Video: Introduction to Bond Investments
Introduction to Bond Investments
Your savings account is most likely paying you little interest. No worries, you have other options.
Blaine Carr here, and today I will break down five main risks you will face with bonds as well as why you should consider a bond investment.
You might recall in our last episode that organizations issue bonds to raise money for projects and other expenses. These loans get paid back over time, including interest. Bond issuers are made up of thousands of companies and government entities around the world. You generally make a little more money investing in a bond than in a bank account, but you can also lose money. Okay let’s cover these risks and rewards.
Credit and default risk can be a concern. This means you can lose some or all of your investment if the bond issuer cannot pay the borrowed money back.
Bonds carry interest rate risk. Most bonds have fixed interest rates. When market interest rates rise, the price of an existing bond declines, and vice-versa. Think of this like a seesaw, a drop in rates increases prices, and an increase in rates lowers prices.
Inflation is an enemy of bonds because inflation erodes bond purchasing power. You might benefit from allocating some of your portfolio to stocks because higher investment growth is a great defense against inflation.
Liquidity risk is also a factor. Sometimes there are lots of sellers and few buyers for a particular bond. A bond holder who really needs to sell might be forced to take a low price for that bond.
A bond holder might want to reinvest the proceeds collected when a bond matures. This presents risk because those proceeds might be reinvested at a lower interest rate.
You might be thinking “why do I want to invest in bonds and take on all that risk?” First, bonds generally pay higher interest than cash. You might already have investments in stocks, real estate, etc. Adding bonds is a good way to diversify your investment portfolio. Bonds generally do better than stocks in a struggling economy. Bonds can make a potentially bumpy ride in the stock market smoother, like shocks on an automobile.
You need to diversify amongst the bonds you put in your portfolio. We typically invest in bond mutual funds or bond ETFs. These investments hold many different bonds. We do this so that we can diversify into thousands of bonds issued by various governments and companies, with a variety of term lengths. This results in reducing your risk in the specific areas I previously covered.
Let’s do a quick recap. Investing in bonds comes with risk. You are compensated for taking this risk by receiving higher interest rates than a bank account. Bonds can be a great compliment to stocks and real estate in a portfolio. You should also aim to achieve diversification amongst your bonds to lower your risk.
As always, do check with your experienced wealth manager before you invest. Please share this with your friends and family. Also, I encourage you to check out our additional insights at www.petersenhastings.com. Come back next time and we’ll talk about stocks.