Tips Before You Invest in Bonds
Here are 10 tips to consider before you invest in bonds or bond funds:
- Don't reach for yield. The single biggest mistake bond investors make is reaching for yield. This tends to happen when interest rates are low or have recently declined, or when investors feel they are not earning a rate of return they feel they need. Don't be tempted by higher yields offered by bonds with lower credit qualities, or focus only on gains that resulted during the prior period. Yield is one of many factors an investor should consider when buying a bond. And never forget: With higher yield comes higher risk.
- Define your objectives. Is your investment objective to have enough money for your child's college education? Is your goal to live comfortably in retirement? If so, how comfortably? You probably have multiple goals. Lay them all out and be as precise as you can. Remember: If you don't know where you're going, you'll never arrive.
- Assess your risk profile. Different bonds and bond funds, like stocks and stock funds, carry different risk profiles. Always know the risks before you invest. It's a good idea to write them down so they are all in plain sight.
- Do your homework. You're off to a good start if you've come this far—but keep going. Read books and articles about bond investing. Look up information on the Web or visit your local library. Start following the fixed-income commentary on financial news shows and in newspapers. Familiarize yourself with bond math. You should also read the bond's offering statement. It's where you will find a bond's important characteristics, from yield to the bond's call schedule.
- If you're considering buying a bond fund, read the prospectus closely. Pay particular attention to the parts that discuss the bonds in the fund. For instance, not all bonds in a government bond fund are government bonds. Also, pay attention to fees. Individual bonds also have prospectuses, which derive information from a bond's indenture, a legal document that defines the agreement between bond buyer and bond seller. Ask your broker for a copy of the prospectus or indenture to read it.
- If you're buying individual bonds, locate a firm and broker specializing in bonds. Talk to a number of brokers, and find one you are satisfied with. Make sure your broker knows your objectives and risk tolerance. Check broker credentials and disciplinary histories using FINRA BrokerCheck.
- Ask your broker when, and at what price, the bond last traded. This will give you insight into the bond's liquidity (an illiquid bond may not have traded in days or even weeks) and competitiveness of the pricing offered by the firm.
- Understand all costs associated with buying and selling a bond. Ask upfront how your brokerage firm and broker are being compensated for the transaction, including commissions, mark-ups or mark-downs.
- Plan to reinvest your coupons. This allows the power of compounding to work on your behalf. It's a good idea to establish a "coupon account" before you start receiving coupons, so that you have a place to save the money and are not tempted to spend it. If you are buying a bond fund, you don't have to worry about this—the fund does this for you.
- Don't try to time the market. Avoid speculating on interest rates. Decisions are too often made on where rates have been rather than where they are going. Instead, stick to the investment strategy that will best help you achieve your goals and objectives.