If you are new to investing perhaps you are not familiar with
bonds. Before you get started, you need to understand some of
the risks associated with bond investing. Most people assume
that all interest-bearing securities are completely risk free,
but this is not the case. Even if you know a lot about
investing, you may not be aware of some of the risk
characteristics associated with bonds.
The most important thing to take into account is the interest
rate. The Federal Reserve (also known as the Fed) meets every
6-8 weeks to evaluate the health of the economy. At each
meeting, the Fed renders a decision regarding interest rates.
If inflation is rising, the Fed will need to raise interest
rates to tighten the money supply. If inflation is moderate or
contained, the Fed will likely leave rates unchanged. However,
if the economy is slowing down and there is very little
inflation or maybe even deflation, then the Fed might decide to
reduce interest rates to create a stimulus for economic growth.
The reason why you need to consider present and future interest
rate levels is because as interest rates increase, bond prices
go down, and vice versa. If you are able to hold your bond until
maturity, then interest rate movements do not really matter,
because you will redeem the principal upon redemption. But
often, investors have to cash out their bonds well before the
maturity date. If interest rates have moved up since you
purchased the bond, and you sell it prior to maturity, then the
bond will be worth less than your initial investment.
You should also be aware of the claim status of the bond you are
buying. Claim status refers to your ability to liquidate your
investment in the event the bond issuer goes bankrupt. If you
are buying a government bond, such as a Treasury Bill, claim
status is irrelevant, because the odds of the Federal Government
going bankrupt are slim and none.
If you are buying a corporate bond, however, there is always a
chance that the issuer could go out of business. In the event of
liquidation, bondholders are given priority over stockholders.
However, there are often different classes of bondholders.
Senior note holders can often claim against certain kinds of
physical collateral in the event of bankruptcy, such as
equipment (computers, machines, etc.). Regular bondholders can
not always claim against physically collateral, and are next in
line after the senior note holders.
Next, you should always check the three main features of the
bond you are buying; the coupon rate, the maturity date, and the
call provisions. The coupon rate is the interest rate. Most
bonds pay an interest rate semiannually or annually.
The maturity date is the date that the bond will be redeemed by
the issuer; simply put, the maturity date is when the company
must pay back to you the principal you loaned to them. The call
provisions are the rights of the issuer to buy back your bond
prior to maturity. Some bonds are non-callable, while others are
callable, meaning that the company can buy your bond back before
maturity, usually at a higher price than what you paid.
Finally, you should also understand that if economic conditions
become more favorable after you a buy a bond, and interest rates
start to go down again, the issuer will likely issue a lot more
bonds to take advantage of the low interest rates, and will use
the proceeds to try to buy back any callable bonds it issued
previously. So, when interest rates go down, there is an
increasing likelihood that your bond will be redeemed prior to
maturity, if in fact the bond is callable.
You should invest in bonds. However, you should also take into
account the risk factors we have covered. Your portfolio should
contain a mix of corporate, federal, municipal, and even junk
bonds (there is always a default risk associated with junk
bonds, but they pay a huge interest rate). Talk to your broker
about diversifying the kinds of bonds in your portfolio and you
will reduce your overall risk and maximize your return.
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