Market Beat: Why invest in bonds?
February 10, 2012
TRUCKEE, Calif. andamp;#8212; What is a bond? A bond is a debt instrument. It can be issued by a corporation, a municipality, the US government, foreign jurisdictions and more. If an investor buys a bond they get paid a coupon payment at a regular interval and get their money back at the time the bond matures.Though bonds are bought primarily for income, they can also provide growth. Bond prices rise when interest rates fall and bond prices can rise when stock prices fall, historically portfolios with stocks and bonds have less volatility than all stock portfolios.There is an inverse relationship between interest rates and bond prices. Different bonds have varying price sensitivity to interest rates; this measure of interest rate sensitivity is known as the andamp;#8220;durationandamp;#8221; of a bond and is derived from the price of the bond, the coupon rate it pays, the time until maturity and other factors.The concept is pretty straightforward andamp;#8212; say you could buy a bond today that paid an interest rate of 5 percent and matures in 20 years. The bond will cost you $1,000. It pays annually so youandamp;#8217;ll receive $50 per year until maturity and then get your $1,000 back from the issuer. If interest rates rise, the price of your bond will decline, even though it will still be worth $1,000 when it matures. If rates where to rise to 7 percent, no one would pay you $1,000 for your bond that only pays 5 percent andamp;#8212; they would pay you a discounted price so the bond would yield the current rate of 7 percent. All other factors being equal your bond would only be worth about $715 on the market if you wanted to sell it prior to maturity.One advantage to bond investing is that you do expect to get your investment back when the bond matures. The risk of a bond defaulting can be partly determined by its credit rating. US treasury bonds issued by the federal government are back by the full faith and credit of the treasury. Bonds issued by municipalities are typically free from income tax and are backed by the municipality that issued them. Local governments have gone through bankruptcy; Orange County, California declared bankruptcy in 1994. Corporate bonds are issued by companies and will have a credit rating from a rating agency, the lower the rating, the higher the yield and the higher the chance of a default.Even though bonds have historically been less risky than stocks, there are several risks to be considered when investing in bonds, including interest rate risk and credit risk or default riskKenneth Roberts is a Truckee based Registered Investment Advisor. Ken has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm, and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found-at http://www.fusiontargetretirement.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.