Michael Ralby on Factors of Investing in Bond Funds

Most investors are well aware of how bonds and bond funds fit into an overall investment strategy. Unlike growth investments, bonds are often designed to provide stable income and a hedge against the more volatile prospect of a stock position that may see its price change dramatically from day to day and week to week.

That said, bonds and bond funds are not without risk. As the most recent financial crisis demonstrated, bonds can lose value, lose their ability to produce income and go to zero value just as easily as stocks or any other investment. It is incumbent upon investors to understand the unique risks posed by bonds so they can be strategically incorporated into a long-term investment plan without exposing the portfolio to unnecessary risk.

Credit Ratings

One of the pieces of good news to come out of the 2008 housing crisis was the fact that ratings agencies are likely to be held to a higher standard in the future. This means that the credit rating and investment-worthiness of any bond should be at the top of any investor’s priority list when evaluating which funds to choose. Not all bonds are created equal. Non-AAA issues, for example, can be good candidates for investment provided the fundamentals line up properly.

Fund Expenses

With many government bonds, for example, offering much lower interest, it is vital any bond fund investment take expenses into account, lest all the gains be consumed by unexpected fees. The advantage to bonds is they provide a predictable path for income, so making certain there is at least some kind of positive return isn’t as difficult or speculative as performing the same evaluation of a stock fund.

Bond Types

Investors should always keep in mind the fact the non-government bond market is limited by how much borrowing corporations and partnerships need to do. When the economy is on an upswing, companies may borrow heavily to expand, or to leverage existing investments in new product lines or expansion. But the reverse is also true. If the market for private bonds contracts, the performance and expenses of any given fund could change dramatically. It is important to keep this in mind, especially during economic transitions.

Bonds and bond funds are a great way to hedge risk in the stock market. But they have their own risks and management challenges. Understanding the market is the first step to success.