Many investors buy into bonds, either as a primary investment or to diversify an investment portfolio and hedge against stocks. A bond is a debt security that entitles the buyer to interest over the life of the bond, and a return of the principal investment once the bond reaches its maturity date. But bonds carry their own risks for investors, including risks tied to interest rates.
Bonds and Interest Rates
Bonds are directly tied to interest rates through an inverse relationship. Most bonds have fixed interest rates, which means that investors who buy bonds know how much they'll receive in interest, and how often, until the bond matures. However, during the life of a bond, interest rates can rise or fall. If they rise, an investor who holds bonds must continue to receive a lower interest rate than would be available by investing the same money elsewhere.
Like stocks, bonds are available for sale on open markets. This means that bonds have market prices, which rise and fall as interest rates change, and as bond issuers make operational decisions. For example, if a company issues bonds and spends the money it receives to invest in developing a new product that sells poorly, its ability to repay the bonds will come into question. Even if interest rates are not rising, the value of that company's bonds may fall since the risk of not receiving repayment is greater. Interest rate trends and expectations are the largest factors in bond pricing.
Bond funds are mutual funds that pool money from investors and use it to buy bonds from different issuers. Bond funds distribute risk the same way mutual funds do when their managers invest in multiple stocks. The goal is that gains in one product will offset losses or slow growth in another. However, bond funds don't have the fixed maturity dates that individual bonds do. This means that bond fund owners can sell early and take a loss on principal repayment, but seek higher interest rates elsewhere. Or, they can wait for individual bonds in the fund to mature and tolerate interest payments that are lower than those available through other investments.
Investing in bonds is a relative safe move because issuers typically repay principal and allow investors to earn interest, at a predictable level, until the bond matures. The value of a bond with a high interest rate will rise if interest rates fall, allowing the investor to sell and realize a gain. Since each investor has a different investing time horizon, the term of a bond is an important factor. Interest rates, and expectations for interest rate changes in the future also drive bond investment decisions.
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