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This chapter is from the book

Income Investing—Time Diversification

You will learn more about income investing along the way, particularly in Chapter 4, "Income Investing—Safer and Steady . . . But Watch Out for the Pitfalls," so at this time we limit the area of income investment diversification to issues involving time diversification in the establishment of a bond portfolio.

As a general rule—not always—the more distant the maturity of a bond (the date when the loan signified by the bond is due to be paid to bondholders), all else being equal, the higher the interest return you will receive as an investor. This should not be surprising. A bond represents a loan by the bondholder to the bond issuer, who is the borrower. A loan that is to be repaid in, say, 20 years, carries many more risks than a loan that is to be repaid in 20 days. Such risks include potential inflation over the life of the loan—the greater the inflation, the less will be the value of the repayment in today’s dollar purchasing power, the higher will be prevailing interest rates in the future, and the lower will be the face as well as the real value of the bonds you own. There are also risks associated with the solvency of the borrower. (Who would have thought in 1985 that in 2005 bonds issued by General Motors would be down rated to junk status?)

Investors, therefore, must decide between the benefits of receiving higher rates of return from longer-term bond investments and the additional risks involved. As a general rule, it is probably better to purchase intermediate bonds—bonds whose maturities lie, say, between five and seven years—than to purchase longer-term bonds. Intermediate-term bonds pay approximately 80% to 85% the rate of interest of long-term bonds but are considerably more stable in price. For example, in mid-April 2005, 5-year Treasury notes provided yields of 4.13%, whereas 20-year bonds provided yields of 4.87%. The 5-year note’s interest payments were as much as 84.8% the size of the 20-year bond, even though the implied loan was for only 25% the length of time.

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