Bonds – also known as fixed bonds instruments – are used by governments or companies to raise money by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.
Certain types of bonds – corporate and government bonds – are rated by credit agencies to help determine the quality of those bonds. These ratings are used to help assess the likelihood that investors will be repaid. Typically, bond ratings are grouped into two major categories: investment grade (higher rated) and high yield (lower rated).
What are some tips for investing in bonds?
When investing in bonds, it’s important to:
- Know when bonds mature. The maturity date is the date when your investment will be repaid to you. Before you commit your funds, know how long your investment will be tied up in the bond.
- Know the bond’s rating. A bond’s rating is an indication of how creditworthy it is. The lower the rating, the more risk there is that the bond will default – and you lose your investment. AAA is the highest rating (using the Standard & Poor’s rating system). Any bond with a rating of C or below is considered a low quality or junk bond and has the highest risk of default.
- Investigate the bond issuer’s track record. Knowing the background of a company can be helpful when deciding whether to invest in their bonds.
- Understand your tolerance for risk. Bonds with a lower credit rating typically offer a higher yield to compensate for higher levels of risk. Think carefully about your risk tolerance and avoid investing solely based on yield.
- Factor in macroeconomic risks. When interest rates rise, bonds lose value. Interest rate risk is the risk that rates will change before the bond reaches its maturity date. However, avoid trying to time the market; it’s difficult to predict how interest rates will move. Instead, focus on your long-term investment objectives. Rising inflation also poses risk for bonds.
What are the benefits of investing in bonds?
Bonds offer a host of advantages:
- Capital preservation: Capital preservation means protecting the absolute value of your investment via assets that promise return of principal. Because bonds typically carry less risk than stocks, these assets can be a good choice for investors with less time to recoup losses.
- Income generation: Bonds provide a fixed amount of income at regular intervals in the form of coupon payments.
- Diversification: Investing in a balance of stocks, bonds and other asset classes can help you build a portfolio that seeks returns but is resilient through all market environments. Stocks and bonds typically have an inverse relationship, meaning that when the stock market is down, bonds become more appealing.
- Risk management: Fixed income is broadly understood to carry lower risk than stocks. This is because fixed income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events.
- Invest in a community: Municipal bonds allow you to give back to a community. While these bonds may not provide the higher yield of a corporate bond, they often are used to help build a hospital or school or that can improve the standard of living for many people.
