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When Bonds Go Bad

Bonds are a popular fixed income investment for seniors who want to reduce their risks and create a plan for predictable income throughout their retirement. But bonds aren’t without risk. Understanding the risks posed by bonds is an important part of protecting yourself against them.

 

What Are Bonds?

 

A bond is a debt instrument. It’s essentially a loan you make to a company or municipality. In return for the loan, the bond issuer agrees to make set interest (also called coupon) payments until maturity, at which time they pay back the bond principal.

 

Two Ways Bonds Go Bad

 

The first way that a bond can go bad is when the bond issuer defaults on payments. This doesn’t happen very often when you’re choosing highly rated bonds—but it is still a risk you need to consider.

 

The second way bonds can essentially go bad is when you’re locked into a low-coupon rate bond as new issue rates rise. When this happens, your money is tied up in a lower-performing instrument until maturity—unless you sell the bond at a discount to par. When you do this, you sell the bond for less than you bought it for in order to give the buyer an incentive to buy when they could just as easily invest in a new issue with a higher rate.

 

Hedging Against Bond Risks

 

There are a couple of things you can do to help protect your portfolio in the event that you’re exposed to bad bonds:

 

  1. Diversify bond issuers. When you invest the majority of your fixed income capital into one or two bonds, you increase the risk that you will lose money to default. Instead, spread that capital over several issuers to decrease those odds.

 

  1. Use bond ladders. A bond ladder is a way of structuring your bonds so that you have many different maturity dates. That way, you’ve always got bonds maturing so you can take advantage of increasing interest rates and you’ve also got bonds invested longer term in the event that interest rates drop.

 

 

 

 

 

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