THE STEADY STAPLES OF A WELL-BALANCED PORTFOLIO
Default risk—The possibility that a corporation or other bond issuer will fail to make payment on its debt.
Interest rate risk—The risk that interest rates will rise, which will lower the market value of earlier issued bonds.
Original issue discount—When bonds are issued at a price that is less than their face value.
Usually, the longer the duration of the bond, the higher the interest rate, because you are loaning your money for a longer period of time. It’s important to compare the interest rate with the amount of money you will be investing to make sure that they are commensurate amounts. Also, consider who is issuing the bond before purchasing one. The tax status of the interest income you receive depends on who the issuer is, as does the risk associated with the bond.
Then look at how the bond is rated. Two of the institutions that rate bonds are Moody’s and Standard & Poor’s. They rate the ability of the issuer to pay back the debt plus the interest payments. These compa- nies have financial analysts that study the issuer’s creditworthiness at the time the bonds are issued, as well as periodic reviews throughout the duration of the issue. The ratings indicate the bond’s investment quality. The first four ratings for both Moody’s and Standard & Poor’s represent investment-grade bonds, those that are highly unlikely to go into default. Junk bonds are corporate bonds that are characteristically poor in quality, but pay higher-than-average interest.
Bonds are not foolproof, though. They carry with them interest rate risk: the chance that interest rates will rise after the bond issue, and thus, the price of the bond will fall. On the other hand, if interest rates drop, the prices of bonds will rise. The closer the bond is to maturity, the smaller the price fluctuation because (assuming no default) you will receive the full face value at maturity. Conversely, the longer until maturity, the more price fluctuations may occur, and the greater the risk of default.