When considering investing in bonds, whether corporateor government,you shouldfully understand how they work, including their risks and abilities to create the return you seek as an investor. Here are seven essential questions to ask before investing in bonds, whether you are a seasoned investor or a beginner.
key takeaways
- Before investing in a bond, know two things about risk: Your own degree of tolerance for it, and the degree inherent in the instrument (via its rating).
- Consider a bond's maturity date, and whether the issuer can call it back in before it matures.
- Is the bond's interest rate a fixed or a floating one?
- Does the issuer seem able to handle the interest payments? In case of default, where does this bond stand in the pecking order of repaying principal?
What Is My Risk Tolerance?
Before investing, it’s absolutely vital forinvestors to perform a risk-disposition self-assessment. The goal is to determine how much risk they can or are willing to takewhen investing in bonds. Without knowing how much risk you want to takeor avoid, an overall strategy cannot emerge. Therefore, several factors must be considered in terms of the investor’s risk profileincluding:
- What negative effects may result from failed investments
- Potential costs for each risk
- Overall target return for the investment
Clearly, any investor has to fully understand the concept of risk-return tradeoffwhen making a decision whether to invest in higher-yielding bonds,investment-grade bonds or a mix of both.
How Risky is This Bond?
There are numerous risks involved with bonds, especially corporate bonds. Some specific types of risk of primary concern are inflation risk, interest rate risk, liquidity risk, and credit risk. Happily, several management tools exist to assess, analyzeand ultimately help investors manage these risks. One of the primary ones is the bond rating, a letter grade assigned by an independent credit rating company to the debt that indicates its credit quality. The better the grade, the less likely the chance of the issuer's defaulting on the bond.
How Does the Bond Jive With My Investment Horizon?
Investors should have both a well-defined return target as well as an investment horizonin accordance with their chosen bond’s maturityterms. The maturity date is the date the bond falls due. The investor redeems—that is, receives back—his principal (the money they invested in the bond)—selling the bond back to the issuer, in a sense. The exact amount investors can expect to receive is the face value plusany accrued interest due that has not been paid out in a coupon.
Can I Keep the Bond Until Maturity?
Investors must consider another significant risk factor with a bond: the chance it is called —that is, bought back before its maturity date. Commonly referred to as the bond’scall risk,this refers to the chancethe issuer may redeem the bond at an early date in response to rising market prices or falling interest rates. It’s vital, therefore, to determinewhether a bond has a call date before its maturity and how likely an issuer is to make good on that call.
Are the Interest Payments Fixed or Floating?
It is also important for an investor to determinewhether a bond’s coupon has afixed or floating interest rate. Fixed coupons offer a set percentage of the face value in interest payments. Floating rate bonds, on the other hand, pay a variable coupon rate that is pegged to a particular benchmark rate. U.S. issuers frequently use one of these three benchmarks: the U.S. Treasury rate, London Interbank Offered Rate (LIBOR), or the fed funds rate. Most floating rate bonds are issued with two-to five-year maturities. A bond’s prospectusshould fully educate buyers on the floating rate, including when the rate is calculated.
Canthe Bond's Issuer Cover Its Debts?
Keep in mind that companies issue bonds as a way to attract loans, so bond purchasers are lending their funds to the issuer. Therefore, just like they would when assessing anyone they offer a loan to, investors should make sure the issuer is prepared to make good on the payments and principal promised at maturity. This isn’t simple, as it requires constant monitoring as well as an in-depth analysis by qualified professionals.
In Case of Default, Can I Get Repaid?
Before investing, you should determine whether you are likely to receive your money back (or part of your money) in the eventan issuergoes into default or becomes insolvent. Typically, investors will do this both through the determination of two figures:loss given default (LGD) andthe recovery rate. Additionally, besides knowing whether or not a bond is secured, it is important to know where it ranks in seniority for other secured bonds in terms of payout—should the issuer become insolvent when do they close during insolvency.
The Bottom Line
Investing in bondsrequires attention bothbefore the actual investment and as long as the bonds are held.
FAQs
Bonds lower volatility but have significantly higher inflation risk when compared to shares. The risk of inflation destroying the purchasing power of your portfolio is one of the biggest risks that you face as an investor.
Why are bonds no longer a good investment? ›
Bond funds tend to lose value when interest rates rise, and when inflation ticks up. “The aggressive nature of those interest rate hikes contributed to the aggressive decline of bond values,” Lee said. Rising interest rates tend to lift rates on new bonds.
