Bonds explained

By Dr. Jason White
Family Investment Center

One of the bedrock fundamental approaches to successful personal investing is to proper diversify one’s portfolio based on individual factors like age, investment goals and risk tolerance. To diversify means to spread out financial risk by investing in a variety of asset classes including, but not limited to, stocks, bonds and real estate. The focus of today’s column is to provide you with some of the basic terminology from the world of bonds.

A bond represents evidence of a loan made from an investor to government, quasi-governmental agencies or corporations. Bonds are referred to as “fixed-income” securities because they typically pay a fixed rate of interest to the investor. This interest rate is known as the “coupon-rate” of interest.

The face value, known also as the par value of a bond, is paid back to the bondholder at the time of maturity. This is usually $1,000 with many bonds, but it can be just about any amount that the original issuer wished at the time of issuance. At the time of original issue, an indenture contract is put into place specifying the terms of the bond, along with any special provisions the issuer or underwriter think are necessary.


Bonds can be backed by some form of collateral, but many times they are simply debentures, meaning that no specific collateral has been pledged to back that particular bond issue. In the event of default, bondholders who enjoy the protection of specific collateral, such as mortgage bondholders, get paid back before debenture bondholders do. Still, debenture bondholders will be paid before preferred and common stockholders, so their priority claims at least have some chance of recovery.

To assist investors in making informed bond investing decisions, companies like Moody’s Investors Service, Standard and Poor’s Financial Services LLC and Fitch Inc. analyze the financial strength of firms and issue a bond rating for the debt of those companies. The lower the bond rating of a firm is, the higher the risk for the investor. The following chart is a proxy of these rating systems, but I think you’ll get the idea.

Rating Rating Interpretation

AAA Best Quality
AA High Quality
A Upper Medium Grade
BBB Medium Grade
BB Speculative
B Very Speculative
CCC Very Very Speculative
C No Interest being Paid
D Currently in Default

Bonds with a BBB or higher rating are referred to as “investment-grade,” while bonds with a rating below BBB are known as non-investment grade or “junk bonds.” While junk bonds often pay high rates of interest, this is because they are very risky investments and should only make up a very small percentage of your portfolio, at most.

A special feature of some bonds is a call provision. Callable bonds include a provision allowing the issuing company to force early maturity by calling the bonds in. Corporations might issue callable bonds when interest rates are high, hoping to call them in before maturity and refinance the issue if interest rates go down. In the current low interest rate economic environment, I suspect that any bond which can be called already has been, at least where the issuer is financially able to refund debt.

Don't put all of your money in one investment

By Dan Danford

You need fish. For the sake of illustration, let’s pretend you own a seafood restaurant and you need fresh fish every single day. In a sense, your business – your very livelihood – depends on the fisherman’s ability to catch fish daily in the varieties and quantities you need.

Now, nothing can be easier or cheaper than using just one fisherman. He ventures out each morning, returns around noon, and you meet him at the dock when he arrives. The fish are fresh and his schedule predictable. Besides that, Mr. Fisherman is delighted to sign a contract giving you preferred prices.

There’s only one small catch (you’ve already spotted it, haven’t you?). Sometimes the fish don’t bite. Mr. Fisherman meets you at the dock with an empty creel. Franticly, you race from boat to boat to boat seeking tonight’s red snapper. Too late, you discover that today’s bay is empty. The fish moved on during the night. Perhaps tomorrow will be better.

Tomorrow? What about today? There’s an anniversary party … and a business meeting … lunch customers already waiting … well, you get the picture. Tomorrow is too late, and crisis is a bad time to learn anything.

Looking back, one lesson is pretty clear. You can’t rely on one fisherman or just one bay. Instead, you need several (maybe dozens) of fisherman working with a variety of bays, baits, and boats. Good fisherman, all, but each subject to the ocean’s movement and whims. When one fails, another succeeds. Through variety, you develop a reliable source of fish for your restaurant. And, a safety net for your livelihood.

Mutual funds and investment managers are a lot like those fishermen. By design, they use certain techniques in certain waters. They are experts at catching fish, but only when fish in their part of the bay are biting. Otherwise, they troll for the day when fish return. That’s their job and they do it rather well.

My job is to develop reliable sources of growth. We build a network of solid managers operating in a variety of strategic environments – a portfolio. We diversify to include different kinds of investments and different kinds of managers. Through diversity, we build a safety net for the future.

Come learn more about investing in small caps

By Dan Danford

At the Family Investment Center, we believe strongly in investor education. We hold periodic free events for our clients, friends and members of the public. Next Thursday, May 28, we will host Jason Votruba, CFA, who will present “A Winning Strategy for Investing in Smaller Capitalization Equities.” Jason has served as a Portfolio Manager for the UMB Scout Small Cap Fund since 2002 and has more than 10 years of investment management experience.

The presentation will be held in the East Hills Library's basement auditorium in St. Joseph, Mo., beginning with refreshments at 6:30 p.m. and the presentation at 7 p.m.

At FIC, we believe that a properly diversified portfolio should own a variety of asset classes and sizes. UMB Scout Small Cap is one of the funds we've been using for client portfolios. This is a great opportunity to meet the fund manager, and get a face-to-face report on the strategies and stocks that make them so successful.

Diversify your retirement investments

On Mondays, we answer a question from a reader on the blog. If you have a question for us, post it in the comments section or e-mail us.

QUESTION: I work at a company that is not doing well. Our stock is suffering. Most of my retirement is in company stock. What do I do with it? Should I sell now and do something else? I’m 52 years old. Thanks.

ANSWER FROM DAN DANFORD: This is one of the most frustrating issues I encounter. It seems that everyone understands the value of diversification except with company stock in their retirement plans. I've been working with retirement plans for almost 30 years and this is a recurring problem over and over again. In fact, my first job was with a bank trust department, and that bank failed. Many of my colleagues at the time lost most of their retirement savings because they owned bank stock - exclusively - in their accounts.

Sadly, the time to fix this is two years ago. Who knows what the next two years hold for your company? I pray that our economy has seen the worst from this horrific cycle, but even that's a hopeful guess. Every industry faces certain perils, and how yours will fare in the future is anybody's guess. Whether to hold or sell it too hard to call for me, and I don't carry emotional baggage from working there.

Certainly, put new retirement contributions into other things. I'd suggest an S&P 500index fund and/or a good international stock fund. Put diversification to work for you now, and remember this lesson for the last decades of your work life. And - urgently important - share the lesson you learned with colleagues, family, and friends. Especially your family. Teach your children to diversify so they won't face the same crisis when they are 52. Good luck.