Understanding Bonds To Avoid Risk By Bill Dufrane

With a plethora of ways to analyze bonds, it might make your head spin. Even so, evaluating the potential risk before you buy and calculating your potential returns is an essential step in the process of acquiring bonds.

1. Evaluate All Potential Risks

You should pay attention to all the details - interest rates, inflation, how easy it is to sell that particular bond, you name it.

2. Credit Risks

It doesnt matter what kind of bond you choose to invest in, there is always a credit risk. In 1995, U.S. Treasuries, considered the gold standard of bonds were close to default for the first time in history. For corporates and municipals the risks are even greater, running everywhere from the AAAAaa to B and below. These are often called junk bonds.

3. Bond Evaluation Checklist

- What is your earning potential?
- What is the current earnings per share?
- What is a typical divident payment?
- What is the outstanding debt?
- What forseeable technological changes might affect this bond?
- What is the track record of management?

4. Dividends

As debt loads grow, the amount of interest paid increases, reducing the amount for such investments as well as bringing a company closer to default on existing debt, since only so much can be sustained by current revenues.

5. Interest Rates

A large number of bond issues have maturities with 5-30 year periods. Any change in the prevailing interest rates affects unmatured bonds in two ways. A rise in rates depresses the price for those considering selling prior to maturity, since investors can get a better rate with a new instrument. Also, the pressure to sell rises, since the bondholder can himself get a higher rate with a new instrument. The longer he holds the older one, the more opportunity costs he incurs.

7. Dealing With Inflation

Inflation is the enemy of bonds. It will significantly reduce your return on any bond. Even ignoring tax issues, an 8% bond in a 4% inflation environment is worth half its coupon value. Historically, inflation tends to increase more than it decreases. When it does decrease the general economy tends to suffer, worsening returns for all investments. Know the rate of inflation and the market conditions before you invest.

Resource: http://www.isnare.com/?aid=92565&ca=Finances