Recently with our low interest rate environment and the likelihood of rate hikes in the near future, many need to understand the basics of bonds and the difference between a traditional bond compared to a basket of bond funds that may be in a mutual fund. Even though they both will fluctuate based on interest rates, they care different. If you have bonds in your portfolio, you should understand the difference.
Bonds can be confusing, but it’s a great asset for diversification in a portfolio. Simply put, bonds are loans that an investor makes to a corporation, government, federal agency or other organization. They are sometimes referred to as debt securities. Since bond issuers know you aren't going to lend your hard-earned money for free, the issuer of the bond (the borrower) enters into a legal agreement to pay you (the bondholder) interest. The bond issuer also agrees to repay you the original sum loaned at the bond's maturity date. Some conditions may apply such as the bond being “callable” which can cause repayment to be made earlier. This could occur if the bond you purchased is “callable”.
However, the majority of bonds have a pre-determined maturity date—a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities because many pay you interest—also called a coupon rate—this interest rate is set when the bond is purchased.
A bond's term, or years to maturity, is determined at the time it’s purchased and usually ranges from 1 to 30 years. The borrower fulfills its debt obligation typically when the bond reaches its maturity date, and the final interest payment and the original sum you loaned (the principal) are paid to you since all bonds mature at par value or the starting value. Bond funds never mature, therefore the money manager is constantly purchasing new bonds to keep up with interest rates. You can liquidate these accounts at anytime, but you are subject to the fluctuation in market value based on the interest rates.
Bonds are generally issued in multiples of $1,000. However, a bond's price is subject to market forces and often fluctuates above or below par. If you sell a bond before it matures, you may not receive the full principal amount of the bond and will not receive any remaining interest payments. Why would the price change or fluctuate? In most cases it’s because of interest rate adjustments, credit rating may have changed or maybe supply & demand.
Remember the cardinal rule of bonds:
When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. Interest rate risk is the risk that changes in interest rates in the U.S. or other world markets.
Like any other investments, when you invest in bonds and bond funds, you face risk that you may lose money.
Slow down and give serious thought when you see "high yield"
Bonds are lumped into two broad categories—investment grade and non-investment grade. Bonds that are rated BBB, bbb, Baa or higher are generally considered investment grade. Bonds that are rated BB, bb, Ba or lower are non-investment grade. Non-investment grade bonds are also referred to as high-yield or junk bonds.
Junk bonds typically offer a higher yield than investment-grade bonds, but the higher yield comes with increased risk - the risk that the bond’s issuer may default.
Here are 10 tips to consider before you invest in bonds or bond funds:
Don't reach for yield. The single biggest mistake bond investors make is reaching for yield after interest rates have declined. Don't be tempted by higher yields offered by bonds with lower credit qualities, or focus only on gains that resulted during the prior period. Yield is one of many factors an investor should consider when buying a bond. And never forget: With higher yield comes higher risk.
Define your objectives. Is your investment objective to have enough money for your child's college education? Is your goal to live comfortably in retirement? If so, how comfortably? You probably have multiple goals. Lay them all out and be as precise as you can. Remember that if you don't know where you're going, you'll never arrive!
Assess your risk profile. Different bonds and bond funds, like stocks and stock funds, carry different risk profiles. Always know the risks before you invest in any security. To make sure your risk is in-line with the security, you can visit our website which provides you with a free risk questionnaire to help eliminate any future surprises.
Do your homework. You're off to a good start if you've come this far—but keep going.
If you're considering buying a bond fund, read the prospectus closely. Pay particular attention to the parts that discuss the bonds in the fund. For example, not all bonds in a government bond fund are government bonds.
If you're buying individual bonds, locate a firm and broker specializing in bonds.
Understand all costs associated with buying and selling a bond. Ask upfront how your brokerage firm and broker are being compensated for the transaction, including commissions, mark-ups or mark-downs.
As always, don't try to time the market. Avoid speculating on interest rates. Decisions are too often made on where rates have been rather than where they are going. Instead, stick to the investment strategy that will best help you achieve your goals and objectives with a properly defined asset allocation portfolio.