It is important to understand that a variety of factors affect bond prices and their overall safety as an investment. Here are some important considerations you should understand when investing in bonds.
In theory, even government bonds, which are considered to be one the safest of all investments available, could go down the tubes. I don’t expect this to occur, nor should you, but government bonds are backed by the full faith and credit of the United States government. If Armageddon strikes and the government ceased to exist as it does today, even those bonds could become worthless.
Corporations do not need such an unprecedented circumstance to go out of business. Unfortunately, some corporations do go out of business each year. Even the companies that appear to be vibrant and successful are not immune from economic downturns. Corporate bonds are backed by a company’s assets. If a company is in financial trouble, bond holders, even though they are at the front of the line when it comes to collecting their money, could be at risk. That being said, there is a hierarchy of bond types with respect to their safety. High yield or junk bonds as they are often referred to are corporate bonds that pay an investor a higher yield than other types of bonds. These bonds have a higher risk of default, which is why an investor is compensated with a higher yield.
There is a grading system which ranks bonds as either investment grade or below investment grade. This is not foolproof as recent economic times have proven, but this grading system offers some visibility into a corporate bonds safety and a company’s creditworthiness. Investment grade bonds are less risky than non investment grade bonds and with the lower expected risk; the bond yields are lower as well.
Another factor that can affect a corporate bond, regardless of the company’s overall financial health is interest rates. If interest rates should rise, then existing bond values will decline. This is not specific to corporate bonds, but almost all bonds unless they have certain features associated with them. While this rise in interest rates may not affect the price of a bond if it is held to maturity, it very well may reduce the price it could fetch in the secondary market. The secondary market is a market where sellers and buyers of bonds trade bonds prior to their maturity date.
Another important consideration when evaluating risk is whether you are considering individual corporate bonds or corporate bond funds. Individual corporate bonds will have a maturity date; where as corporate bond funds do not. When bonds mature, the principal is repaid to the investor and interest payments stop.