The landscape of the bond market has undergone massive changes over the years. What was once a plain-vanilla way to create steady income is now replete with variety as well as risk.
First, the basics. Bonds are a form of debt, a loan to a borrower with the promise of future payback of the loan amount, plus interest. The credit-worthiness of the borrower and the amount of time until the loan is repaid directly impact the interest rate offered. The more risk you accept when loaning your money, the higher the interest rate should be as compensation.
Prevailing interest rates affect bond prices, and they are inversely related. Rising interest rates cause bond prices to fall as new bonds, issued at the higher rate, cause bonds with lower rates to be less valuable. A bond held until maturity will return its initial investment amount provided the issuer doesn’t default. If you need to sell your bond prior to maturity, though, you may get back less (or more) than your original investment.
Bond mutual funds function a bit differently than individual bonds. Bond funds do not have a specific maturity date and they invest across a variety, sometimes hundreds or even thousands, of individual bonds. For the individual investor, building a diversified portfolio of individual bonds can be difficult and expensive. Bond funds provide an efficient way to achieve broad, inexpensive diversification.
For many investors, bonds are an important portfolio component. Low interest rates over the past few years have sent many investors on a quest for higher yield and the acceptance, sometimes unwittingly, of significantly more risk. Consider these principles as you review your bond strategy in this low-interest environment:
How Markets Work
Current bond values reflect everything the market knows and anticipates about economic conditions, inflation, and monetary policy.
Have a Plan
Understand the overall portfolio allocation (equities vs. bonds) that’s appropriate for you. Don’t confuse the distinct roles stocks and bonds play in your investment strategy.
Know What You Own
Be educated about your portfolio, especially if an advisor manages your assets. Don’t assume your plan and their philosophy align – verify.
Risk vs. Reward
There are two primary ways to potentially increase bond returns: lengthen maturity and reduce credit quality. Pursuing higher income generally means accepting more risk, increasing the likelihood of losing value if interest rates rise or the issuer defaulting.
Don’t ignore costs
Investment costs can be large relative to a bond portfolio’s return; minimizing these costs is critical.
A broadly-diversified portfolio of bonds issued by governments and companies around the world reduces risk.
Many investors have anticipated an upward interest rate move for several years. Those seeking higher yields should understand the elevated risks. Your best solution remains the same: establish your plan…seek needed return primarily from equities…use bond funds to dampen volatility of your overall investment strategy…and stay diversified.
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