Understanding Bonds

 

Bonds are investments. And like nearly every type of investment, they carry risks. The good news is that, as an asset class, bonds are widely perceived to be less risky than equities, real estate and alternative investments. That said, individual bonds can run the gamut from low- to high-risk. Always consider the specific risks of any particular fixed income vehicle or issue, and discuss it with your financial advisor before making a buying decision.

 

Some Risks to Consider

Interest rate risk

Changes in interest rates have a clear impact on the value of bonds and their yields.

 

Prepayment risk

Certain bonds have provisions allowing them to be “called” before maturity, depriving investors of expected interest income.

 

Default risk

All bonds carry some risk that the issuer will default on interest payments, repayment of principal, or both.

 

Credit risk

It is possible that an issuer’s credit rating will be lowered before the bond reaches maturity, making that bond less attractive to investors.

 

Currency risk

Shifts in currency exchange rates can impact the value of a bond denominated in a currency other than the U.S. dollar.

 

Liquidity risk

The risk that a bond cannot be sold quickly applies to all areas of fixed income.

 

Rates and Duration

Interest rates change all the time. And every time they do, bonds are affected.

Of course, no one knows when or how much interest rates may change in the future. But it stands to reason that the longer the time remaining before a bond’s maturity date, the greater the possibility that interest rates could change in the interim.

To assess this risk, investors should consider a bond’s duration. Duration is not the time left before a bond matures. Rather, it’s a calculation of the weighted average maturity of a bond’s cash flows.

What you really need to know is this: the longer the duration, the greater the potential for changes in interest rates to affect the bond’s value.

 

Credit Ratings

The Importance of Credit Ratings:

To help investors accurately gauge the ability of a bond issuer to meet its future debt obligations, several independent firms provide credit ratings based on the issuer’s financial health and history. Two of the most widely used services are Moody’s and Standard & Poor’s. These firms conduct research and assign letter-based ratings to the bonds being offered, as shown in the chart to the right. While these ratings do not constitute any guarantee against default, they are used widely and are important resources to help guide investors.

 

In General, Bond Ratings Fall into Two Categories:

Investment grade (top quality) and below investment grade, also known as “high-yield” (lower quality). The lower the rating, the higher the perceived potential for default and the higher the yield that investors will demand before purchasing the bond.

 

Credit ratings at a glance
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Understanding Bonds - Risk, Rates, Ratings

A brochure outlining rates (and how they affect duration), risk and ratings when it comes to understanding bonds. Includes information about the specific types of risk to consider when investing.


 


Your financial advisor can help you develop a long-term investment plan with a balance of strategies that addresses your need for portfolio growth, income, capital preservation and risk management.

 

 

All investments involve risk, including possible loss of principal. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

Equity investments generally provide an opportunity for more capital appreciation than fixed income investments, but they are subject to greater market fluctuations.

Diversification does not assure a profit or protect against market loss.

As interest rates rise, the value of fixed income securities falls.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.