The stock market is no place for the shy investor who prefers a low risk-return profile. The only certainty is that not even a 1,000-point pandemic nosedive can keep it down. The market’s steady comeback was expected, but experts were blind-sided by bond yields.
Also, the recovery path is still uncertain. Even with increasing optimism that the U.S. economy will take off in 2021, many have voiced fears about the risk of inflation. For example, the $1.9 trillion federal injection into the GDP could have the undesirable effect of overheating consumer spending.
Fed Chair Jerome Powell recently told a Senate committee, “The economic recovery remains uneven and far from complete, and the path ahead is highly uncertain.” That dovish assessment might prompt many investors to hold onto their corporate and treasury bonds.
A bond is really just a loan taken out by a company or government organization. Rather than going to a bank, the organization gathers money from investors who buy the bonds. The company, in exchange for the investor’s capital loans, pays an annual interest coupon. That annual payment is an interest rate paid as a percentage of the face value of the bond. Those payments are usually annually or semiannually.
So, unlike stocks, bonds can come with a variety of legal restrictions and debt agreements, known as indenture. Each company bond issue is different, and there are important features to look for when investing in a bond:
Maturity: The date when the principal amount of the bond is paid to investors and the life of the bond expires. Bonds come as short-term, medium-term, and long-term varieties. Short-term bonds will mature within one to three years. While medium and long-term bonds can yield coupons over periods of ten years or longer.
Secured vs. Unsecured: A secured bond has a pledge that the specific assets will go to bondholders if the company cannot repay its obligations. An unsecured bond is not backed by any promises or collateral.
Liquidation Preference: If the company fails, it must sell off its assets and pay investors in the order specified in the bond terms. First priority would be banks, followed by so-called junior or subordinated debt holders. Where the bond purchaser falls in that unfortunate pecking order would, again, be specified in the bond indenture terms.
Taxation status: Most corporate bonds are taxable, but some government and municipal bonds are tax exempt, and the capital gains on those public issues are not subject to taxation.
Callability: When a bond has a call provision, it could be paid off at an early date. This is at the option of the company and could be done when it chooses to call in its bonds when interest rates permit them to borrow at a better rate.
So, bonds, like any other investment, come with some risks. When the Fed raises interest rates, bonds become less competitive with stocks. Of course, there is always the risk of default on the company’s debt and its inability to make bond principal payments when due.