1. Know what you are buying As with any investment, it is important to understand how bonds work before you invest. The eZonomics video How bonds work explains the basics, including how bond holders loan money and make a return through regular payments (known as coupons).
2. Understand the different types of bonds Bonds types include corporate and government, with different levels of risk. Some bonds are designed to protect against inflation. Like shares, bonds can be bought either as individual investments or in bundles through a collective instrument (such as a mutual fund). Some pay coupons more frequently than others - and different bonds offerdifferent rates. The lengths of time bonds last (known as its maturity) may vary. Such factors are important when planning investments.
3. Know why you are buying Bond holders may be investing to put money aside for a particular future event (such as retirement or paying for a child's education) and others may use bonds as a way to diversify their investment portfolio. Bonds are particularly useful for saving for a future event as, if we exclude the possibility of default, they guarantee to pay a certain amount at a known date.
4. Be aware of the risks While bonds are generally considered less risky than shares and property, there is still a risk that investors will lose money. This is particularly the case if the exposure to bonds is obtained by buying units in a mutual fund rather than an individual bond. When interest rates rise, bond prices fall – although there is good evidence that many people are not aware of this. A 2009 US survey found only 21% of respondents knew the relationship between bond prices and interest rates.
When one owns a single bond, it can be held till maturity and the original amount invested will be repaid. However, if one has an exposure to a bond fund, there is a greater chance that an investor will lose money if interest rates rise because the fund will hold many bonds and it is improbable that they will all mature at the date an investor needs to sell.