When it comes to investing in bonds, it’s easy to get confused with the possible complexities you might encounter.
Bonds have become a worry for investors who don’t understand the relationship to interest rates. The price of a bond and interest rate move in opposite directions.
When interest rates rise, bond prices decline. When interest rates slip, bond prices increase. Investors who are not aware for this kind of correlation need to know that individual bonds should be held to maturity in a rising interest rate environment.
The term duration is also becoming important to bond buyers. Duration is the measure of sensitivity is the gauge of sensitivity a bond or a bond portfolio has to interest rates. Lower duration means lower sensitivity.
Bonds that have a shorter maturity have a lower sensitivity to interest rates. Bonds with a longer maturity have a higher duration and are more affected when interest rates fluctuate.
Investors that hold longer-term bonds should hold the issue until maturity. Investors who buy bond mutual funds need to be aware of the fund duration. When interest rates rise, the underlying bond prices may fall, along with the mutual fund value.
Credit Quality
Individual bonds have a credit rating associated with the issuer’s financial strength. Bonds that are investment grade usually have higher quality and are therefore the most stable. Bonds that are below investment grade are also called junk bonds, which are of lower quality.
To appeal to investors, junk bonds issue a higher interest payment in exchange for the risk of investing in lower quality bond.
Bond buyers that are interested in chasing yield need to understand the credit quality of the bond issuer. If the bond issuer misses an interest payment, the credit rating will go down. This will also reduce the value of the bond price.
Purchasing Complex Bonds
Many different types of bonds are available in the fixed-income market. The basic function of a bond is to provide interest payments and pay its par value to the investor upon maturity.
On the other hand, there are many complexities that investors may not understand about bonds. Many bond investors do not understand call features, defeasance, and accrued interest.
Floating rate, convertible, and catastrophe bonds are overly complication for a common bond investor. You can also purchase bonds through an exchange-traded note that can be leveraged or inversed. Before investors buy a fixed-income security, they should fully understand how the investment works and the associated risks.
Inflation and Taxes
Investors who have too high a percentage on their portfolio in bonds might not be able to keep pace with inflation. Bonds may diminish volatility in portfolios. However, over the long term, they have considerably less returns than stocks. Bond interest payments do not increase with inflation.
That means, for example, a 20-year bond that is paying a 5-percent coupon today provides more buying power than it will in two decades. If you want to keep pace with inflation, you need to have an allocation of stock in your portfolio.
Taxation is also important for bond buyers to understand. Municipal bond interest is tax-free on both a state and federal level.
