Most people think of investing in Bonds as being a dry subject,
and to a degree, they are right. However, boring can sometimes
be a good thing, especially when it comes to investments. Too
much "excitement" in your portfolio can lead to undue stress, so
a diet rich in bonds and bond mutual funds can help smooth out
the rough edges in a portfolio made up mostly of common stocks.
Bonds are generally considered to be less risky than stocks, but
they are not without peril in their own right. The risk in a
bond is directly related to the issuing company, and the type of
debt instrument. Depending on the type of debt issued, and what
underlying assets are involved, certain bond investments can be
as risky or more risky than investing in stocks. But there's
good news: with a higher risk generally comes a greater return.
Bonds tend to be less flexible to trade than common shares, so
most individual investors will end up investing a a bond mutual
fund. This has many advantages for the beginning investor, not
the least of which is that she can rely on the investment
experience of a firm that specializes in analyzing the
companies, and their capability of repaying their notes.
The biggest risk associated with bonds is referred to as the
interest rate risk. This term refers to changes in the market
interest rates, which have a direct bearing on bond returns.
Fixed-income securities, in general, move inversely with the
changes in interest rates. What this means is that during a
period of rising interest rates, like the current climate in the
U.S. in 2006, people holding bonds will end up seeing declining
bond returns. This will affect long-term issues the most.
In fact, the longer the time to maturity, the greater the risk
of interest rate erosion becomes. For this reason, careful
pruning of a bond portfolio becomes of greatest interest to the
fund manager. One technique bond mutual funds use is staggering
maturity dates so that they have less risk based on any one
scenario. The great size of the funds allow them to do this
easily and quickly.
The biggest risk for any bond holder is the risk that the
company will default before making its' scheduled payments. This
is directly related to how credit worthy the company is, and
their capacity and will to repay their debts. Companies with
lower credit ratings have to pay higher interest rates, just
like consumers in the same boat. The worse the credit, the
higher the interest rates to bond holders have to be in order to
attract investment dollars. Companies with excellent credit
ratings pay a much lower cost for capital, which is one of the
reasons they have superior credit in the first place!
Whenever considering an investment in a bond, make sure first
and foremost that the company has an excellent rating from
Standard and Poors or Moody's. This will ensure they have the
capacity to pay back your loan to them over the entire duration
of the bond contract.
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