Fully understanding how different types of bonds work, whether they are corporate or government, can give you essential information regarding potential investments in them. There are many key things to know before investing in bonds. These essential parameters can help you gauge how likely you are to create returns from your bond, how much risk you are willing to take on, how long you should stay invested, and more. Consider the following parameters before following through with a bond investment.
- How risky is the bond investment?
Although they seem more stable then equity investments, there are numerous risks associated with bond investments as well. One of the things to know before investing in bonds is the amount of risk associated with your particular investment. This can include credit risk, liquidity risk, interest rate risk, and inflation risk, among others. There are a slew of management tools an investor can use to not only assess the degree of risk your investment offers but also how you can manage it.
- How tolerant are you of risk?
Your own risk tolerance is a crucial factor in determining your overall investment strategy. With bonds, in particular, knowing how much risk you are willing to take translates into the following risk profiling- what negative results do you expect to see from a hypothetical failed investment, what is the cost that could be associated with each risky investment, and what your target return on investment is from bonds.
- Does my bond investment align with my investment horizon?
Does the bond investment’s maturity terms align with the investment horizon you have planned? This is important as different types of bonds have different maturity periods. Upon maturity, an investor redeems or receives his principal amount back with earned interest. The same date is one at which the bond is resold to the issuer. If a bond goes over one’s investment horizon, there may be issues of having enough liquid funds available for one’s financial goals. If a bond’s maturity period falls under one’s investment horizon, one may be cutting their investment short too soon without taking advantage of the available time to compound their earnings.
- Will I be keeping my bond until maturity?
Sometimes, bond issuers might redeem an investor’s bond investment at a date earlier than its maturity date. This is a significant risk associated with some bond investments known as ‘call risk.’ Cases in which the issuer takes the call to redeem the funds are in response to a drop in interest rates while observing a rise in market prices. Investors should be careful when determining which bond to invest in as some may have a call date prior to maturity while others will not. Different issuers can be comparatively more likely or less likely to take action on the call.
- How is interest paid out?
The structure of your bond interest rate payments also affects your investment. It is vital to figure out if your bond’s coupon has floating or fixed interest rates. A fixed coupon bond interest rate will provide a set percentage of interest payments given at face value. Floating interest rates vary as per the current benchmark. If a bond offers the latter type of interest structure, their prospectus shall carefully educate potential buyers on when the rate is calculated and how the floating rate operates.
- What happens in case of a default?
Going default is another way of stating that the issuer has become insolvent or bankrupt. This is the worst-case scenario of investment in bonds but it is vital to consider what might happen to your investments if this became a reality. Investors can determine their LGD or loss given default and also their recovery rate. Another key parameter to consider when it comes to determining the security of one’s bond issuer is to see how high in seniority it ranks with respect to payouts. This estimate can give you an idea of how likely you are to receive your payouts in case the issuer becomes insolvent.
Investments in any asset require attention before and during the process. Key parameters like risk tolerance, call-risk, bond interest rate, investment horizon, and more, can allow an investment to strategically align with one’s long term financial goals.