Investment Advisors at DLG Wealth Management Discuss the Basics of Investing in BondsThere is no question that the volatility in the equity markets has many investors worried about the stock market and drawing out money from equity funds and putting the money in bond funds at a record pace. With the state of the market, it is important to discuss the basics of investing in Bonds and the reasons why investors should be careful about being in bonds.
When you invest in bonds you are lending your dollar. Lending your dollar means to give your dollar to an entity that will pay you interest on your dollar for a specific length of time. What are some common ways of lending your dollar?
• The most common way is to lend your money to a bank by opening a savings account. The bank will pay you interest on your money in return, as long as the money stays in the account.
• Certificates of Deposits or CD’s pay a higher rate of interest because you tie up your dollar for a specific time (typically 1 month to 5yrs).
• You can lend to the U.S Government (Treasuries). The government will pay you an interest rate depending on the maturity. The longer you go out the higher the rate of interest.
• Corporate Bonds – let you lend your dollar to a corporation (IBM, APPLE). You will receive a fixed interest payment usually paid every 6 months for a specific amount of time. These corporate bonds usually pay higher interest rates than the bank but do have more risk. The longer the maturity is the higher the rate of interest. The higher the risk (can the corporation make its interest payments and pay the bond back at maturity) the higher the interest rate. All of the above examples of lending are taxable.
• Municipal Bonds are issued by states, state agencies & local governments. The interest is federal tax free and can be state tax free if you lend within the state you reside.
All these lending vehicles can be done within a mutual fund that can specialize in all or certain areas listed above. By investing in a mutual fund you can diversify your lending which can lessen risk. This lending is known as “fixed income” investing.
It is important to understand that bonds fluctuate in value. When interest rates go up, the value of bonds you hold go down. When interest rates go down, the bonds you hold go up in value. Today interest rates are being kept at very low levels by the Federal Reserve policies. There will come a time when the Fed will not be able to hold interest down. They are sitting on a very tightly coiled spring (interest rates), when the Fed starts to release this coiled spring, rates will rise very fast causing large losses in bond portfolios. Investors should make sure portfolios are not over weighted in bonds. If you have a question about your portfolio, make sure to contact your advisor. For more information, contact us.