When considering investing in bonds, whether corporate or government, you should fully understand how they work, including their risks and abilities to create the purchasing power you seek as an investor. Here are seven essential questions to ask before investing in bonds, whether you are a seasoned investor or a beginner.
What Are My Risk Profile and Target Return?
Before investing, it’s absolutely vital for investors to perform a risk-disposition self-assessment. The goal is to determine how much risk they can or are willing to take when investing in bonds. Without knowing how much risk you want to take or avoid, an overall strategy cannot emerge. Therefore, several factors must be considered in terms of the investor’s risk profile including:
- what negative effects may result from failed investments
- potential costs for each risk
- overall target return for the investment
Clearly, any investor has to fully understand the concept of risk-return tradeoff when making a decision whether to invest in higher-yielding bonds, investment-grade bonds or a mix of both.
What Are the Bonds’ Maturity Dates and Do the Terms Meet My Investment Horizon?
Investors should have both a well-defined return target as well as an investment horizon in accordance with their chosen bond’s maturity terms. The date of maturity is the date the investment ends and the principal is redeemed by the investor, who sells the bonds back to the issuer. The amount investors can expect to receive is the face value plus any accrued interest due that has not been paid out in a coupon. Of course, if the issuer defaults, this will not happen.
What Are the Risks?
There are numerous risks involved with bonds and several management tools to assess, analyze and ultimately help investors manage the risks they take on as they invest in bonds. Some specific types of risk of primary concern to investors in corporate bonds are inflation risk, interest rate risk, liquidity risk, and credit risk. (For related reading, see: Bond Risks and Duration.)
Can the Issuer Purchase the Bonds Back Before Maturity?
Investors must consider another significant risk factor with bonds: the chance it is called or bought back before its maturity date. Commonly referred to as the bond’s call risk, this refers to the chance the issuer may redeem the bond at an early date in response to rising market prices or falling interest rates. It’s vital, therefore, to determine whether a bond has a call date before its maturity and how likely an issuer is to make good on that call.
Are the Interest Payments Made at a Fixed or Floating Rate?
It is also important for an investor to determine whether a bond’s coupon has a fixed or floating rate. Fixed coupons offer a set percentage of the face value in interest payments. Floating rate bonds, on the other hand, have their coupon rate set by movements in the market’s benchmark rates. For U.S. issuers, this benchmark is determined by the U.S. Treasury rate, London Interbank Offered Rate (LIBOR) or the prime rate/fed funds. Most floating rate bonds are issued with two- to five-year maturities by governments, banks or other financial institutions. A bond’s prospectus should fully educate buyers on the floating rate, including when the rate is calculated.
Can the Bond's Issuer Cover Its Debt Obligations?
Keep in mind that companies issue bonds as a way to attract loans, so bond purchasers are lending their funds to the issuer. Therefore, just like they would when assessing anyone they offer a loan to, investors should make sure the issuer is prepared to make good on the payments and principal promised at maturity. This isn’t simple, as it requires constant monitoring as well as an in-depth analysis by qualified professionals.
How Are the Bonds Secured?
Before investing, you should determine whether you are likely to receive your money back (or part of your money) in the event an issuer goes into default or becomes insolvent. Typically, investors will do this both through the determination of two figures: loss given default (LGD) and the recovery rate. Additionally, besides knowing whether or not a bond is secured, it is important to know where it ranks in seniority for other secured bonds in terms of payout during insolvency.
The Bottom Line
Don't just purchase bonds because it seems like the right or safe thing to do. Investing in bonds requires attention both before the actual investment and as long as the bonds are held. (For related reading, see: Investing in Bonds: 5 Mistakes to Avoid in Today's Market.)