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Quality counts when buying bonds

POSTED: May 31, 2007 5:02 a.m.

One of the reasons you invest in bonds — perhaps the main reason — is the interest payments you’ll receive. So, naturally, you’d like these payments to be as large as possible. However, “chasing” high rates may not always work out in your favor. But when buying bonds, you can hardly go wrong when you look for quality.

As you may know, there’s a direct — and inverse — relationship between a bond’s quality and its interest rate. To attract investors, the lowest-quality bonds typically pay the highest interest rates. Conversely, high-quality bonds pay lower rates.

But what does it mean to say that a bond is of high quality? Essentially, it means that an independent rating agency, such as Moody’s or Standard & Poor’s, has evaluated a bond and found that its issuer — a corporation or a municipality — is unlikely to default on its payments. And the higher-rated the bond, the less likely a default.

Before buying a bond, then, check out its rating. Moody’s ranks “investment grade” bonds (the highest quality bonds) from Aaa down to Baa-1 or Baa, while Standard & Poor’s ranks these bonds from AAA down to BBB. If you see a bond with a rating below these, it is considered “speculative,” “highly speculative” or in default.

Is it smart to chase higher rates?

It’s not hard to understand why high quality is desirable when choosing bonds; after all, you’d like to be fairly confident that the issuer is going to continue making interest payments throughout the life of your bond. But what may be more difficult for some people to understand is why they can’t sacrifice some quality for higher rates. After all, in times of low interest rates — such as the present — higher-return bonds can look attractive to those who rely on their investments for income and to those who are looking for the best return on their money. So why not buy lower-quality bonds that carry higher yields?

For one thing, while it’s true that lower-quality bonds generally pay more than those with higher grades, the difference is no longer as great as it once was. Why? Because, in the declining-rate environment we’ve been in for several years, yield-hungry investors have aggressively sought out lower-quality bonds. Consequently, the increased demand for these bonds has caused their price to go up, relative to higher-rated bonds. And because interest rates move in the opposite direction of bond prices, the “quality spread” — the difference in yields for bonds of different quality — has narrowed.

In plain English, this means you are probably not getting paid enough, in terms of yield, for taking on the risk of buying lower-quality bonds. So chasing higher yields, and sacrificing quality to get them, may not work in your favor.
Rather than pursuing higher yields in today’s marketplace, you might be better off by creating a bond “ladder” composed of bonds of varying maturities. When rates are rising, the proceeds from your maturing bonds can be used to invest in new bonds at the higher levels. When market rates are falling, you’ll continue to benefit from the higher rates offered by your longer-term bonds.

But in any case, stick with quality bonds. They may not always give you the top interest rates, but they can still be quite rewarding.

Jeff Hupman is a financial advisor with Edward Jones in Rincon.

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