Bonds have a reputation as a "safe" investment, compared to stocks. And in some respects, that's true. But they can also be risky, which is why investment advisors generally recommend that people in typical circumstances keep a balanced portfolio, in other words, one that includes both stocks and bonds. If you have a retirement savings account, you probably do own stocks and bonds, contained within large institutionally managed funds, such as retirement target-date funds.
As noted, when you buy a bond (or invest in a managed bond portfolio), you are lending money to the bond issuer. The primary measure of risk in a bond investment is the credit quality of the issuer, that is, an analyst's assessment of the probability that the issuer will go bust and default on its obligations. Based on that assessment, the agency analyst will assign a bond rating (such as AAA or BBB, and so on). The higher the rating, the more confidence investors can have that the issuer will have the long-term ability to fulfill its promises to them.
Investors also need to be mindful of another big hazard: interest rate risk. You may have heard that there's an "inverse relationship" between the movement of market interest rates and the value of bonds trading in the markets. That means, for example, that if interest rates rise, the value of bonds being traded in the bond markets go down.
The opposite is also true. If interest rates fall, the value of bonds go up. In fact, that has been the general pattern over the last several years.
When the performance of bond funds is stated, it includes both the amount of interest collected, and the changing value of the bonds in its portfolio.
Bond issuers, also referred to as borrowers, fall into several basic categories: the U.S. Treasury, financially strong corporations (they issue "investment grade" corporate bonds), financially shaky corporations (those with higher credit risk often called "junk bonds"), state and local public sector entities (typically just referred to as "municipals" or "munis), and bonds issued by the governments of other countries (known as "sovereign" debt).
Here are the hallmarks of each type of borrower you could lend your money to:
Another fundamental facet of bond investing is that the longer into the future a bond matures (when its issuer must repay the bond principal, the amount that was borrowed), the more vulnerable it is to interest rate risk.
Here's an example. Consider what happens to the market value of a bond currently yielding 4% when interest rates rise by 1%. An analysis shows that if the bond has five years to maturity, the value would drop by about 4.6%. The same bond with 10 years to maturity would come with higher interest rate risk, and lose roughly 7.8% of value. With 20 years to maturity it would lose about 12.6%.
The higher the yield on the bond, the lower the interest rate risk, So, in the example above, if the bond yield were 6% instead of 4%, the interest rate risk would drop and the bond's loss of market value would also be lower (around 4.1%, 7.1% and 10.6%, respectively).
Keep in mind that you will only actually sustain a loss or gain in a falling interest rate scenario if you sell your bond (or the bond is sold by the investment manager of your fund). If instead you hold it until maturity, you'll collect the same amount of interest you would have otherwise received.
There's a lot more to know about bond investing, including the specific role bonds might play in your portfolio given your financial circumstances, risk tolerance and goals. But this introductory primer can lay the foundation for learning the finer points of bond investing when you're ready to tackle the topic.
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