How to Evaluate Bonds and Mutual Funds for Lowering Risk Factors
Understanding Differences in Investment Vehicles
When investing in bonds, an investor is owed money by a corporation or by a government entity known as a municipal bond. The bond typically pays interest or is offered at a “discount to face value” and offers the investor interest on an annual basis plus a repayment of principal when the bond matures.
Mutual funds represent a group of investors who have agreed to combine their money and have their money managed by an investment professional. In some cases, mutual funds may invest in equities, in bonds or in a combination of the two. Mutual funds offer no guaranteed rate of return nor do they guarantee the return of principal.
Both investment options do carry risks, however a mutual fund investment typically carries more risk than an investment in bonds. Bond investments may be made by multiple investors, but their investment is not part of a “pool” of investors, rather individual investors take on the investment on their own.
Mutual funds allow an investor to deposit funds and have those funds combined with other investors funds. Some mutual funds allow small investments ($100 in many cases) while a bond typically requires a larger up-front investment. Those who are considering investments in those areas should spend time evaluating bonds and mutual funds for potential risks that may be inherent to the investment.
Evaluating Bonds
People investing in bonds of any type will hear the term “coupon rates”. This term shows the percentage of interest that the bond will earn for its holder. By making a comparison of the coupon rates of various bonds, investors can identify bonds that yield the highest rates of return. When evaluating bonds, the investor should also review the maturity date which indicates when the bond can be redeemed.
Bonds often carry call provisions that mean that they may be subjected to an early pay-off. When early payoffs occur, the bond may entail loss of interest. The reliability and reputation of the issuer of the bond is critically important as the investor may lose the entire investment if the issuing company files for bankruptcy. All bonds are rated by class by companies like Moody’s and Standard and Poors.
Standard & Poor’s offers the following ratings for bonds: AAA, AA, A, BBB. EP. Each of these ratings carries a different meaning in terms of the risk that the investor is taking. Like S & P, Moody’s ratings are on a slightly different scale which is Aaa, Aa, A and Baa. There are also “junk bond ratings” that are offered by both companies. These “junk bonds” are typically for investors who are willing to take on higher risk for potentially larger rewards. These ratings include the credit worthiness of the issuer as well as the potential rates of interest that are paid for the bonds. The risk is calculated with the understanding that fluctuations in interest rates may impact the return that the investor may realize. Rate of return is an important aspect of evaluating bonds and mutual funds.
Evaluating Mutual Funds
When evaluating bonds and mutual funds for potential investments, investors must have a basic understanding of how mutual funds are rated. Companies like Morningstar evaluate mutual funds based on previous returns to investors as well as the level of risk that the fund is undertaking. Mutual fund investments do carry risks and it is important that these risks are understood by the investor. There is always a potential that an investor will lose their entire investment.
Mutual funds offer a wide range of funds including stock funds, bond funds and a combination of the two. Mutual funds are classified as “closed end funds” or as “open end funds”. Mutual funds also may carry a sales charge that is known as a “load”. Some funds will require these loads be paid up front and others will be paid when the investor liquidates the fund. In some instances, mutual funds will have a graduated load that decreases over time and may be eliminated completely over the life of the investment.
For many investors, mutual funds offer a chance to diversify their holdings without having to purchase individual shares of stock. This may help a small investor have more buying power than they would if they were to invest in individual companies. Mutual fund managers are paid based on the performance of the funds that are managed and all investment fees must be disclosed in the offering documents which are known as a prospectus. Investors are strongly urged to review these documents carefully and should ask questions if they are uncertain about terminology that might be used.
Investors who are interested in evaluating bonds and mutual funds should pay careful attention to information that is publicly available. While past performance is never an indication of future performance, it can help an investor make a better decision. Whether an investor chooses to invest in bonds or mutual funds may be a function of how much money they have to invest at the time. Investors who are concerned about the potential loss of principal may feel more comfortable investing in bonds while those with smaller amounts to invest may find that a long-term investment in mutual funds is more beneficial.
Resources
Sources:
Bond Ratings
Mutual Fund Ratings
Securities and Exchange Commission:
- Bond Funds
- Callable and Redeemable Bonds
- Beginners’ Guide to Mutual Funds
- Mutual Fund Prospectus, Tips for Reading One
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