Understanding the workings of different types bonds, whether corporate or government, is crucial for making informed decisions about potential investments. Before investing in bonds, there are several key points you should know. These key parameters will help you determine how likely your bond investment will produce returns, how risky you are willing and how long it should be held. Before you make a bond investment, consider the following factors.
While they may seem safer than equity investments, bond investments can be more volatile than equity investments. However, there are still risks. Before you invest in bonds, it is important to understand the risk involved with each investment. These include credit risk and liquidity risk, as well as interest rate risk and inflation risks. An investor has a variety of management tools that can be used to assess the risk associated with an investment and how they can be managed.
In deciding your investment strategy, it is important to consider your risk tolerance. Particularly with bonds, knowing your risk tolerance is key to determining your overall investment strategy. The following risk profiling is done: What negative outcomes do you expect from a failed investment, what are the costs associated with each risky investment and what is your target return on bonds investment.
Is the maturity term of the bond investment in line with your investment plan? This is crucial as different types have different maturity dates. An investor receives the principal amount and earned interest back when the bond matures. At the same date, the bond is resold back to the issuer. A bond that is beyond one's investment horizon may cause problems with liquidity. A bond's maturity date falls below one's investment time horizon. This could lead to one cutting back on their investment too quickly without taking advantage the opportunity to compound their earnings.
Bond issuers may redeem bonds invested by investors at a time that is earlier than the maturity date. This is known as "call risk" and it can be a risky investment. The issuer might redeem the bonds at a date earlier than the maturity date in order to respond to a fall in interest rates or a rise in market price. You should choose the right bond for you. Some bonds may have a maturity date before others. Different issuers may be more or less likely than others to act on the call.
Your investment will also be affected by the structure of your bond interest rates payments. It is important to determine if the coupon you have for your bond has fixed or floating interest rates. Fixed coupon bond interest rates will pay a fixed percentage of the face value. The current benchmark determines how floating interest rates will change. Prospectus must be carefully reviewed by potential buyers if a bond offers this type of interest structure.
Another way to say that an issuer is insolvent or bankrupt is going default. This is the worst case scenario for bonds investment, but it is important to think about what would happen to your investments in the event of default. Investors can calculate their LGD (loss due to default) and their recovery rate. When assessing the security of a bond issuer, another important parameter is how senior it is in terms of payouts. This can provide an estimate of your chances of receiving your payouts if the issuer goes under.
Any asset investment requires attention prior to and during the process. Strategic alignment can be achieved by adjusting key parameters such as risk tolerance, call-risk and bond interest rate.