- Bond purchases are relatively complicated investments that involve a decision about the general level of interest rates and the ability of the bond to pay interest and repay borrowed principal on a timely basis as called for by the terms of the bond. Bond yields are inverse to bond prices. Rising interest rates cause bond prices to fall because the coupon payment of an older bond is not comparable to the higher rates available in the current marketplace. Investors can protect the market value of the bond by buying bond maturities of short duration. However, only very short term instruments fully protect principal from volatile price fluctuations.
- Bond prices can only increase if the credit quality of the bond increases or interest rates decline. Credit quality should be the foremost consideration of any bond investor. High credit quality is represented by the ability of bond issuers to hold ample cash to meet pay debt service, or interest and principal, after paying tax burdens and normal operating expenses. In addition, the issuer should have outstanding assets well above the amount borrowed and the ability to convert these assets to cash if needed. Investors should always consult major investment credit rating services for detailed reports about the claims paying ability of any public bond issuance.
- Investors not well versed in credit finance or capital market investments should consider professional bond management. Professional management may come from tax advisers and investment managers for individuals seeking customized advice. However, beginning investors should also consider mutual funds and exchange traded funds, particularly bond index funds. Mutual funds are actively managed companies with professional bond traders, bond researchers, legal analysts and operations specialists. As a result mutual funds provide active investment management, tax reporting and regular statements of portfolio value. Mutual funds charge a fixed fee for their services. Exchange traded funds provide passive management. Management and trading fees are less than mutual funds. Investments are pegged to widely known and recognized bond indexes. Trading only occurs when the individual index is reviewed and modified.
- Traders with experience in bonds can consider bond proxies such as bond options or bond futures. Bond options, for a fee, give the buyer the right but not the responsibility to buy bond in the future at a stated price and expiration date. Bond futures require large capital risk taking and are extremely volatile because substantial leverage is involved in every bond futures contract. Bond options and futures are used for trading the price effects of interest rate movements. They do not provide interest income. In fact, while trading futures and options there are substantial trading costs and foregone interest payments from bond coupons.
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