Investors in the stock market often use bonds to balance the volatility of stocks and to generate current income.
When interest rates are low and appear likely to remain that way for several years, investors in bonds must choose between low-risk and you low yield; and higher risk with higher yield bonds.
Obviously the choice often depends on what role the bonds will play in the investor's portfolio. It also must take into account whether the investor plans to hold the bonds to maturity or trade them.
Interest rates are unlikely to stay low forever and guessing when they will begin rising is just that: a guess.
If the bond investor plans to hold his purchases until maturity then changes in interest rates are not as important.
However if the bond investor plans to buy and sell bonds than changes in interest rates can have a dramatic impact on their choices.
For the conservative investor who wants a safe place to park money until a future date bonds offer a safe way to achieve that goal and to earn a small amount of interest while the bond matures.
The advantages of holding a bond until maturity are that the investor knows exactly how much money she will receive when the bond matures and how much interest she can earn over the life of the bond.
However, if interest rates change she may find newer bonds are much more attractive than the one she's holding.
Investors who trade bonds, that is buy and sell bonds on the secondary market, take more chances with interest rates.
In the low interest-rate environment high quality bonds will pay not much in interest and their market price will not very greatly. However when interest rates start rising, especially if the rise is at a fairly steep rate, high-quality bonds will suffer on the secondary market because of their low stated interest rate.
One alternative is to look at junk bonds for a higher interest rate along with a much higher risk that the bond issuer will default.
Junk bonds are issued by companies with an uncertain ability to repay the loan. The company may be young or struggling is some other manner.Because junk bonds have a low credit rating (usually BB or lower), they must pay a higher interest rate than higher quality bonds. How much higher depends on the credit worthiness of the issuer.
Investing in junk bonds is a risk and as such only be a small portion (if any) of your portfolio.
Junk bonds may not suffer as much if interest rates rise since they are a pay a higher interest rate. However, investors must balance the risk of default with the opportunity to earn a higher yield than might be presently available in other fixed income products.
While it is always challenging to find a decent rate of return in a low-interest environment, most investors will do themselves a favor if they avoid junk bonds or only commit a very small percentage of their investing assets to these risky products.
Many investors use bonds as a way to preserve capital for important investing goals such as your retirement fund. While interest rates of high quality bonds will never be high the risk of default is also very low.
This makes them ideal for retirement accounts, but it also means investors may have to adjust the amount they are setting aside for their retirement fund to compensate for the low interest rates paid.
Most investors at or approaching retirement will do themselves a favor by avoiding such high risk activities as trading bonds in the secondary market and committing large portions of their portfolio to junk bonds.
In this case, slow and steady makes a lot more sense than trying to trade your way into a solid retirement fund.
