Got bonds? Some might say that building a portfolio without including bonds is a little like eating cereal without milk.
Bonds can help diversify a portfolio — and that’s important since diversification is an effective risk control strategy. (Diversification does not ensure a profit or protect against loss in a declining market.) Stocks and bonds tend to perform differently under various market conditions, so investing in both asset types can potentially help balance overall portfolio risk.
Bond Fund Basics
You may not be able to invest directly in individual bonds through your retirement plan. But you probably can invest in bond funds (or portfolios). A bond fund is a professionally managed collection of bonds, and there are several different types. Some invest only in U.S. government bonds, others specialize in corporate bonds, while others hold both types. Some funds hold only bonds with short maturities, others hold longer term bonds. Blended maturity funds also exist. (Maturity refers to the date the bond issuer repays the investor.)
One thing to keep in mind about bond funds: They don’t mature. Fund managers often sell bonds before maturity and buy different bonds. When bonds in a fund’s portfolio reach maturity, the proceeds are reinvested in other bonds.
Corporate Bond Funds
Since there’s a chance that corporate issuers may “default,” corporate bonds are riskier than government bonds. Default occurs when a bond issuer doesn’t pay the promised interest to bond holders or fails to repay principal when the bond matures.
Before investing in a corporate bond fund, check the prospectus to find out the fund’s policy regarding credit risk. Many funds seek to control risk by buying only bonds that receive high ratings for quality from major ratings agencies, such as Moody’s and Standard & Poor’s.
U.S. Treasury Bond Funds
Treasury bond funds or portfolios hold debt issued by the United States government. Backed by the full faith and credit of the U.S. government, Treasury bonds are less risky and usually pay lower interest rates than corporate bonds.
A Word About Interest Rates
The market value of a bond can change at any time due to different economic factors. So investors who sell bonds before maturity might receive more or less than they initially paid. Although bond funds don’t mature, their share values also vary.
Bond values are sensitive to interest rates. If interest rates have changed since a bond was issued, the market value of the bond in the secondary market will be affected. When market interest rates fall, the prices of existing bonds usually rise. Investors are willing to pay more for them because they offer higher interest rates than new bonds. The opposite occurs when interest rates rise. Longer maturity bonds tend to be more price sensitive to market conditions than short-term bonds.
Questions about bonds? Our Sioux City wealth management team can help. Contact us today.
Back to Articles