Bonds provide something that very few investments can claim. They provide a high current income and preservation of the money invested, the capital.
Bonds basically make you the lender in this financial transaction. As the lender, you of course would like to have the loan paid on time and with interest. You would also like the best reward for your money possible, which is called the yield. While investing in them is a complicated matter outside of a mutual fund situation, it is still vital to remember two things.
First, the price of a bond moves in the opposite direction from the yield. It is not as hard to understand as it seems. If you are in need of money as a company, a municipality, or a government, you need to attract investors. The higher the return on their investment you can offer, the greater the chance that you will attract people who want to lend you money. But these investors will ask themselves why the company, municipality, or government is offering such a high yield. Perhaps they will wonder, is there a chance that the money might be used for a risky investment? Is there a chance that this risk might not pay-off?
On the opposite end is this example is a company, municipality, or government who uses bonds to raise money and because of their good credit rating, are most assuredly able to pay you, the lender back with interest.
So the safer the investment, the higher the price and the lower the yield. The riskier the investment, the greater the price will be low to attract investors willing to take a high degree of risk.
But that is the incredibly simplified version. Many more elements play into this investment that further complicated an easy understanding.
The second is that bonds do play a part in a balanced portfolio.
The best way to do that is through a mutual fund manager that specializes in bonds or through a balanced fund that invests in both bonds and stocks.
It is important that you use the same criteria for bond fund investing as with equity funds. Always choose a no-load fund with low expenses. Choose a manager or management team that has some experience with the fund. It is best if that experience is over at least a three to five year period. Be sure the fund is being compared to similar type funds with comparable investing styles. Index when you can and be sure that the performance results are over a long period of time that includes a good market cycle such as five years.
Fixed income funds can invest in stocks but they have a tendency to be
the dividend producing preferred equity without much price movement. But
bonds are the mainstay of these funds investing in corporate and government
backed mortgage securities. These have a fixed payoff rate that is called return.
These funds, it is important to note, do carry a risk tied directly to the
interest rate. The higher the rate, the lower the price for these types of
funds and their value. The lower the interest rate the greater the value
of bond funds and their is additional growth of capital.
When investing in a bond fund, stability is the next consideration . The riskier the investment such as with lower rated (a list if ratings can be found below) corporate bonds, the higher the yield. The safer the investment, the lower the yield. Stability is better in bonds funds than in
stock funds but the principal is not as safe as with money market type funds.
Funds that invest in government backed securities tend to be the best bet
because of the full government backing.
Municipal bonds funds or tax exempt bond funds are essentially just that. The
fund invests in municipal bonds which usually come with a longer maturity
date, lower rating, and of course, with those risks taken into account, a
high yield as well. These types of funds are not as effected by interest
rates, although there will be some movement in prices of these funds
(remember, lower interest rates mean higher prices and vice versa).
If you include these funds in your portfolio, the income produced by them
is free of federal taxes.
The following are summaries of the definitions of Moody's ratings for long-term bonds.
Aaa Best quality, with smallest degree of investment risk.
Aa High quality by all standards; together with the Aaa group they comprise what are generally known as high-grade bonds.
A Possess many favorable investment attributes. Considered as upper-medium-grade obligations.
Baa Medium-grade obligations (neither highly protected nor poorly secured). Bonds rated Baa and above are considered investment grade.
Ba Have speculative elements; futures are not as well-assured. Bonds rated Ba and below are generally considered speculative.
B Generally lack characteristics of a desirable investment.
Caa Bonds of poor standing.
C Lowest rated class of bonds, with extremely poor prospects of ever attaining any real investment standing.
If you have additional questions about these investments, you can find the answers on rates here and on definitions here.
