Understand the risks inherent in bonds
It’s important for investors interested in bonds to understand the potential pitfalls.
For example, some don’t realize that there is an inverse relationship between interest rates and bond prices. When interest rates increase, the value of bonds decreases in value, and vice versa.
Regardless of the quality of the bond or bond fund you invested in, if interest rates increase significantly, the value of your bond portfolio, even if you only have invested in U.S. Treasury bonds, will decrease in value. If the portfolio is primarily long-term bonds, such as those with maturities of 30 years, the decrease will be much greater.
Interest rate risk
There’s a term for this: interest rate risk. And it’s a significant factor to consider.
The only way to avoid or minimize interest rate risk is to buy short-term securities. For example, you can buy Treasury bills directly with varying terms (typically four weeks, eight weeks, 13 weeks, 26 weeks or 52 weeks), or you can invest in a mutual fund or exchange-traded fund (ETF) that only invests in T-bills.
Although you would be minimizing interest rate risk, the interest you would receive would be small in comparison to what you would receive with a long-term Treasury bond.
You should invest in T-bills only if your primary investment objective is to avoid any capital loss while also receiving some income.
A second type of risk is investment risk. This is the risk that you won’t get your principle back in full when the bond matures.
If you buy a U.S. Treasury security, you can be sure that you will receive your principal back at maturity. Because of this certainty, the U.S. Treasury does not have to pay interest rates as high as other lenders.
You can buy bonds issued by a corporation that pay more interest than the U.S. Treasury with the same maturity length. However, no corporation has an equivalent ability to promise repayment of principal.
During the period you own the bond, the corporation may face financial problems or even bankruptcy. If that happens, the value of your bond in the market may fall significantly. For this reason, if you wish to buy corporate bonds, you should consider buying a diversified mutual fund or ETF.
Finding a good fund
Some mutual funds and ETFs manage portfolios of high-yield or “junk” bonds — bonds issued by corporations whose ratings are not considered investment-grade. The payoff for the greater investment risk is much higher interest than investment-grade corporate bonds pay.
Some mutual fund managers, such as Vanguard, have relatively conservative high-yield portfolios that have performed well over the long term.
If you are going to invest in corporate bonds, I recommend bond funds or ETFs. If you have a diversified portfolio, you minimize investment risk.
There are many reliable choices of funds with low annual fees, reinvestment options and check-writing capabilities. If you are conservative, you can restrict yourself to only investment-grade mutual funds.
However, if you are a long-term investor looking for high income and willing to take some risk, you may consider devoting some proportion of your bond portfolio to conservative high-yield funds or ETFs.
If you are very conservative, not concerned with income and risk averse, you can restrict your bond investments to short-term Treasury investments.
Elliot Raphaelson welcomes your questions and comments at email@example.com.
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