People usually choose to invest in bonds because they are usually less risky than, let’s say, common stock shares, and they pay off more than just keeping money in a bank account. However, they aren’t always a win-win alternative especially if their owner doesn’t take into account at least three criteria – bond’s yield, duration, and the credit quality of the issuer.
Financial experts claim that the higher the bond’s yield, the higher the risk it involves. We are aware that bonds are issued by big companies, states or local municipalities, or the U.S. government. But not all of those are creditworthy. Not even states.
When someone buys a bond that person actually loans the issuer with the value of the bond’s price. In return, the issuer is compelled to return the principal when the bond matures, while also making interest payments at set intervals of time.
But borrowers with a good reputation usually pay less in interest than those that are more risky to do business with. For instance, the U.S. Treasury’s 10-year note usually doesn’t yield more than 2.00 percent, while Greek bonds currently yield 10.42 percent.
However the bond buyer must take into account that the cost of insuring his bonds against Greek collapse could cancel the extra yield of Greek bonds. So, if the buyer, instead, chooses to invest in U.S. Treasury’s 10-year notes he/she is entitled to that 2 percent over a decade with no added risk.
Still, experts explain that a high yield doesn’t necessarily mean that the bond’s manager is involved in a shady deal. But a high yield should raise some questions.
Experts also recommend that you take into account the bond’s duration, when you plan to invest in bonds. The duration is a way to tell you how sensitive that bond is to rising or falling interest rates (also called the coupon rates) since long-term bonds are more affected by interest rate changes than short term ones.
For instance, if you own a bond with a price of $500 with an interest rate of 3 percent and you want to sell it before it matures, but the interest rate has risen to 4 percent, you’ll have to lower the bond’s price until the yield is 4 percent (the yield is the interest divided by the bond’s price.)
And not every time a higher interest will offset your principal losses, so it is better to invest in a bond that doesn’t have a longer duration than the period you plan to hold the bond.
Experts also advise that you take into account the credit quality offered by the bond’s issuer. Usually high-quality bonds issued by a corporation bring more interest payments than the U.S. Treasury notes. Instead, lower quality corporate bonds, yield even more than high-quality bonds, but are more risky. These lower-quality bonds called junk bonds pay off when there’s a good economy, otherwise investors treat them like… junk.
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