Many investors own bonds or debt based investments as a strategy for balancing the short-term market risk historically associated with stocks.1 It’s important to understand the characteristics of bonds when making decisions about how to invest.
A bond is an “IOU” for money loaned by an investor to the bond’s issuer. In return for the use of that money, the issuer agrees to pay interest at a stated rate known as the “coupon rate.” When the bond matures, the issuer repays the investor’s principal.
Benefits and Risks of Bonds
Because bonds may not move in tandem with stock investments, they may help provide diversification within an investor’s portfolio. Bonds frequently provide investors with a steady income stream, although zero-coupon bonds and Treasury bills are exceptions: The interest income is deducted from their purchase price, and the investor then receives the full value of the bond at maturity. Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and, if held to maturity, offer a fixed rate of return and fixed principal value.
Some bonds carry credit risk, or the risk that the bond issuer will default before the bond reaches maturity. In that case, you may lose some or all of the principal amount invested and any outstanding income that is due. Bonds are often rated by Moody’s and Standard & Poor’s (S&P), with ratings based on the issuer’s creditworthiness.
High yield “Junk” bonds (so-called because of their lower credit ratings) are fairly common investment vehicles. Lower-quality debt securities involve greater risk of default or price changes due to changes in the credit quality of the issuer and may not be suitable for all investors.
Like stocks, bonds can present the risk of price fluctuation, or market risk, to an investor who is unable to hold them until the maturity date when the principal and interest are paid to the bondholder. If the investor is forced to sell or liquidate a bond before it matures, and the bond’s price has fallen, the investor will lose part of the principal investment as well as the future income stream.
An Inverse Relationship: Interest Rate Risk
Another risk common to all bonds is interest rate risk. When interest rates rise, a bond’s price usually will drop. When interest rates fall, the price of a bond usually rises. Historically, bond prices have been more stable than their stock counterparts. Moreover, because bond investors may be concerned primarily with receiving income (instead of capital appreciation) from their bonds, they may not be as concerned with fluctuating bond prices.
Types of Bonds
Most bonds fall into four general categories: corporate, government, government agency, and municipal.
- Corporate bonds can provide an investor with a steady stream of income at a generally higher rate than other bonds.
- Government bonds include long-term and U.S. Treasury bonds. Intermediate-term bonds mature in three to 10 years, whereas long-term bonds generally mature in periods of up to 30 years.
- Government agency and government-sponsored entity bonds include those issued by the Federal National Mortgage Association (“Fannie Mae”) and the Government National Mortgage Association (“Ginnie Mae”).
- Municipal bonds are issued by a government authority to raise funds for general use or particular public works projects. Municipal bonds are subject to availability and change in price. They are also subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.
1Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
2There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
GNMA’s are guaranteed by the U.S. government as to the timely payment of principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
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