What are 2 ways you can lose money with bonds? ›
You can lose money on a bond if you sell it before the maturity date for less than you paid or if the issuer defaults on their payments. Before you invest. Often… + read full definition , understand the risks.
Are bonds a good investment in 2024? ›
Investment-grade corporate bonds remain attractive given their lower risk and relatively high yields.
Are bonds safe if the market crashes? ›
Bonds usually go up in value when the stock market crashes, but not all the time. The bonds that do best in a market crash are government bonds such as U.S. Treasuries. Riskier bonds like junk bonds and high-yield credit do not fare as well.
What is the major disadvantage of investing in bonds? ›
Historically, bonds have provided lower long-term returns than stocks. Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
Is there a better investment than bonds? ›
Preferred stock resembles bonds even more and is considered a fixed-income investment that's generally riskier than bonds but less risky than common stock. Preferred stocks pay out dividends that are often higher than both the dividends from common stock and the interest payments from bonds.
Can bonds become worthless? ›
If a bond is held past its maturity, the federal government remains responsible for the debt. However, savings bonds that are held past their maturity date do not continue to earn interest and may actually lose value due to inflation.
Why do investors dump bonds? ›
They include: Selling bonds because interest rates are about to increase, making your existing bonds less valuable. Selling bonds because its issuer has become financially unstable, raising the risk that it will default on its payments. Selling bonds to take advantage of a current upswing in its market value.
What happens to bonds during a recession? ›
In every recession since 1950, bonds have delivered higher returns than stocks and cash. That's partly because the Federal Reserve and other central banks have often cut interest rates in hopes of stimulating economic activity during a recession. Rate cuts typically cause bond yields to fall and bond prices to rise.
Top 8 bonds to invest in for the long term
| Name | Ticker | Yield |
|---|
| iShares iBoxx Investment Grade Corporate Bond ETF | (NYSEMKT:LQD) | 4.3% |
| Vanguard Tax-Exempt Bond ETF | (NYSEMKT:VTEB) | 3.5% |
| Vanguard Short-Term Corporate Bond Index Fund | (NASDAQMUTFUND:VSCSX) | 5.1% |
| Guggenheim Total Return Bond Fund | (NASDAQMUTFUND:GIBIX) | 5.1% |
4 more rowsJul 25, 2024
But the rise in interest rates has made bonds more attractive than they've been in over a decade. Investors can now earn attractive rates on short-term cash through money market funds, while longer-term bonds present an opportunity to lock in yields in case rates fall.
Can 2024 be the year of the bond? ›
2024 was supposed to be the year of the bond, but to date, it hasn't been. Economic data has been stronger than expected, and inflation readings higher. Central bankers have continued to talk tough and dented hopes of an early rate cut.
Should I move my 401k to bonds in 2024? ›
A good rule is to invest more in safer options if you're nearing retirement, depending on market conditions. On the other hand, younger investors can afford to take more risks. You can move your entire fund to bonds if you want to.
What is the best investment right now? ›
Overview: Best investments in 2024
- High-yield savings accounts. Overview: A high-yield online savings account pays you interest on your cash balance. ...
- Long-term certificates of deposit. ...
- Long-term corporate bond funds. ...
- Dividend stock funds. ...
- Value stock funds. ...
- Small-cap stock funds. ...
- REIT index funds.
I bond cons
The initial rate is only guaranteed for the first six months of ownership. After that, the rate can fall, down to a fixed-rate component which, as of May 2024, stood at 1.3%. One-year lockup.
Why should you avoid bond funds? ›
This is because as new bonds are issued with higher or lower interest rates, it inversely impacts the price of older bonds on the secondary market. Thus, bond funds exhibit more volatility in their performance when interest rates rise or fall in comparison to bonds that are held until their maturity date.
Are bond funds a bad investment now? ›
While investment-grade bonds offer low risk and potential for attractive total returns in the second half of 2024, less familiar areas of the market are presenting opportunities for skilled managers to find attractively-priced assets with the potential to rise in price and deliver return to bondholders.
Why might bonds be a bad choice? ›
That said, some bonds do carry the risk of default, where it is indeed possible for an investor to lose their money. Such bonds are rated below investment grade, and are referred to as high-yield bonds, non-investment-grade bonds, speculative-grade bonds, or junk bonds.
