Bond market fixed income

Definition

Bonds represent a "loan" of money from the bond holder to the bond issuer. Just like a loan, the issuer "borrows" money from the investor and promises to pay "interest" (dividends) on a regular basis, over a fixed period of time, to the investor. The issuer also promises to repay the principal amount of the bond to the investor at maturity or at the end of the fixed time period.

The rate of dividends paid is fixed at the time of issue and does not change. However, the principal value of the bond will fluctuate on a daily basis depending upon many factors, including interest rate changes, supply and demand, tax law changes, and the credit-worthiness of the issuer.

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Risk

Bonds are usually "rated" by nationally recognized ratings services (i.e., Moody's, Standard & Poor's, etc.) using many factors, including past history, credit-worthiness, future earning prospects, cash-flows, other debt, and many more. The rating of a bond is a guide to help determine the relative "safety" of the investment.

The four highest ratings (AAA - AA - A - BBB) are considered "investment grade." Below this is considered noninvestment grade, with the lower ratings (i.e., CCC - CC - C) considered speculative or "junk" bonds. The lower rated bonds are generally considered to have a higher risk factor and therefore generally pay a higher dividend rate to the investor as compensation for the higher risk.

Note: An important factor to keep in mind: the current market value of a bond will rise and fall inversely to the rise and fall of market interest rates. As interest rates go up, the current value of the bond goes down, and vice versa: bonds held to maturity are redeemed at full or par value; bonds sold before maturity may be worth more or less than their original cost.

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Types of Bonds

Perhaps the most common bond is the "Government Bond" which includes U.S. Treasury Bills, Notes, and Bonds, which are issued by and guaranteed by the U.S. Government as to the timely payment of dividends when due, and principal at maturity. These are considered "safe" because the U.S. Government has never failed to pay dividends and principal and is regarded as having no credit risk. Also bonds may be issued by or guaranteed by agencies of the U.S. Government such as FNMA, GNMA, FHA, SLMA, etc. While these are not direct obligations of the U.S. Government, it is implied that the U.S. Government will back the issuing agencies. This also conveys a very high (usually AAA) credit rating to this type of security.

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Corporate Bonds

These are issued by corporations, are usually rated, and may or may not be backed by specific assets or revenues of the corporation. Corporate bonds are considered riskier than Government bonds because the bonds are only as "safe" as the corporation. As we have seen in the past, many corporations, or industries in general, that were once thought of as completely safe, have encountered difficult times and now are not considered as good an investment risk.

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Municipal Bonds

Municipal bonds are generally issued by state and local governments; i.e., cities, boroughs, townships, counties, etc., and their political subdivisions, agencies, and instrumentalities. This includes industrial development authorities, public water and/or sewer projects, health and education facilities, and many more.

The most obvious advantage to investing in municipal bonds is that the income generated to the investor is generally exempt from Federal taxes. Issues from within the investor's state of residence are also generally free of state and local income taxes.

There are also nonincome-producing bonds, often referred to as "Zero Coupon" bonds. These bonds are essentially "stripped" of their dividends and are offered at a deep discount to par. The investor receives the full par value of the bond at maturity. The difference between the purchase price and the redemption value represents the investor's return. The investor would purchase a Zero Coupon bond when current income is not needed, but a fixed maturity value at a future time is desirable. This may include retirement, college, etc. Zeros may be issued by the U.S. Government agencies, municipalities, and corporations.

As with other bonds, municipal or "tax-exempt" bonds are rated for credit-worthiness in much the same manner - revenues, debt load, future projections, etc.

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Bond Funds

Many investors use mutual funds to participate in the income stream derived from bonds. Mutual funds provide diversification, professional management, liquidity, and the option of receiving a monthly income or automatic reinvestment. There are many bond funds, each dedicated to a certain objective. Some invest primarily in Government Securities, some in Corporate Bonds, and some may have both, in addition to income-producing stocks. Generally, a tax-exempt fund will only invest in Municipal Securities, either nationally or within an individual state.

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Primary Objective

Current income should be the primary objective of investing in a bond or income fund. Many investors will invest for reasons other than income; i.e., tax reduction, safety, future income needs, preservation of capital, etc. Income funds normally do not have capital appreciation as a primary objective, but some funds offer growth as a secondary objective. The level of income and/or growth potential depends upon the strategy, objectives, and philosophy of the particular fund.

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Investment Considerations

The basic decision with respect to investing in a bond fund is whether a taxable or tax-exempt fund is more appropriate. The key factor is the individual tax bracket.

The yield spread between taxable and tax-exempt bonds is such that persons in high brackets should consider tax-exempt funds.

The interest yield on long-term bonds is generally higher than what is available in the short-term market. There have been times when unusually high demand for short-term capital has driven short rates higher. However, be aware that long-term bonds are generally more volatile regarding the principal value, thus resulting in a less stable net asset value.

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Securities offered through WesBanco Securities, Inc. a U.S. broker/dealer and a member
FINRA and SIPC.

Not a deposit       Not FDIC insured       Not insured by any federal government agency
Not guaranteed by the bank       May go down in value

WSI@WesBanco.com

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