, which equaled the market rate at the time they were purchased and the duration determined. If the market rate remains 12% throughout the bond term, the investment's yield will be 12%, regardless of the investment horizon. However, if the market rate changes and the bonds are held to maturity, the return on the investment will differ from that expected.

Use of duration to immunize bond investments. Bond investments can be immunized by investing in bonds with a duration (as computed in exhibit 4) equal to the investment horizon. Once the investment has been made, the investor must reinvest all interest upon receipt at the market rate then applicable and must sell the bond at the end of the investment horizon. The investment then yields the future value expected at purchase. This is true regardless of market rate changes because the two components of interest rate risk offset each other.

Exhibits 5 and 6 illustrate two alternative investment strategies. Exhibit 5, at left, uses the duration strategy; exhibit 6, page 54, uses the maturity strategy. The difference in the two is the time to maturity. The maturity strategy equates the time to maturity with the investment horizon. The duration strategy ignores the time to maturity and instead equates the duration with the investment horizon.

Exhibit 5 illustrates how the immunization strategy locks in the 12% expected yield regardless of interest rate changes. The investment's expected future value is $20,490, (the future value of a $10,000 investment held for 6 1/3 years at 12%). The $20,490 future value is achieved regardless of how interest rates change. It's relatively constant because a market rate change causes an equal and opposite reaction in the price and reinvestment risks. The interest's future value increases as rates increase, but the increase is offset by a decrease in the bond's sales price at the investment horizon's end. The net effect is minimal, and the investment returns the implied 12%.

This offsetting of price and reinvestment risk does not occur if the bond investment is not immunized. Exhibit 6 indicates the future value of a portfolio that has not been immunized. As the exhibit shows, the future value of the principal is constant at par regardless of the direction of interest rates. Reinvestment risk, on the other hand, is still present. With no price risk to offset the reinvestment risk, the investment's future value is determined by interest rates after the bond purchase.

Immunization also works when there are multiple rate changes if the changes are not extreme. An unlikely scenario exists in which immunization fails to yield the approximate rate implied at purchase. If interest rates fall while the bond is held and increase immediately before sale, the yield on the investment will be lower than anticipated. In this case, the amount earned on reinvested interest is less than the amount expected at purchase (negative reinvestment risk), and the amount received when the bonds are sold is less than par (negative price risk). The opposite is true if interest rates increase while the bonds are held and decrease immediately before sale.

Use of immunization in bond investments. Immunization should be used cautiously. If interest rates are expected to increase, the return on the investment is higher using a maturity strategy than using a duration strategy. This can be seen by comparing exhibits 5 and 6 at 14%. At that rate, the bond investment's future value is greater using the maturity strategy than using the duration strategy. When the maturity strategy is used during periods of rising interest rates, the increase in interest reinvestment earnings is not offset by a decreased amount received at the investment horizon's end. Instead, bond principal is recouped by collecting the par value from the issuing company. The opposite is true during periods of decreasing interest rates.

Predicting interest rate movements over an extended period is very difficult; therefore, the investor's risk attitudes should be considered when choosing a strategy. A conservative investor should use the duration strategy even if interest rates are expected to increase. On the other hand, an investor willing to accept more risk might use the maturity strategy if rates are expected to increase.

Duration also can be used for bond portfolios. To immunize a portfolio, the weighted average duration of all bonds in the portfolio must equal the investment horizon. Interest must be reinvested in bonds so the portfolio's duration equals the investment horizon. This implies an active investment strategy; the portfolio must be monitored and holdings adjusted as the horizon shortens. Quarterly or semiannual adjustments may be necessary, depending on the number of bonds in the portfolio, frequency of interest payments and investment-horizon length.

MEANS OF DIVERSIFICATION 

As more investors look to bonds to diversify their investment portfolios, they must consider the bonds' risk and return characteristics before investing. Default risk can be lessened by diversifying the portfolio and purchasing bonds with higher ratings from bond rating agencies such as Moody's Bond Record. Interest rate risk can be reduced or eliminated with the duration strategy. While this strategy eliminates most interest rate risk, it may require some management over time as the investment horizon is reduced. Certainly, other factors also should be considered when advising clients about bond investments, but the above strategies will help minimize the long-term risk of bond investing.

EXECUTIVE SUMMARY

* INSTITUTIONS ARE NOT the only potential investors in bonds. Bonds can help individual investors meet a variety of goals. CPAs can help their clients by explaining the role bonds should play in the financial planning process.

* BONDS ARE FIXED-INCOME securities issued by federal, state and local governments and their agencies and by corporations. They pay periodic interest at a specified rate during the bond term and return the full amount of principal at maturity.

* THE POSSIBILITY OF default by the issuer is one risk bond investors face. Another risk is the possibility of changes in prevailing interest rates, which includes reinvestment and price risk.

* TO PROTECT AGAINST reinvestment and price risk, bond investments can be immunized; that is, the bond duration is equal to the investor's desired holding period.

* CAREFULLY SELECTED and managed, a bond portfolio can play an important role in a diversified investment plan, with little or no unnecessary risk being taken.