Factors to Consider When Selecting a Bond

March 15, 2023 Beginner
How can investors decide which bond best suits their portfolio? Consider these factors.

Investors looking to add bonds to their portfolios face a trade-off: The safest government bonds typically pay very low yields, while higher-yielding corporate bonds are more prone to default.

As a rule, high-yield corporate bonds come with more risk. On the other end of the spectrum are U.S. Treasury bonds, which are generally considered to be one of the safest investments around.

So how can investors decide which bonds to add to their portfolios?

Selecting a bond: Factors for investors to consider

Three popular types of bonds include corporate, municipal, and U.S. Treasury. Of the three, high-yield corporate bonds generally represent the most aggressive investment and Treasury bonds the least aggressive.

The difference in the credit quality of the bond issuers certainly plays a role, but other factors can influence bond yields as well. A company issuing high-yield corporate bonds typically won't have as strong a track record or as strong financials as a firm that can issue an investment-grade corporate bond. Investment-grade bonds are rated "BBB" or better as designated by Standard & Poor's.

During times of uncertainty, the difference in investment-grade bonds versus lower-rated bonds becomes increasingly obvious, which is why it's important for investors to do their own research when considering which bonds to add to their portfolio.

In addition to prevailing interest rates, the yields for a municipal bond depend on the financial condition of the issuing authority and whether the bonds are insured. With various exceptions, interest paid on municipal obligations is generally not subject to federal taxes. U.S. Treasury bonds, besides being considered safest from default, aren't taxable at the state or local level. As previously mentioned, corporations issue bonds, and their yields depend on the company's perceived financial strength.

During times of market and economic uncertainty, investment-grade bonds can quickly be downgraded, and their value can fall dramatically, which is why it's important to know what you're buying.

But it's difficult to know for sure which corporations or municipalities can weather a prospective financial storm and come out in good shape.

Low interest rates help drive decisions

Aggressive investments, such as high-yield bonds, aren't for everyone. But during low-interest rate environments, their yields can look lofty.

Still, chasing yield is never a good idea without understanding that it comes with added risk. Look at the rating and read the ratings agency reports, and if you do go down the credit scale to obtain yield, understand the risk you're taking.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. The government "guarantee" applies to the payment of principal and interest on the underlying securities in a bond fund and not to shares of the fund itself.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.