When considering investing in bonds, whether corporate or government, you should fully understand how they work, including their risks and abilities to create the return 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.
- Before investing in a bond, know two things about risk: Your own degree of tolerance for it, and the degree inherent in the instrument (via its rating).
- Consider a bond's maturity date, and whether the issuer can call it back in before it matures.
- Is the bond's interest rate a fixed or a floating one?
- Does the issuer seem able to handle the interest payments? In case of default, where does this bond stand in the pecking order of repaying principal?
What Is My Risk Tolerance?
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.
How Risky is This Bond?
There are numerous risks involved with bonds, especially corporate bonds. Some specific types of risk of primary concern are inflation risk, interest rate risk, liquidity risk, and credit risk. Happily, several management tools exist to assess, analyze and ultimately help investors manage these risks. One of the primary ones is the bond rating, a letter grade assigned by an independent credit rating company to the debt that indicates its credit quality. The better the grade, the less likely the chance of the issuer's defaulting on the bond.
How Does the Bond Jive With 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 maturity date is the date the bond falls due. The investor redeems—that is, receives back—his principal (the money they invested in the bond)—selling the bond back to the issuer, in a sense. The exact amount investors can expect to receive is the face value plus any accrued interest due that has not been paid out in a coupon.
Can I Keep the Bond Until Maturity?
Investors must consider another significant risk factor with a bond: the chance it is called —that is, 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 Fixed or Floating?
It is also important for an investor to determine whether a bond’s coupon has a fixed or floating interest rate. Fixed coupons offer a set percentage of the face value in interest payments. Floating rate bonds, on the other hand, pay a variable coupon rate that is pegged to a particular benchmark rate. U.S. issuers frequently use one of these three benchmarks: the U.S. Treasury rate, London Interbank Offered Rate (LIBOR), or the fed funds rate. Most floating rate bonds are issued with two- to five-year maturities. 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 Debts?
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.
In Case of Default, Can I Get Repaid?
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—should the issuer become insolvent when do they close during insolvency.
The Bottom Line
Investing in bonds requires attention both before the actual investment and as long as the bonds are held.