Index Funds and Bonds

Index Funds and Bonds

Investing in bonds means that you are buying the debt of the issuer. It could be the debt of the U.S. government, or an affiliated body like a state or city government or borrowing authority. You can even purchase the debt of a corporation when you invest in bonds.

Bonds are considered safer than investing in the stock market for various reasons. They have a definite maturity date on which the issuer promises to repay the bondholder who owns the security, a promise to pay taxable or tax-exempt interest as a stated rate in defined intervals, a return on investment, which is the function of the bonds rate and the price the investor pays, and the ability to find out the credit rating of the issuer, meaning that if they have good credit, there’s a good chance the issuer will be able to repay its debt.

That may sound all well and good, but keep in mind that investing in bonds also has its risks. When interest rates rise, bond prices fall. Meaning that if you need money and have to sell your bond well before its maturity in a higher interest rate environment, you’re going to get back less than what you paid for it. Good credit rating was mentioned before, but if this is overlooked and you invest in a bond in where the company is at credit risk, they may declare bankruptcy and default on payment, meaning that you could lose everything you invested. There’s also the risk of a call, in where the issuer can redeem it prior to maturity on a defined rate for a defined price. This usually happens when interest rates are falling, leaving the investor to reinvest the proceeds at a lower rate.

The best way to go about investing in bonds is to diversify your portfolio. Invest in different bonds with different companies with different maturity dates. Aside from investing in trading bonds, though, you can also build up your portfolio by investing in bond index funds. When you do this, you are investing in an already established portfolio that is created and managed to pursue a specific investment income.

Index bond funds offer a significant advantage over traded bond funds. Most important is their consistent performance. Many times, an index bond fund will out perform a traded bond fund, and at a lower operating expense. This is because bond fund managers have a greater difficulty beating the indexes. Unlike stock, index bond funds vary little in their gross returns. Once an investor has chosen a level of credit quality and average maturity, most bond funds will have a similar gross yield. It is really expenses more than anything that differentiates bond funds, and it is index funds that are the leaders in keeping expenses down. In stock terms, index bond funds are the blue chip of the bond-investing world.

Not only that, but index bond funds are a conservative investment. They pay out a regular return, which eliminates the need to seek out superior returns. When you invest in a bond index fund you’ll receive monthly dividends from the fund that include interest payments on the fund’s underlying securities plus any capital appreciation in the prices of the portfolio’s bonds. As with other types of mutual funds, bond index funds have a net asset value (NAV) that is the dollar value of one share in the fund; this is the price that investors pay or receive when they buy or sell shares in the fund.

Deciding on which types of bonds to invest in is not an easy decision. It depends on the type of person you are. Do you like to take risks with your portfolio, hoping for a bigger return on your money, or do you like to play it safe and invest in something that is going to pretty much have a guaranteed return? It’s best to take a look at just how much you are willing to invest, and figure out the worst case scenario, meaning calculating just how much you are willing to lose.

The easiest way to go about all this is to talk to a financial advisor. Don’t try and play the markets yourself without arming yourself with the knowledge you’ll need to build a successful portfolio. That’s a fool’s game, and if you don’t know what you are getting into, you could end up losing your entire life savings. In fact, you’d be better off just going to the casino and putting $10,000 down on black. Maybe the roulette wheel will yield you a better return.