Bonds: The Simple Facts

By | February 21, 2014

Bonds

There are so many different facts and information that try to give you the latest and most up to date information. But how do you know the information is accurate?

The simple way to understand information is to ensure you are aware of the basics. This protects you from being misled or given information which could mean you purchase a bond that doesn’t meet your needs.

The distinction between different managed bonds

There are two main differences between the different managed bonds; those that are actively managed and those that are passively managed.

The passively managed funds do not have an active team making sure the investments are in the right places. These bonds are often cheaper because there is less involvement needed.

The actively managed funds are watched and the performance managed. This means there are more people involved and this puts the price of the bond higher, to cover the costs of more staff.

Risks

Risk comes from not knowing what you’re doing.

Warren Buffett

As with all investments there is going to be an element of risk, but ensure you understand which of the risks you should be considering, when you are investigating a potential investment.

You must consider all of these risk items:

  • Interest rate
  • Credit
  • Market
  • Liquidity
  • Foreign investment
  • Exchange rate
  • Leverage
  • Management risk

 

The top priority on your list has to be the interest rate. You need to know this information to work out the potential to make money or lose money.
The interest rate of a bond is crucial. If there is an increase in the interest rate, then the potential value of the bond that you have invested in, will go down. This means that you will have a lower rate of return.
The length of the bond also has an effect on the risk, as well as the interest rate. The longer the length of time that the bond has before it matures is going to be more sensitive to the rate changes; because it is going to be more susceptible to the long term risk of a rate change. This means that it is higher risk than the shorter term bonds.
If you have a selection of bonds in your portfolio, or in the investment portfolio that you are considering to invest in, then you need to understand the Weighted Average Maturity or the WAM. If you are aware of the average length of the bonds until they mature, then you will be more aware if the investment has the higher risk of being affected by an increase in the interest rate. The longer the length of time before the bonds mature means the portfolio could have a higher risk factor.
You need to be cautious and understand the credit rating as well. The better the credit rating the lower the risk; but this will mean less money in return for your investment.

If a bond has had a great history in paying great returns, this is not necessarily going to be what happens in the future. All investments carry risk. Bonds tend to be a safer option than some of the other investments that you can use on the stock market, but they still carry risk. This is why it is so important that you are fully aware of all the different terms and abbreviations that are used. The more familiar you are the less likely you will make a mistake and invest in a bond that isn’t right for you.

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