Bonds are simple. A bond is basically like an IOU, a debt investment, and is commonly referred to as a fixed-income security. You give me a loan, I promise to pay you a certain interest rate (coupon) over an agreed upon timeframe (maturity), and at the end of the term I’ll give you back the original amount (the principal). This, in very basic terms, is the description of a bond.
Even though there are millions of different bond issues, there are four primary types of bonds: corporate, municipal, agency and government. Bonds come with varying degrees of risk, depending on who issues them and the repayment timeframe. There are also differences between buying individual bonds directly, or buying into a bond fund or bond ETF (exchange traded funds, which are baskets of bonds).
Here are some basic terms:
Term: All bonds have a maturity, which is the timeframe during which the interest payments will be made. A bond’s maturity indicates when you should expect to get your principal back.
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Coupon: the stated interest rate. Two features of a bond — credit quality and duration — are the principal determinants of a bond’s interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. It’s called a “coupon” because before the digital age you received a printed paper coupon and printed interest rate.
Duration: an important measure of interest rate risk. Basically, the bigger the duration number, the greater the interest-rate risk or reward for bond prices. Bond values and interest rates have an inverse relationship. If interest rates rise by 1 percent and your average duration is 10, it means the value of your bonds will drop 10 percent. In a rising-rate environment, it’s wise to adjust a bond portfolio and look for bonds with shorter durations — avoid long-term bonds (bonds with a term of 20 to 30 years) or look for alternative fixed-income investments with no duration or rates that reset very frequently, such as senior loans.
There is a common misconception that investing in bonds and bond funds are risk free, but they are not. Investors need to be aware of two main risks that can affect a bond’s investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration (see above) of a bond or bond fund addresses interest rate risk. Buying individual bonds and holding them to maturity largely eliminates interest rate risk because no matter what, the principal should be repaid at the end of the term. However, bond funds, which provide diversification, are definitely subject to this risk because they trade bonds regularly.
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Default risk is the risk that your loaned funds will not be repaid. Corporations, municipalities and governments have credit ratings that assess the financial health of an entity. A lower-rated bond issuer is usually forced to pay a higher interest rate to attract investors because of the higher risk of default. These are called “high-yield” bonds and are usually rated BBB or lower. There is also currency risk if you’re buying foreign government bonds in local currency.
One of the main differences between holding individual bonds and bond funds is that most individual bonds pay interest once every six months. Most bond funds pay interest monthly or quarterly. This is an advantage to investors looking to receive a more regular income stream, and it allows compounding to happen more regularly, which can increase returns. However, keep in mind that with bond funds, you’re essentially giving away control to a fund manager.
When constructing a bond or fixed-income portfolio, investors should diversify their bond holdings among many types of bonds and fixed-income securities with different risk-profiles. As with all investing, risk-tolerance, investing timelines, the investor’s financial goals and unique situation should be taken into account. A qualified financial planner or investment adviser can help build the right fixed-income portfolio that is in perfect alignment with your needs.
Michael Philips is the founder and owner of Financial Mastery Wealth Management and a Registered Investment Advisor in California.
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