What You Should Know Before Deciding
When you invest in a bond, you buy the debt of its issuer, which might be the U.S. government or an affiliated entity, a state or city government or borrowing authority, or a corporation. Every bond has certain characteristics:
- A definite maturity date when the bond issuer promises to repay the bondholder who owns the security at the time.
- A promise to pay taxable or tax-exempt interest at a stated “coupon” rate in defined intervals over the life of a bond.
- A yield, or return on investment, which is a function of the bond’s coupon rate and the price the investor pays, which may be more or less than the bond’s face value depending on a variety of factors.
- A credit rating indicates the likelihood that the issuer will be able to repay its debt.
Risks of Bond Investing
While generally considered safer and more stable than stocks, bonds have certain risks:
- Interest rate risk: when interest rates rise, bond prices fall. If you need money and have to sell your bond before maturity in a higher rate environment, you will probably get less than you paid for it. Interest rate risk declines as the maturity date gets closer.
- Credit risk: if the issuer runs into financial difficulty or declares bankruptcy, it could default on its obligation to pay the bondholders.
- Liquidity risk: if the bond issuer’s credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer. Bonds are generally more liquid during the initial period after issuance as that is when the largest volume of trading in that bond generally occurs.
- Call risk or reinvestment risk: If a bond is callable, the issuer can redeem it prior to maturity, on defined dates for defined prices. Bonds are usually called when interest rates are falling, leaving the investor to reinvest the proceeds at lower rates.
Diversifying Risk by Building a Portfolio
Bond investors can diversify risk by purchasing bonds from different issuers with different maturities.
Treasury securities are available in $1,000 increments, but the minimum purchase for municipal and corporate bonds can be $5,000 or more. The cost of buying a bond includes a commission or a “markup” on the price, depending on whether you are buying from a firm acting as an agent who is getting the bond from someone else, or as principal, meaning the firm owns the bond it is selling.
Executing an effective diversification strategy requires a significant minimum investment to start. While there is no absolute requirement, a rule of thumb says it often takes at least $10,000 or more to build a fully diversified bond portfolio.
Bond Funds: Convenient, Affordable way to Invest in a Diversified Portfolio of Bonds—With some Differences
Bond funds—including mutual funds (open-end and closed-end, actively managed and indexed), exchange-traded funds and unit investment trusts—offer a convenient and affordable way to invest in a diversified portfolio of bonds, but a bond fund investment can differ from a bond investment in ways that are important to understand.
When you buy a bond fund, you buy shares in a portfolio of bonds that is created or managed to pursue a specific investment objective such as current income, current tax-exempt income, total return, or to match the performance of a market index. The portfolio might invest in a particular type of bond (government, municipal, mortgage or high-yield) or a particular maturity range (short-term: three years or less; intermediate term: three to 10 years; or long-term: usually 10 years or longer).
Many bond funds make monthly or quarterly “dividend” payments, as opposed to the semiannual payment schedule common to most bonds. Their price is based on their Net Asset Value (NAV), or the total market value of the portfolio divided by the total number of fund shares outstanding. A fund’s NAV changes daily with market conditions and in some cases with cash inflows and outflows to and from the fund portfolio.
Types of Bond Funds
Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds.
- Actively managed bond funds, as their names suggest, have managers who buy and sell bonds in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital gain, or at a loss if they need cash to pay shareholders who want to sell their shares.
- Index bond funds are not actively managed but constructed to match the composition of a given bond index, such as the Lehman 10-year Bond Index. When the index changes, the portfolio changes automatically.
- Sponsors of open-end bond funds (usually a mutual fund company) offer new shares and redeem existing shares continuously, requiring their managers to invest cash coming into the fund and liquidate positions when they need cash to meet redemptions. Investors in open end funds have the choice to collect their interest income and capital gains or reinvest them automatically in new funds shares.
- Closed-end bond funds have a fixed number of shares that trade on exchanges similar to stocks at a price that may be above or below net asset value depending on supply and demand. Closed-end bond funds can be indexed or actively managed. To buy or sell shares in a closed end fund, you have to go through a broker and pay a commission.
- Exchange traded funds (ETFs) represent shares in a “basket” of bonds that mirrors an index, but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold through brokers who charge commissions.
- Unit investment trusts are a portfolio of bonds held in a trust that sells a fixed number of shares. On the trusts’ maturity date, the portfolio is liquidated and the proceeds returned to unit holders on a pro rata basis. UITs are usually created by brokerage firms that maintain a limited secondary market for the units. Unit holders who want to sell before maturity may have to accept less than they paid.