Choosing A Bond Investment

Scott Leonard, CFP (President, Leonard Wealth Management, Inc.) gives expert video advice on: What are the most common mistakes people make when investing in bonds?; What are the key factors to consider when investing in bonds? and more.

What are the top things investors should know about investing in bonds?

When youre thinking about investing in bonds, the factors you really want to look at are: what are the risks associated with the bonds? And theres two key factors that drive risk. One is the credit quality – the quality of the company that is issuing that bond or the country. The other main factor that you want to look at is how long until that bond matures. So, longer term is going to be a riskier bond and credit quality is going to be a riskier bond. Within that realm of looking at those things, theres not a lot of value of owning longer term bonds relative to the risk-reward tradeoff. So, you almost want to think, you want to stay within five years or less maturity lots of times when you buy bonds because of that risk-return tradeoff. As well as, there doesnt seem to be a lot of value in buying junk bonds. Long term, youre not really getting the added return for the amount of risk youre taking as it relates to junk bonds.

What are the most common mistakes people make when investing in bonds?

Some of the common mistakes that we see people make when theyre investing in bonds is really a function of not fully understanding bonds and how bonds work, and bonds can trade at a premium. What that means is that when that bond matures; your actually going to get less money back from that bond than you paid for it and there are a lot of people out there that dont want to buy bonds at a premium because their not going to get their principle back. The common mistake there is your not understanding the dynamic of the bond and what you want to look at is the yield to maturity, and so your probably going to get a higher yield to maturity for buying a bond at a premium; because a lot of people dont want to necessarily own those bonds and so the commone mistake is Oh bonds at a premium. I dont want to own it, and its not looking at the fundamental real end result of what your total return is going to be over that life of that bond. Antoher common one in going out and buying quote high yield bonds. Its chasing yields and saying, Wow Im going to get a little bit more yield by buying this bond. Once again its a lack of understanding really on the risk yourre taking for that bond. Your taking much more risk with a high yield bond than your really getting. If you really willing to take that higher risk, theres probably some place else you should be putting your money than in bonds.

What are the key factors to consider when investing in bonds?

The key factors that you want to consider when youre investing in bonds is one, the credit quality of the company thats issuing that bond or the country. Second, is the term; how long that youre going to be in that bond. Third, you really want to consider yield to maturity, what is your actual investment return going to be on that bond if youre buying it in the secondary market place? You also want to consider what is the equity of the bond, is there a market out there to purchase that bond if you need to go and sell it later down the road?

What market factors impact bond value and rates of return?

When it comes to the market factors that are affecting bonds, there tend to be two different factors and they affect two different parts of the bond market. The short-term bond market is really more determined by the Federal Funds Rate. When people talk about the Fed, and what the Fed is doing with interest rates, those tend to dominate the short-term interest rates that were going to earn on bonds. Long-term interest rates and mid-term interest rates tend to be more market driven and so those are really supply and demand driven interest rates.