7 Things to Consider When Investing in Bonds

Zachary Morlock        3/2/2016        

Financial Services        Investing in Bonds

Investing in bonds is a complex matter, one that involves much thought prior to dumping [usually] a large amount of money into a corporate, municipal, or government bond. There are many things to consider before you should invest in a bond: (1) risk profile and target return, (2) when is/are the maturity date(s) and do they follow your investment horizon, (3) what are the risks, (4) can the bonds be purchased back before maturity, (5) are the interest payments made at a fixed or floating rate, (6) can the issuer cover its debt obligations, (7) and lastly, how are the bonds secured. All of these should be considered before rushing into purchasing a bond of any kind.

First, before investing it is important to perform a self-assessment of risk. Essentially, one should evaluate how much they can, or are willing to risk in their investments. This must be done before a strategy can be drawn up. When thinking about a risk profile, the investor must think about possible negative effects from failed investments, the costs of each risk, as well as target return for the bond(s).

        In addition to a desired target return, an investor should have a defined investment horizon, which should align with the investing bond’s maturity terms, or maturity date. The date of maturity is the date in which the investor will receive the principal payment, which is the amount that was originally invested in the bond, by selling the bond back to the issuer. If any interest was not paid out in the form of a coupon payment, the investor can expect that amount in addition to the principal at the date of maturity. Of course, if the issuer defaults, this payment will not be issued back to the investor, thus the risk involved.

        There are many risks involved when investing in bonds. First, there are risks in analyzing and ultimately investing in the bonds to begin with, depending on the bond itself. Then there are numerous risks such as inflation risk, interest rate risk, liquidity risk, as well as credit risk that can play a factor.

        When investing, it is important to know how the coupon payments will be assessed, as far as interest rates are concerned. A fixed rate offers a set percentage of the face value, meaning that the investor will know exactly how much the coupon will pay each time until maturity, due to the fixed rate. On the other hand, a floating rate bonds have their coupon payments determined by the market. In the U.S., this is determined by the US Treasury rate, LIBOR, or prime rate/fed funds. These floating bonds are typically issued with 2-5 year maturity terms, and typically by governments, banks, and other financial institutions. In the event of a floating rate, the bond issuer should fully make aware to the buyer the method of interest.