Interest Income Challenge
A quick aside Disclaimer I am NOT a Financial Advisor nor am I your lawyer, unless I am, before making any investment decisions, you should seek the advice of a competent financial or investment advisor to discuss your specific financial situation. The conversations and information shared herein and hereon this post are merely educational and not to be construed as investment, legal or financial advice* (The law makes me write that)!
We now turn our attention to Interest income!!!
Not all bond investments are created equal. Use this three-step process to evaluate whether various bonds fit your portfolio to create interest income:
1. Can the borrower pay its bonds?
The answer to this question is paramount, because if a company can’t pay its bonds — its promise to pay back money lent, with interest — there’s no reason for the average investor to consider buying them. With some sleuthing, you can estimate whether the company is able to meet its debt obligations.
Bonds are rated by ratings agencies, with three big ones dominating the industry: Moody’s, Standard & Poor’s and Fitch. They estimate creditworthiness, assigning credit ratings to companies and governments and the bonds they issue. The higher the rating — AAA is the highest, and it goes down from there, like school grades — the greater the likelihood the company will honor its obligations and the lower the interest rates it will have to pay.
Corporate bonds. Beyond ratings, the quickest way to determine the safety of a company-issued bond is by looking at how much interest a company pays relative to its income. Like a homeowner paying off a mortgage every month, if the company doesn’t have the income to support its payments, there will be trouble eventually.
Start with the company’s most recent annual operating income and interest expense, which can be found on a company's income statement. This info is available for every U.S. publicly traded company in a 10-K filing, available on a company's website or in the EDGAR database on the U.S. Securities and Exchange Commission's website. Operating income differs from net income, because it factors out interest payments (which are tax-deductible) and taxes, and is the best measure of a company’s ability to pay its debts.
Municipal bonds. Bonds issued by municipalities, though they've also been safe historically, are not quite so rock solid. You can investigate these bonds further on the Electronic Municipal Market Access (EMMA) site, which provides a bond's official prospectus, an issuer's audited financial statements and ongoing financial disclosures, including payment delinquencies and defaults. A government's credit rating is a good first guide to its creditworthiness, and you can follow up to see if there are any recent defaults or other financial issues that might cause a future default or delinquency.
2. Is now the right time to buy bonds?
Once a bond’s interest rate is set and made available to investors, the bond trades in what’s called the debt market. Then the moves of prevailing interest rates dictate how the bond’s price fluctuates.
Bond prices tend to move countercyclically. As the economy heats up, interest rates rise, depressing bond prices. As the economy cools, interest rates fall, lifting bond prices. You might think that bonds are a great buy during boom times (when prices are lowest) and a sell when the economy starts to recover. But it’s not that simple.
Investors try to predict whether rates will go higher or lower. But waiting to buy bonds can amount to trying to time the market, which is not considered a good idea.
To manage this uncertainty, many bond investors “ladder” their bond exposure. Investors buy numerous bonds that mature across a period of years. As bonds mature, the principal is reinvested and the ladder grows. Laddering effectively diversifies interest-rate risk, though it may come at the cost of lower yield.
3. Which bonds are right for my portfolio?
The type of bonds that might be right for you depend on several factors, including your risk tolerance, income requirements and tax situation.
A good bond allocation might include each type -- corporate, federal and municipal bonds -- which will help diversify the portfolio and reduce principal risk. Investors can also stagger the maturities to reduce interest-rate risk.
Diversifying a bond portfolio can be difficult because bonds typically are sold in $1,000 increments, so it can take a lot of cash to build a diversified portfolio.
Instead, it’s much easier to buy bond ETFs. These funds can provide diversified exposure to the bond types you want, and you can mix and match bond ETFs even if you can’t invest a large amount at once.
A quick aside Disclaimer I am NOT a Financial Advisor nor am I your lawyer, unless I am, before making any investment decisions, you should seek the advice of a competent financial or investment advisor to discuss your specific financial situation. The conversations and information shared herein and hereon this post are merely educational and not to be construed as investment, legal or financial advice* (The law makes me write that)!