As I pointed out last week , bonds are the hardest investment class for most people to understand. Just to make things more complicated, not all bonds are the same. There are great differences between government, corporate, long-term, short-term, TIPS and high-yield bonds.
Both governments and corporations issue bonds when they have a need to raise money. High quality bonds are those rated as unlikely to default. Most governments and large, creditworthy corporations carry a small risk of default. If a country like the US, the UK, or Japan borrows money there is no way they can default. Because they can always print money to cover their debts, it’s impossible for those countries to go bankrupt. However, a municipality or state government can default on its debt, just as any corporation can.
Another major classification of bonds, high-yield bonds, can also be referred to as junk bonds. These are the bonds of governments and corporations that are having credit problems. Because the risk of default is higher, these bonds sell for a large discount, making their yields higher than those of high quality bonds.
Treasury Inflation Protected bonds (TIPs) are usually government bonds that are indexed to inflation. They usually pay a set rate of interest, say 1%, plus whatever the annual inflation rate is. If inflation is 2%, the bond would pay 3%. If the inflation rate rises to 5%, the bond would pay 6% that year. So the interest rate fluctuates annually depending on inflation.
Finally, no matter what type of bond you own, it can be a short, intermediate, or long term bond. It can also be domestic or international.
Short-term bonds usually mature (become due) in under 3 years, an intermediate term is 3 to 7 years, and long-term bonds mature in more than 7 years and can go as long as 30 years. Generally, the longer the term of the bond the higher the risk of the bond being negatively impacted by rising inflation, except for TIPs bonds which benefit from rising inflation.
What happens if you buy a bond that pays off in 10 years, but two years into the term you need your money back? Because we have bond markets where bonds are purchased and sold, getting your money back long before the bond matures is easy. However, you may not get 100% of your money back, depending on any changes in the creditworthiness of the company and changes in interest rates.
This is another confusing aspect of bonds. Suppose you bought a $1,000, 10-year bond at an interest rate of 6%. After 3 years you need to sell it. Bond interest rates are now 8%. Investors won't pay the full $1000 for your 6% bond, because they could get 8% by buying a new bond. You'll need to sell at a discount. If interest rates are 4%, though, you could sell at a premium, getting more than $1,000 because buyers would want your bond's 6% interest.
You may also sell at a premium or a loss if the creditworthiness of the issuing company improves or declines. Buyers may be willing to receive less in interest in exchange for a bond's increased security, or they may want a higher return if the bond's security has declined.
Bonds are an important part of a diversified portfolio, especially when that portion is further diversified with various types of bonds. For example, I like to have international bonds as a third of my bond portfolio. An investment advisor can assist you in putting together a mix of domestic and international bonds that best supports your investment goals.