In one of my earlier posts, I explained in brief detail about bond investments thru a mutual fund. Now, I would like to go deeper and discuss in great detail about investing in bonds.
Bonds are an important mix in a good investment portfolio and a smart way to offset the ups and downs of the stock market. You will notice that somehow these are the safe haven of investors when the stock market is down. Bonds are considered safer than stocks, although historically their return is lower.
But don’t buy bonds just because you think they’re the safest things to invest in. Although some kinds of bonds are extremely safe, some are almost sure to cost you money. Treat bonds just like any other investment. Look at them objectively. Measure their risks against their rewards, and consider who stands behind them.
Learn what to expect. When you buy a stock, you buy a piece of a company. A bond is more like an IOU. In colloquial terms, it simply means “I owe you.” You lend your money to a government, corporation, or other issuer, who then promises to pay you interest until the bond expires. At that point, you get your money back.
Some good reasons to buy bonds include:
Bonds provide better returns than deposit accounts.
Bonds provide a hedge for your stock holdings.
Bonds give you predictable income in the form of interest payments.
Because a bond comes with an interest rate and payment dates, you know exactly when and how much you will get from your investment. That’s why bonds are often the choice of investment of retirement and college education funds.
Evaluate the downside. So what’s not to like about an investment where you get back your principal plus a guaranteed interest rate? Of course, bonds also do have their own downside.
As with other types of investment, bonds have lock in periods. The interest rate is locked in for up to 10 or 30 years depending on the lock in period. You get the same return later as you get now, no matter what happens in the financial world. That’s fine when rates drop, but you’re left behind when they go up.
Bonds are only as good as the company or governmental unit that issues them. Some bonds are backed up by specific assets that can be sold to pay off bondholders before anyone gets their money. Unsecured bonds are backed only by the ability of the issuer to pay its bills. If it gets in trouble and defaults, you’re left with nothing.
For corporate bonds, be sure to check their credit ratings with the help of professional rating agencies like Standard & Poor’s Corp., Moody’s Investors Service, and Fitch Ratings Service. They all evaluate the credit worthiness of companies and rate their bonds accordingly. The best-rated bonds are investment grade, usually having a credit rating of ‘AAA’. Then the ratings range from speculative to a warning of real danger of default.
Consider when to sell. Changing conditions may prompt you to sell your bonds before they mature. However, you probably won’t trade them for their face amount. A bond may sell for a premium, that is, more than its value, or at a discount, depending on several factors.
A bond’s credit worthiness and time remaining until maturity both affects its price. If the credit rating drops, you may want to sell for less rather than risk losing it all if the company goes into trouble. Or you may want your money right away and give a discount in order to cash out the bond before maturity.
But the biggest factor in bond pricing is interest rates. When overall interest rates rise, bond prices fall. When rates are down, bonds are up. There is always an inverse relationship between interest rates and bond prices. Consider the following scenario:
A $10,000 bond at a 7% interest rate per year will pay $700 per year.
A $10,000 bond at 10% interest rate per year will pay $1,000 per year.
At 10%, it only takes $7,000 to get $700 per year.
In oversimplified terms, you lose $3,000 when rates go from 7% to 10%, because a buyer can get a higher return on $10,000 with a new bond. If you want to sell yours, you have to discount it to $7,000 so that it earns at the same rate as a new one. Of course, falling interest rates will work in reverse. In this instance, your bond will be worth more since it will pay better than a new one.
Beware of junk bonds. If someone tempts you to buy “high-yield” bonds, remember that their other name is junk bonds. There’s always a saying in the investing world that “if it’s too good to be true, then it probably is”. The higher the yield, the riskier it is. The higher interest rates are a trade off for the likelihood they’ll turn bad. Make sure you know what you’re doing before you get into junk bonds.
In addition, there has been a new type of bonds in Wall Street that’s becoming popular nowadays. What’s so special about it is its return comes from the life of individuals. Freaking isn’t it? They are called death bonds.