Understanding the Bond Market

With the recent volatility of the stock market, bonds and bond mutual funds are getting a fresh look from many investors. Though bond investing has become more challenging due to the increased volatility of interest rates, the conservative nature of bonds and the stream of income they provide may be what many investors need to balance their portfolios. In this market, bonds can be an investor's best friend if you know how they work and how to use them in your portfolio.

As with most things in life, trends in investing come and go. Take bonds, for example. 40 to 50 years ago, when interest rates were steady, bonds were the staple investment for most Americans. Investors could be sure that on a 30-year, $15,000 bond, they could collect the bond's income for 30 years, and then collect their initial $15,000 at the bond's maturity. Then came inflation and volatile interest rates in the 1970s, and soon, stock investing was in vogue.

Buying Debt: The Principle Behind Bonds
When you buy a bond, you lend the bond issuer the face value of the bond. As the investor, you receive income based on the bond's coupon rate over the life of the bond, as well as the principal (or face value) when the bond reaches its maturity. If you buy bonds directly from the issuer and hold them until maturity, bond investing is fairly straightforward.

Bond investing gets more complex if you buy bonds on the secondary market, where bonds are traded above or below face value (at a premium or discount), or if you sell the bond before maturity and interest rates have changed. In essence, your return on investment is the difference between what you paid for the bond and what you realize when you sell it or it matures.

Fluctuating interest rates, bond supply and demand, and the bond issuer's financial health can all affect both the purchase and sale price on your investment. With all of these things to consider, many investors choose to participate in the bond market by taking advantage of the professional management offered in bond mutual funds.

Different Risks, Different Rewards
Bonds and bond mutual funds have their own set of risks and rewards. Credit risk depends on the financial health of the issuer, which could be a corporation, municipality, or the Federal government. Independent rating services like Standard & Poor's or Moody's evaluate bonds on a regular basis and give ratings for creditworthiness. Interest rate risk comes into play when bonds are sold before maturity. If a bond is sold and interest rates have climbed, the bond will be worth less because there is an inverse relationship between bond prices and interest rates. Investing in bonds over the long term also presents inflation risk—the risk that inflation will increase at a higher rate than the value of the investment.

In today's market, perhaps the most significant reward of bond investing is diversification. Bonds can help balance more risky stock investments, and also provide a steady stream of income. The income combined with lower volatility, compared to stocks, can help balance the risk in your portfolio.

The Advantages of Bond Funds
If you are new to bond investing or want to allocate just a small portion of your portfolio to bonds, you may want to consider investing in a bond mutual fund. Bond funds offer three advantages over investments in individual bonds—diversification, liquidity and professional management. By nature, a bond fund offers greater diversification than an individual bond, something many investors are looking for when they decide to get into the bond market. Generally, bond funds also offer more liquidity since it is usually easier to buy and sell shares of bond funds than individual bonds themselves. Bond funds often specialize in types of bonds based on the bond's issuer. Finally, bond funds offer professional managers who dedicate all of their time to researching, buying and selling bonds.

As you examine bond funds and their place in your portfolio, keep these hints in mind:

• Look for the total return, not total yield. Though yield is important, especially when purchasing individual bonds, total return is more important when choosing bond funds since it measures the investment's impact on your portfolio.
• Compare apples to apples. As you choose between bond funds, make sure you compare funds with those that hold bonds with similar average maturities and similar average credit qualifiers.

You should carefully consider the investment objectives, risks, expenses and charges of the investment company before you invest. Your Northwestern Mutual Investment Services Registered Representative can provide you with a prospectus that will contain the information noted above, and other important information that you should read carefully before you invest or send money.

Source: Mason Street Funds' StreetTalk Spring/Summer 2002

Call your Northwestern Mutual Financial Network representative or 1-888-627-6678 for a prospectus which contains more complete information, including fees and expenses. You will want to read it carefully before you invest or send money.

All securities are offered through Northwestern Mutual Investment Services LLC, (NMIS), Suite 300, 611 E. Wisconsin Avenue, Milwaukee, WI 53202, 1-866-664-7737. Member NASD and SIPC. NMIS is wholly owned by Northwestern Mutual.