When do bonds do well

An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments. Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates.

Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments. Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa.

Interest rate risk comes when rates change significantly from what the investor expected. If interest rates decline significantly, the investor faces the possibility of prepayment. If interest rates rise, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.

Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments—just like any other creditor. When an investor looks into corporate bonds, they should weigh out the possibility that the company may default on the debt. Safety usually means the company has greater operating income and cash flow compared to its debt.

If the inverse is true and the debt outweighs available cash, the investor may want to stay away. Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower interest rate environment.

Most bonds come with a rating that outlines their quality of credit. That is, how strong the bond is and its ability to pay its principal and interest. Ratings are published and are used by investors and professionals to judge their worthiness. Ratings range from AAA to Aaa for high-grade issues very likely to be repaid to D for issues that are currently in default.

Bonds rated BBB to Baa or above are called investment grade. This means they are unlikely to default and tend to remain stable investments. Bonds rated BB to Ba or below are called junk bonds —default is more likely, and they are more speculative and subject to price volatility.

Because the rating systems differ for each agency and change from time to time, research the rating definition for the bond issue you are considering. Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.

As noted above, yield to maturity YTM is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. A simple function is also available on a financial calculator. The current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock.

If that continues, would be the first down year for this popular yardstick since Active bond managers can still beat the indexes, but no team of managers, analysts and traders can fight off every headwind.

However, as I have written for years, there is more to investing in bonds than riding interest rates. And enough good things are happening in the economy and assorted fixed-income sectors for me to say to stand firm. Stronger oil prices, better jobs numbers and much sounder than expected state and local government finances all imply, in different ways, better second-half prospects — perhaps not for T-bonds, but for other types of income-driven or debt securities. What do these picks have in common?

Their high yields, or high fund distributions, continue to attract savers and investors while a tight supply of comparable names supports their prices and economic vigor adds to their appeal. The U. And it will do this at a time when households have built enormous cash reserves, paid down debts and generally regained confidence in the economy and the markets without scaring the Federal Reserve into tightening credit and humiliating us committed bond bulls.

Toward that end, I would add preferred stocks or funds and well-managed high-yield bond funds to the shopping list. As a result, many investors may be wondering if it's time to transfer some of their money to bonds, where returns can still be decent but the risk of losses is typically lower than with equities.

Indeed, portfolios weighted heavier in bonds tend to recover faster from downturns than ones tilted more toward stocks. Here's how to protect your retirement portfolio Retirees worried about stocks cratering can use these portfolio strategies. Recently, Eric Jacobson , a strategist at Morningstar, found that even though U.

Credit risk. The issuer may fail to timely make interest or principal payments and thus default on its bonds. Interest rate risk. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones.

To sell an older bond with a lower interest rate, you might have to sell it at a discount. Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.

Liquidity risk. Call risk. The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.

Corporate bonds are securities and, if publicly offered, must be registered with the SEC. Be wary of any person who attempts to sell non-registered bonds. Most municipal securities issued after July 3, are required to file annual financial information, operating data, and notices of certain events with the Municipal Securities Rulemaking Board MSRB.