INSIGHTS

On August 26, 2015

AAM Viewpoints - Volatility and Investing in Fixed Income Bonds

There has been a fair amount of discussion on the need for fixed income investments for those who are retired or contemplating retirement. With interest rates at historic lows and many believing that rates will eventually rise, not much is said on the potential loss of principal that results in a rising interest rate environment.

The typical investor has been taught that bonds are a safe investment. They are taught that bonds with investment grade credit ratings will mature at par or face value, barring a default, and will pay the stated coupon. The investor can sleep well at night. This is all generally accurate. We all know the merits of many bond funds: diversification, professional management, not a large initial investment required, etc. What is not discussed are things like a bond fund not typically having a maturity date. When interest rates rise, the value of a bond fund should generally go down. The investor will still receive interest payments which could increase with rates rising, but there is no maturity date in sight where the investor gets their principal back without selling or redeeming their interest in the fund. For many this is an important consideration. What does that really mean with regards to rising interest rates? One example is the 30-year Treasury that has a 2.5% coupon traded around 100 on 3/24/2015 and around 90 on 5/6/2015, a month and a half later. On paper, that is a 10% loss in value – pretty volatile. So if it is important to an investor to know they have a date when they will receive their principal back, typical bond funds may not be the answer.

For those who want maturity dates on their bond investments, here are a couple options.

1. Own coupon-paying individual bonds. They have coupons and pay interest on interest payment dates, usually every six months, and stated maturity dates where the investor gets the bond’s principal back (barring default or early repayment). One downside is the initial investments can be relatively large as compared to bond funds so diversification may be a challenge.
2. Another alternative, is to invest in a bond unit investment trust (UIT) that owns coupon-paying bonds. The investor, for a relatively low investment (which does not include payment of a sales fee along with other UIT expenses during a UIT’s life), can invest in a basket of individual bonds that are not actively managed, know what they own, and each bond has disclosed coupon and maturity dates so when each individual bond matures, the maturity proceeds are returned to the UIT which makes a distribution to the investors who own the UIT. The coupon payments are combined and paid out monthly. Another potential upside is bonds bought into the UIT are usually of larger lot size so the investors potentially get the benefit of round lot pricing. A UIT is an Investment Company Act of 1940 registered product and there is a prospectus that clearly details what bonds are in the UIT, change only as bonds mature and repay their principal along with other limited circumstances laid out in a UIT’s trust indenture, along with the UIT’s fees, expenses and costs: very transparent.

Different investors have different considerations that are important. If a maturity date is important on your bond investments, understanding the investment vehicle may be as important as the individual bonds that make up your investment.

CRN:  2015-0519-4760 R

Advisors Asset Management, Inc. is a unit investment trust sponsor. This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.