Evaluating risks
As previously stated, all forms of investments carry some degree of associated risk. As a general rule, the higher the risk, the higher the return. Conversely, the lower the risk, the lower the return. It is entirely dependent on the situation and goal of the investor.
Always consider the type of bond that you are purchasing and the risk associated with it. For example, is the bond secured or unsecured? Is it a corporate or government bond? Does the business have a default history? These are just a few of the questions you should ask yourself and discuss with your broker before investing.
Interest rate
Different bonds pay different forms of interest, such as fixed, floating or interest that is payable at maturity. The type of interest that you choose is entirely dependent on your financial situation and future goals. Always do your due diligence and check the interest rate that is associated to the bond, as this will give you an idea of what your interest payments will be until maturity.
Maturity of the bond
The maturity of the bonds must be taken into account. The investor’s goals will determine the maturity term range that best suits their needs. However, you do always have the option of selling the bond before maturity if required, though this may end up in you receiving less than the initial principal that you invested.
Check the history of the bond
Looking at previous annual reports and reviewing the company’s past performance is a good way to determine whether the history of the company’s earnings was consistent. This will also allow you to verify that the business has made all tax, interest and pension plan obligation payments previously.
A potential investor should read the business’ Management Discussion and Analysis (MD&A) section for this information. The MD&A is a section of a public company’s annual or quarterly reports, which is where you can find their past performance. Also, read the proxy statement, which will display clues about any problems or a company’s past inability to make payments. This will potentially also indicate future risks that could have a negative impact on their ability to meet obligations and or service their debt.
Understanding the link between interest rate movements and price
Interest rates and bond prices tend to move in opposing directions. As interest rates rise, the price of the bond decreases, and vice versa. This means that the price of the bond before its maturity date will vary widely as interest rates fluctuate. This is why it is important to choose your most suitable maturity length and to not sell the bond prior to that date.
Generally, bonds are considered as more conservative and less risky investments than shares. However, contrary to popular belief, investing in bonds still involves a great deal of research and analysis before making a purchase. There is always a risk of suffering low or negative returns if the proper homework is not done.