Buying puts can be an effective strategy to help protect your financial assets in a market downturn, however there are risks.
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 bonds are available at Scottrade?
- 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.
How do you use bonds in your portfolio?
Next Step: Scottrade clients can log in and use the Bond Finder tool under the Trade tab, which allows you to search for bonds based on a variety of characteristics. Not a client? You can open a new account and start your research into bonds.
Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available at www.scottrade.com. Investors should read these carefully.
Keep in mind that while diversification may help spread risk it does not assure a profit, or protect against loss, in a down market.
The content provided is for informational and educational purposes only and its use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in a particular type of security or pursue a specific strategy. Investors should fully research any security or strategy before making an investment decision.
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