Bonds have a reputation as a "safe" investment compared to stocks. In some respects, that's true. But they can also be risky, which is why investment advisors generally recommend that people in typical circumstances keep a balanced portfolio -- in other words, one that includes both stocks and bonds. If you have a retirement savings account, you probably do own stocks and bonds, contained within large institutionally managed funds, such as a retirement target-date fund.
When you buy a bond (or invest in a managed bond portfolio), you're essentially lending money to the bond issuer. The primary measure of risk in a bond investment is the credit quality of the issuer; that is, an analyst's assessment of the probability that the issuer will go bust and default on its obligation to repay you. Based on that assessment, the agency analyst will assign a bond rating (such as AAA, BBB and so on). The higher the rating, the more confidence investors have that the issuer possesses the long-term ability to fulfill its promises to them.
Investors also need to be mindful of another big hazard: interest rate risk. You may have heard that there's an "inverse relationship" between the movement of market interest rates and the value of bonds trading in the markets. That means, for example, that, if interest rates rise, the value of bonds being traded in the bond markets go down. The opposite is also true. If interest rates fall, the value of bonds go up.
When the performance of bond funds is stated, it includes both the amount of interest collected and the changing value of the bonds in its portfolio.
Bond issuers, also referred to as borrowers, fall into several basic categories:
Here are the hallmarks of each type of borrower you could lend your money to:
Yield and Interest Rate Risk
Another fundamental facet of bond investing is that, the longer into the future a bond matures (when its issuer must repay the bond principal, the amount that was borrowed), the more vulnerable it is to interest rate risk.
Here's an example: Consider what happens to the market value of a bond currently yielding 4% when interest rates rise by 1%. An analysis shows that, if the bond has five years to maturity, the value would drop by about 4.6%. The same bond with 10 years to maturity would come with higher interest rate risk, and lose roughly 7.8% of value. With 20 years to maturity, it would lose about 12.6%.
The higher the yield on the bond, the lower the interest rate risk, So, in the example above, if the bond yield were 6% instead of 4%, the interest rate risk would drop and the bond's loss of market value would also be lower (around 4.1%, 7.1% and 10.6%, respectively).
Keep in mind that you'll only sustain a loss or gain in a falling interest rate scenario if you sell your bond (or the bond is sold by the investment manager of your fund). If instead you hold it until maturity, you'll collect the same amount of interest you would have otherwise received.
There's a lot more to know about bond investing, including the specific role bonds might play in your portfolio given your financial circumstances, risk tolerance and goals. We hope this introductory primer can lay the foundation for a strong understanding of the finer points of bond investing.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
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