En español | If you pay attention to the news from financial markets these days, you know that prices of bonds have been headed down. Nonetheless, most financial professionals agree that every investment portfolio should have some bonds as part of a diversification strategy.
See also: 5 common money mistakes.
So here are 10 things you should know about investing in bonds.
1. Just what is a bond?
In its simplest form, it's a pledge — you lend money to an issuer in return for a promise of interest payments and return of the full amount at the end of a fixed term. Unlike with a share of stock, you are not buying ownership; you're just lending your money. You can hang on to a bond until maturity, or you may be able to sell it in a financial market to someone else who will then collect the interest and get the principal payment at maturity.
2. Why invest in bonds?
"Bonds offer protection against stock market swings," says Mike Ruff, fixed income portfolio manager at Seattle-based Russell Investments. Their returns come mainly in the form of interest payments, which can be counted on even in turbulent times when asset values are tumbling.
3. Who issues bonds, and how do bonds differ?
Bonds are issued by the federal government, states, municipalities, corporations, foreign governments and more. "Some bonds pay higher interest than others," says Michael Sullivan of the Estate Planners Group in Washington Crossing, Pa. "Some offer interest that's free from federal and state tax."
4. How can I buy bonds?
You can buy individual bonds or bond mutual funds through stockbrokers. "A diversified, carefully managed mix of individual bonds will often perform better than buying a mutual fund," says Sullivan. But he cautions that putting together such a portfolio requires significant personal expertise or expert help.
5. Are bonds risk-free?
No form of investment is entirely free of risk. The market value of your bond can fluctuate — when interest rates go up, bond prices typically come down. There's credit risk in whether the issuer will be stable enough to be able to pay interest and principal. And there's liquidity risk — will you be able to sell your bond when you need to?
6. How about federal government bonds?
Known in the investment community as "Treasuries," these bonds are protected against default (but not price fluctuations due to interest rate changes) by the full faith and credit of the U.S. government. You can purchase Treasuries for a fee through a stockbroker or direct from the U.S. Treasury with no fee. For more information, go to TreasuryDirect.
7. Are municipal bonds — commonly called "munis" — especially risky?
Though defaults in municipals are quite rare, some professionals fear a rise in muni defaults because of the serious budget problems that many cities across the country are facing. Sullivan disagrees. "There was similar ruckus about the high-yield [junk] bond market in 2007-2008. We saw great opportunity in high-yield debt at that time, and our clients have been rewarded with wonderful returns in 2009-10."
8. Are bonds in a price "bubble"?
Some industry experts argue that bond prices have run up so high in the last two years that they're overinflated and that the current decline in prices will keep right on going. "This fear, along with headline-making predictions that dozens of state and city governments will default in 2011, has driven many investors away from bonds," says Ruff. "These concerns shouldn't prevent investors from considering the cushion that bonds can offer as part of a well-diversified investment portfolio."
9. How are bonds rated?
A bond's rating is a function of the issuer's financial strength. Rating agencies such as Standard & Poor's look at such fundamentals as sources of revenue and capitalization of the balance sheet. Bonds are rated on a scale that ranges from AAA (the best) down to D (in default). Generally speaking, the lower the rating of a bond, the higher an interest rate it pays. "Bonds rated Baa are at the low end of investment grade and, all other things being equal, should pay a higher interest rate than bonds rated AAA," says Sullivan.
10. How much of my portfolio should be invested in bonds?
The professionals give different answers, based on variables such as age of the investor and tolerance of risk. One common base is 60 percent stocks and 40 percent bonds and cash.
"Investing in bonds may not be as exciting as madly fluctuating stocks and funds," says Sullivan. But bonds can "limit risk, offer stability and are an essential part of a balanced portfolio."
For more information, see the Investing in Bonds website, operated by the Securities Industry and Financial Markets Association.
William J. Lynott is an author and freelance writer who specializes in business and financial issues.