Portfolio Management: Bond Investing Misconceptions

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Portfolio Management: Bond Investing Misconceptions

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Several misconceptions surround bond investing, including:

It’s difficult to assess the safety of a particular bond.

U.S. Treasury securities are the safest bonds, because they carry the full faith and backing of the United States government. Municipal and corporate bonds have more risk, but their credit rating is typically assessed by at least one of the four major credit rating agencies. The rating agencies evaluate the financial health of the issuer and rate the bonds according to their ability to repay their debt obligations. Bonds with one of the top four credit ratings are considered investment grade, while bonds with lower ratings are considered non-investment grade or high-yield bonds. While ratings are not a guarantee of a particular bond’s quality, they do give you an overall feel for the credit quality of a particular bond. Keep in mind that the credit rating of a bond can change over time. Thus, after purchase, you should continue to monitor the bond’s credit rating.

Bonds tie up your funds until they mature.

You can sell a bond prior to its maturity date, but interest rate changes can significantly affect the bond’s market value. A bond’s price rises when interest rates fall and declines when interest rates rise. That occurs so an existing bond’s price provides the same yield to maturity as an equivalent, newly issued bond paying prevailing interest rates. Thus, if you sell before maturity, you may incur a gain or loss on the transaction. You can eliminate the effects of interest rate changes by holding the bond to maturity, when you will receive the full principal value. Although you can’t control interest rate changes, you can limit the effects of those changes by selecting bonds with maturity dates close to when you need the principal. In many cases, you may not know exactly when that will be, but you probably know whether you are investing for the short, intermediate, or long term.

Bonds are a long-term investment.

Bonds can be purchased with maturity dates ranging from several weeks to several decades. Thus, you can purchase a bond that fits your particular time frame. You do not need to select a maturity date of several decades when purchasing a bond.

You shouldn’t invest in bonds if you are concerned about inflation.

Since bonds typically pay a fixed amount of interest and principal, the purchasing power of those payments decreases due to inflation, which is a major risk for intermediate- and long-term bonds. Investing in short-term bonds reduces inflation’s impact, since you are frequently reinvesting at prevailing interest rates. You can also consider inflation-indexed securities issued by the U.S. government, which pay a real rate of return over inflation.