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Understanding bond investing: It’s a matter of balance
It’s a common misconception to think of bonds as “plain vanilla” investments that are appropriate only for certain types of people, such as financially conservative retirees. But, in reality, bond investments may have the potential to add stability to a portfolio and help reduce overall investment risk; regardless of your age or financial outlook.
What is a bond?
Bonds are investment securities issued by corporations or governments to raise money for a particular purpose. Basically, bonds are the “IOUs” of the business world. There are different types of bond funds, each with varying levels of risk and return potential. Generally speaking, the higher the risk, the better the return potential. For example:
• Government bond funds invest in bonds issued by the US Treasury. Historically, they have been among the strongest types of bond investments. However, they typically offer lower returns than other bonds.
• Corporate bond funds invest in bonds issued by private companies. They can range from “investment grade” (safer, lower return potential) to “below investment grade” (riskier, higher return potential).
Know the risks
Bond funds are subject to several types of investment risk, including:
• Market risk: like stock prices, bond prices move up and down. However, such fluctuations tend to be less severe in the bond market.
• Interest rate risk: When interest rates rise, bond prices may fall, and vice versa.
• Inflation risk: If the return on a bond fund does not outpace the rising cost of living, the purchasing power of your investment could decline over time.
Despite these risks, investors of all ages may potentially benefit from putting some money in bond funds. Because bond funds tend to respond to market influences differently than stock funds, they may help balance out the risks associated with stock investing. In addition, lower-risk bond funds, such as government and investment-grade corporate bond funds, may help protect some of your money from losses during turbulent times.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk.
Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer.
Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bond funds and bond holdings have the same interest rate, inflation and credit risks that are associated with the underlying bonds owned by the funds. The return of principal in bond funds, and in funds with significant bond holdings, is not guaranteed.
Morgan Stanley, its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Individuals should consult their personal tax or legal advisors before making any tax or legal related decisions. Article by Wealth Management Systems, Inc. and provided courtesy of Morgan Stanley Financial Adviser.
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