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Does Your Portfolio Have Room for Bonds?
You’ve probably heard that bonds are less risky than stocks. But that doesn’t come close to telling the whole story of bonds, which are a core component in many investors’ portfolios for a variety of reasons.
Do you want to diversify your portfolio? Are you interested in the potential to generate income? Bonds may help.
What is a bond?
A bond is a promise to repay a loan. When you buy a bond, you’ve effectively become a lender. The issuer of the bond makes regular interest payments to you, which is why bonds are called fixed income securities. The issuer also agrees to redeem the bond for its initial (or par) value at some point in the future.
So what happens between the time a bond is issued and the time it’s redeemed? That’s where the interesting and sometimes confounding aspects of bond ownership can occur. Bonds trade in the marketplace at prices that can be either higher or lower than par value. Interest rates are a prime factor affecting bond prices; when interest rates rise, bond prices usually fall, and when interest rates fall, bond prices rise.
The longer the redemption period, the more sensitive a bond is to interest rate changes – and the riskier it becomes. In general, a 30-year bond is riskier than a 10-year bond, and a 2-year bond is less risky than a 5-year bond.
Who issues bonds and why should you care?
Government agencies and corporations issue bonds when they need to raise capital. You should pay close attention to the financial health of a bond issuer because bonds could become worthless – and interest payments will stop – if an issuer defaults.
Agencies such as Fitch Ratings and Moody’s Investors Service provide credit ratings on bonds ranging from investment grade to non-investment grade (i.e. junk bonds). As ratings change on a bond, the price can be impacted.
Interest rates act as indicators of bond risk as well. In general, the higher the interest rate, the higher the risk. So while junk bonds typically pay relatively high interest rates, the risk of default is higher as well.
2 reasons investors might include bonds
Income. Many investors use bonds as a source of predictable income; you know how much interest you will get and generally when you’ll get it. In general, longer-term bonds pay higher interest rates than shorter-term bonds. But, as noted above, longer-term bonds are riskier investments.
Diversification. Bonds can help when building a diversified portfolio. Because bonds and stocks don’t always move in the same direction, holding bonds can potentially offset a decline in stocks and smooth out the performance of your portfolio.
What type of bonds are available?
- Various types of bonds have different risks, tax benefits and interest payment methods:
- Treasuries are U.S. government-issued bonds that (unlike any other debt instrument) are considered free of credit risk because they are backed by the full faith and credit of the U.S. government. Income from treasuries is only taxed at the federal level.
- Municipal bonds are issued by states, cities and counties to fund projects or improvements such as roads and schools. They are exempt from federal taxes and also from state, city and county taxes if you live in the same municipality where the bond is issued.
- Agency bonds are issued by government agencies or certain government-chartered corporations. They carry some government backing but aren't fully guaranteed like treasuries and municipal bonds — so to compensate for the added risk, they tend to pay a higher yield.
- Corporate bonds are issued by corporations to raise money to expand their businesses, cover operating costs, or finance corporate takeovers or reorganizations. Corporate bonds are generally riskier than government or agency bonds, so they tend to pay the highest interest rates.
Next Step: Scottrade clients can log in and research bonds by hovering over the Trade tab and clicking on CDs & Bonds Overview.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk, and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available by contacting Scottrade. Investors should read these carefully.
Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.
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