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

All fixed income investments are subject to interest rate, credit and inflation risk. As interest rates rise, the price of fixed income securities falls. Investments in high-yield securities and in foreign companies and governments, including emerging markets, involve risks beyond those inherent solely in higher-rated and domestic investments. The risks of high-yield securities include, but are not limited to, price volatility and possibility of default in the timely payment of interest and principal. Foreign securities are subject to certain risks of overseas investing, including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets. Convertible securities are subject to stock market, credit and interest rate risks. Mortgage backed securities involve additional risk over more traditional fixed income investments, including: interest rate risk, prepayment risk, implied call and extension risks, and the possibility of premature return of principal due to mortgage prepayment, which can reduce expected yield and lead to price volatility.

U.S. Treasurys are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasurys when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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.