Many people today recognize the term "bonds," as they have been a popular investment vehicle for many years. Investors see bonds as a more conservative, less volatile option to stocks.
While this might be true most of the time, if used properly in a portfolio, bonds are still an investment and come with their own types of risk: interest rate risk, default risk and opportunity risk, to name a few.
So, what exactly is a bond and what are some questions an investor should ask before adding them to a portfolio?
A bond at its base nature is an I.O.U. In the vernacular of the industry, it would be described as a fixed income instrument that represents a loan funded by an investor (purchaser of the bond) to a borrower in need of capital (issuer of the bond). It is considered a fixed income instrument because the issuer of the bond must pay interest on the loan at an agreed upon rate, until the entire premium of the loan is repaid on a specified date.
Bonds generally fall into three main categories: corporate, municipal and treasury. One category is not inherently better than another, but rather they each have different characteristics is areas such as yield (a function of the bond's price and interest payment), default risk, taxation and duration (price sensitivity to interest rate changes). These categories also contain bond variations such as convertible, callable, puttable and zero-coupon bonds.
As this article is only scratching at the tip of the iceberg when it comes to the complexity of the bond market, investors should ask some important questions before committing capital.
Here are few to consider:
1. What is the purpose of the bond portfolio? What is the goal? The category and variant of the bond chosen should be determined by what is trying to be accomplished. Is it to reduce volatility in the portfolio? Is it a hedge against market loss risk by diversifying a portfolio? Maybe it's to create income? Is the income needed now or 10 years down the road? Are the tax advantages of muni bonds preferable to the higher coupons offered by corporate bonds?
2. What investment vehicle(s) will be used to build the portfolio? Does it make sense to purchase individual bonds to build a portfolio or is a mutual fund or ETF more suitable? What are the positives and negatives of those different options?
Luke Gawronski, a financial planner with Barnum Financial Group, is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. firstname.lastname@example.org