Selecting Bonds For Your Portfolio

Do You Understand How To Select Bonds For Your Investment Portfolio?

Most investors who have a portfolio own bonds, either individual bonds or bond mutual funds. Including bonds in a portfolio diversifies the investment strategy.  And, if you understand how several factors affect bonds, you will manage your bond risk.

What Is a Bond?

A bond is no more than a company or agency promising to pay an interest rate to you to borrow your money.  Think of it this way.  You take out a home loan or car loan.  You pay an interest rate to the company that loans you the money to make your purchase. The loaning company does a credit check to see that you are a good risk and loans you the money. Your personal loan is no different than a bond issued by a company in that both of them require payment of both principal and interest.

Why Credit Quality Is Just As Crucial For a Bond Investor.

If you ignore credit quality as an investor you are making a mistake that can negatively affect your bond. Bond credit ratings range from AAA to C.  I will ignore D since these bonds are already in default. Treasury bonds are always AAA since they are guaranteed by the full faith and credit of the government. However, since Treasury bonds are paying historically low interest rates, investors have been reaching for what we call yield.  Yield is the return you receive on your bond investment. As an investor under the current interest rate environment, if you are looking for yield, you are probably ignoring credit risk.  In order to capture the best yield, you have to invest in lower quality bonds. These bonds are the most speculative.

Do You Know What Your Bond Maturity Is and How Rising Interest Rates Can Cause You to Lose Money?

The maturity date is no more than the date when the company or agency, that you have lent your money to, promises to pay you back all of the money you lent to it.  But a lot can happen between the date you loan the money and when the bond matures.  If you are a bond investor, one of those unknowns can be rising interest rates.

Whenever interest rates drop significantly for an investor living off of their interest income, many of them tend to move out of safe investments, such as Certificates of Deposit, into more risky investments. Several years ago when this happened, individuals moved from certificates or money markets into bond funds.  These investors were surprised that the government bonds they invested in lost value when interest rates began to rise. What the investor didn’t understand is fundamental to bond investing.  The longer the bond maturity, the more susceptible it is to rising interest rates.

 There Is a Rule of Thumb For Bond Investors.

All bonds react differently to rising interest rates.  The longer the maturity the more the bond will react to rising interest rates.  The shorter maturity, the less the bond will be negatively affected. When interest rates rise, bond prices fall and the longer the maturity the more the price will fall.  A 30 year bond maturity will fall in price much more than a two or five year bond.

What Is The Lesson In Investing In Bonds?

If you only look at the current yield you are receiving, you are vulnerable to losing money.  You must know what the credit risk is in your investment and how interest will affect the principal of your bond.  If you do both, you are on the road to being a successful bond investor.

Have a great week and I look forward to chatting with you again.

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