In its simplest form, a bond represents a financial obligation to pay a specified sum of money at specified future dates. Bonds are typically issued by governments and corporations. The issuer promises to make payments, which consist of interest in the form of regular coupon payments, and principal, which represents repayment of the initial amount borrowed.
Incorporating bonds into your plan
Bonds can serve many purposes for investors. They can provide a predictable source of income, help preserve capital, and add attractive diversification benefits to an investment portfolio as they tend not to move in the same direction as other asset classes.
Fixed income mutual funds can provide investors with access to a diversified portfolio of bonds for a relatively small initial investment. They also offer professional investment management, liquidity and monthly income distributions.
What are the risks?
Although less prone than equities to large changes in value, bonds are subject to risks of their own.
Interest-rate risk is a primary risk facing investors in the bond market, and is explained by the inverse relationship between the yield required by the market and current bond prices. The price of a typical bond will change in the opposite direction of the change in interest rates (i.e. bond prices fall as yields rise).
Consider an existing bond with a coupon rate of 5%. If interest rates rise, any newly issued bonds will offer a higher coupon rate, for example 5.5%. The 5% bond will be less appealing to new investors and consequently its price will drop in order to remain competitive with the newer, higher-coupon bond.
Since the price of a bond fluctuates with market interest rates, an investor faces the probability that prices will decline in a rising interest-rate environment. The silver lining in this scenario is that coupons received from existing bonds can be reinvested in newer bonds at higher rates.
To learn more about fixed income investing, talk to your financial advisor.