FIN343 6 Discussion Question Responses
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R1
Bonds are similar to stocks but are structured a little differently. These differences can be very beneficial when we analyze the strengths and weaknesses of bonds compared to stocks. Each has its own place in a portfolio to serve different needs. Bonds are like loans, which gives them a little more security compared to stocks. The lowered risk comes with a lowered potential return though. As you get closer to retirement it may be a good idea to convert more of your portfolio to bonds to lower risk since you do not have the time available to overcome an economic downturn that would greatly reduce retirement accounts with high stock consistencies.
I think bonds are often overlooked in portfolios for most people, especially younger investors. The message we hear about investing is that we can withstand to have more risk because of our age group. This steers us to stocks that have a little more upside but come with extra risk as well. This is a good strategy, but a diversified portfolio does not contain only stocks. Bonds still have a place in diversified portfolios. This website highlights that bond prices are inversely related to stock prices. This means that in an economic downturn bond rates would increase. It is always a good idea to have a portfolio with inversely related assets to be diversified. If your entire portfolio melts in a recession it will be a long uphill battle to grow it back. Even with just a small chunk in bonds some risk can be minimized to find the “sweet spot” between risk and reward.
Parker, T. (2020, November 2). The Basics of Bonds. Investopedia. https://www.investopedia.com/financial-edge/0312/the-basics-of-bonds.aspx.
R2
Bonds are debt that is usually divided and sold to investors in smaller units. The different types of bonds consist of government, corporate, municipal, and mortgage bonds. Amongst these corporate bonds are typically seen as riskier than government bonds thus they usually have higher interest rates. Depending on the agency the rating scale may be a little different but the important fact to know is that the top four ratings are considered safe or investment grade.
Bonds are typically considered more conservative than stocks. Bond prices vary inversely with interest rates therefore if interest rates rise bond values fall. Investing in some form of bonds is a good way to stay diversified. They are generally priced at a face value of $1000 per bond but can be sold on the market at a discount or premium. If an investor doesn’t have the funds to directly buy a bond they can buy a bond ETF or mutual funds. Bonds pay a steady stream of interest called the coupon (similar to dividends) which are taxable. Bonds can be sheltered from tax in an IRA or other retirement accounts. Some local governments and municipalities also offer tax-exempt bonds.
R3
My first takeaway from this article is that bonds come in a variety of forms, with each type having its own level of risk. This article goes over the 4 primary categories of bonds; corporate, municipal, government and agency bonds. Just like different stocks can have varying levels of risk, so do bonds. Government bonds are considered the safest, as they are issued by the U.S. treasury. Corporate bonds are usually considered the riskiest. Risk is with bonds is essentially the possibility of the bond issuer defaulting. However, investment-grade bonds do not typically default (Parker, Tim). Researching the credit rating of the bond issuer will help make sound investment decisions.
The second highlight I feel this article does a good job explaining is the importance of bonds in a diversified portfolio. Particularly as one gets closer to retirement, bonds will become more important as they have less risk associated to them. On top of that, they typically pay a coupon that offers additional income to the investor. Even someone decades away from retirement can still benefit from having some bonds in their portfolio. During turbulent times in the stock market, bonds will remain more steady.
Parker, Tim. (November 2, 2020). “The Basics Of Bonds” https://www.investopedia.com/financial-edge/0312/the-basics-of-bonds.aspx.
R4
Anytime you are thinking of an investment it is important to understand how the investment works and the risks and rewards. Before investing the risk vs. reward analysis needs to suit your needs and portfolio. I think the most important question to get answered before purchasing a bond is the term and coupon rate of the bond. This can give you an idea of the quality of investment it is right away. These numbers can help you sift through the vast amount of bonds offered. Once you see one that meets your liking, then we need to ask the second question about the bond. Does this bond fit the needs of my portfolio? This is the deep dive into the bond. Does the maturity date match what you are looking for? Does the risk/reward ratio fit what you are looking for? There are multiple questions that are packed into the greater question of determining if it is the right one for you.
All investments require homework to be done and bonds are no different. Just because they are advertised as a safer option does not mean they are risk-free. They have their fair share of risk and it is a good idea to be aware of all the risks associated with a specific bond before investing.
Jark, D. (2020, December 8). Don’t Invest in Bonds Without Asking These 7 Questions. Investopedia. https://www.investopedia.com/articles/investing/022516/7-questions-consider-investing-bonds.asp.
R5
After reading the article I believe the first two questions are the most important; what is my risk tolerance? How risky is this bond?
What is my risk tolerance?
Without examining your own risk tolerance you can’t even start. I think most people have a general feeling of how risky they are but monetizing it might be a little bit trickier. Unfortunately, when examining this question it brings up even further detailed questions to come to the conclusion of how risky you really are. Not only do you need to examine whether you are risk-averse or not but you also need to know if you have the ability to take risks. There are actually risk profile questionnaires that you can fill out to determine a suitable investment strategy. Like the one, I found produced by Charles Schwab, located at the link below.
https://www.schwab.com/public/file/p-778947/investorprofilequestionnaire.pdf
How risky is this bond?
Once you know your own risk tolerance then you can examine the risk of each bond. Most bonds already receive credit ratings. The top four ratings are considered safe or investment grade and anything below BBB for S&P and Baa3 for Moody’s is considered “junk” bonds. These ratings take into consideration the inflation risk, interest rate risk, liquidity risk, and credit risk. Basically, the better the grade the less likely the issuer is to default on the bond.
Jark, D. (2016, February 25). 7 Questions to Consider Before Investing in Bonds. Retrieved September 11, 2017, from http://www.investopedia.com/articles/investing/022516/7-questions-consider-investing-bonds.asp
Parker, T. (2020, April 10). Bond Basics. Retrieved from https://www.investopedia.com/financial-edge/0312/the-basics-of-bonds.aspxr
R6
It was such a hard decision for me to only pick two of the questions. I think they are all important and they mesh well together. However, if I had to only pick two, I would choose the following:
What is my risk tolerance? I think it is important as an investor to choose your risk tolerance wisely. Are you at a point in your life where you have lots of money to spare or are you pinching pennies? You need to look at your current situation and your future situation. You must decide what you can afford to invest, or possibly lose. Will you need returns right away or will you be able to wait until retirement? Your age plays an important factor here. Do you want to take big risks or play it safe? You have to decide what types of investment vehicles you should choose and determine if they are right for your situation.
Can the bond’s issuer cover its debts? This question seems like a no-brainer to me. You want to make sure you are making a sound financial decision. Of course, you want to receive your money back. This reminds me of a time when I made a poor investment choice by signing a loan for someone to get a car. The situation got ugly and I took the car back. I had to sell it for less than what was owed. Never again!
ReferenceJark, D. (Dec 8, 2020) Don’t Invest Without Asking These 7 Questions. Retrieved from https://www.investopedia.com/articles/investing/022516/7-questions-consider-investing-bonds.asp
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