The financial crisis of 2009 caused many investors to reevaluate their investment portfolio. Even investors who have historically been risk takers now look for safer options. Bonds, for example, are commonly considered a safe investment option.
However, are bonds really safe for today’s investor? To answer that question, we must consider many factors.
Safe vs. Guaranteed Financial Strategies
As an investor, you may be looking for a guaranteed investment strategy. However, no investment can be 100% guaranteed to provide you with a return on your investment. Instead, you should evaluate how safe a potential investment is before deciding to invest.
Remember that “safe” and “guaranteed” are not the same thing. “Guaranteed” means that you are promised a return on your investment whereas “safe” means that the investment is more likely than other investments to protect your assets and return some type of profit. Overall, bonds are generally considered to be a safer investment than other investment options if chosen carefully.
Strategic Financial Planning: Rates versus Price
Before investing in a bond, an investor should evaluate the expected rate of return versus the price of the bond. The price of a bond, however, includes more than just the upfront price. There may be additional hidden costs that are not clearly identified on an account statement.
Types of Bonds
Certificates of deposit, or CDs, are issued by federally insured banks and are referred to as “guaranteed”. While these investments are widely considered to be the safest investment, the term “guaranteed” is misleading, as there are some loopholes that could cause an investor to lose money in a CD. Agency bonds, such as Treasuries, Fannie Mae, Sally Mae, or Freddie Mac are widely viewed to be almost as safe as CDs because they are backed (not guaranteed) by the United States government.
Municipal bonds are issued by municipalities as a way to raise capital for ongoing expenses and/or improvements. Though safer than corporate or junk bonds, a municipality is not immune from insolvency. Corporate bonds should be well researched before purchasing because they are only as safe as the financial health of the corporation that issues the bonds. Finally, high yield (junk) bonds sound attractive because of the potential for a high rate of return. However, these bonds also have the lowest credit ratings and carry the highest risk of insolvency.
The farther off the maturity date of a bond, the greater the risk of missed opportunities for the investor. Funds tied up in bonds during a period of rising interest rates could cause the investor to miss out on investment opportunities that take advantage of the higher interest rates. Imagine, for instance, that you purchase a bond today for $10,000 at three percent interest with a ten-year maturity date. Two years from now, after a steady rise in interest rates, you might be able to purchase the same bond at a six percent interest rate. You have essentially lost the opportunity to earn that additional three percent.
Bonds have a credit rating just as an investor does. The higher the rating, the lower the risk to an investor. Of course, the lower the risk, the lower the potential rate of return as well. Bonds with a credit rating of BBB (on the S&P) are considered to be investment grade bonds while those below the BBB rating are considered junk bonds.Purpose
Consider the purpose of including bonds into your investment portfolio. If you are extremely risk averse, then the inclusion of low-risk bonds to your portfolio may be a smart move. If, however, you are simply looking for a way to “ride out the storm” until the country is finished digging out of a recession, then bonds may not be your best option because of the length of time until maturity and the potential for lost opportunities. Ideally, your portfolio will include the right amount of diversity, allowing it to handle small to moderate market fluctuations without panicking.
With a better understanding of bonds, you should be able to make an educated decision after consulting with your wealth advisor about the inclusion, or addition, of bonds to your investment portfolio.