When you invest in any bond, your primary concern should be the issuer’s ability to meet its financial obligations. Issuers of bonds have records of meeting interest and principal payments in a timely manner.
Issuers disclose details of their financial condition through “official statements” or “offering circulars,” which are available from your bank, brokerage firm, on the Internet or from a library of official statements. Normally issuers provide continuing disclosure about their financial condition. You may also contact the issuer or visit the issuer’s web site for ongoing information.
Another way to evaluate an issuer is to examine its credit rating. Many bonds are graded by ratings agencies such as Moody’s Investors Service, Standard & Poor’s and Fitch Ratings. A number of banks and brokerage firms have their own research departments which also analyze municipal securities. Bond ratings are important benchmarks because they reflect a professional assessment of the issuer’s ability to repay the bond’s face value at maturity.
Generally, bonds rated BBB or Baa, or better, by Standard & Poor’s and Fitch, or Moody’s, respectively, are considered “Investment Grade,” suitable for preservation of investment capital.
Credit ratings, however, should not be the sole basis for any investment decision. For example, the ratings do not take into account market trends. Before purchasing bonds with lower ratings, talk with your investment adviser to make sure they’re suited for you.
Bonds offer you the chance to maximize your return consistent with the amount of risk you’re willing to accept. In general, as with any fixed-income investment, the higher the yield, the higher the risk.
Know the risks before you invest
Bonds can play an important role in many investors’ portfolios but you need to understand the risks associated with investing in bonds before you invest. It is always prudent to speak directly with your financial adviser before making any investment decisions.
Higher risks and higher yields
The yield of a bond is generally reflected by its yield, which is the rate of return for an investment. The current yield of a bond is dependent on the bond’s coupon rate and its current price.
Yield to maturity is determined from the coupon payments between now and maturity and the difference between the current price of a bond and its par value. Yield to call is similar to yield to maturity, but is calculated to the first call date instead of the bond’s maturity date.
Bonds that have a higher yield tend to be a riskier investment than those with lower yields in order to compensate investors for taking a higher risk.
Risks of all types of bonds
Call risk – The risk that a bond may be called by the issuer prior to maturity. This is more likely to happen during periods of declining interest rates.
Credit risk – The risk that a borrower may be unable to make interest or principal payments when they are due.
Default risk – The risk that a borrower may be unable to make interest or principal payments when they are due.
Inflation risk – Inflation leads to higher interest rates, which drives down the prices of bonds. Inflation also reduces the purchasing power of the future interest and principal payments of a bond.
Interest rate risk – When interest rates decline, bond prices rise and when interest rates rise, bond prices fall. Bond with more time until maturity have higher interest rate risk than those with shorter maturities.
Legislative risk – The risk that changes in the tax code can affect the value of tax-exempt or taxable security.
Liquidity risk – The risk that an investor may have a difficult time finding a buyer of a security when trying to sell that security, which may force the investor to sell the bond significantly below market value.
Market risk – The risk that the bond market as a whole will decline. This can decrease the values of individual securities, regardless of other characteristics. As world interest rates go up the value of existing bonds declines.
Reinvestment risk – When interest rates fall and investors have to reinvest interest income and the return on principal of their bonds, that money will be reinvested at the lower rates available in the market.
Selection risk – The risk that a specific security performs worse than the market for unanticipated reasons.
Timing risk – The risk that an investment performs poorly when purchased or better after being sold.