Are Bond Funds Right for You?

When you think about diversifying your portfolio, it’s important to understand your options. Let’s take a closer look at bonds, which can be used to help offset some of your risk and can offer greater stability.

What Is a Bond?

Bonds represent a debt of the issuer to its bondholders. When you buy a bond, you are essentially acquiring an IOU—the issuer promises to repay you the original amount of the loan when the bond matures, plus a stated rate of interest in the meantime. As with stocks, investors can invest in individual bonds and in bond funds. Bonds can be issued by a corporation, government or government agency. Corporate bonds are the riskiest type of bond, but usually pay higher interest than government bonds. Federal government bonds are considered the safest of all bonds because they generally are backed by the full faith and credit of the U.S. government. Bonds can provide a regular source of income. Also, bond interest rates are generally above interest rates on short-term investments (such as cash or stable value investments).

Bond Investing Is Not Without Risk

Bonds generally carry less risk than stocks, but they generally also offer lower long-term returns. One of the primary risks associated with bonds is that they may not keep pace with inflation. Some of the other risks associated with bond investing are described below.

Credit risk. This is the risk that the issuer of the bond won’t be able to make payments on time or at all. The credit risk of a particular bond depends on the type of bond and the financial health of the borrower. Federal government bonds carry the least amount of credit risk, but generally yield less than other types of bonds. Bonds issued by corporations are considered to carry greater risk. Note that not all corporate bonds carry the same degree of credit risk; risk will vary according to the financial health of the borrower.
Interest rate risk. Bond prices and interest rates move in opposite directions: When interest rates rise, bond prices fall, and vice versa. This is why bonds can be an appealing investment option, especially during a volatile or declining stock market. During economic downturns, bonds tend to perform well because the Federal Reserve generally lowers short-term interest rates to stimulate the economy. It’s important to know that changes in interest rates don’t affect all bonds equally. Bonds with longer maturities have a greater risk that prices will fluctuate and that the fluctuations will be greater. If, however, a bond is held until it matures, price fluctuations over the life of the bond matter less.
Call risk. With many bonds, the issuer has the right to redeem or “call” the bond before it matures. Bond issuers generally call bonds if interest rates drop significantly because they can offer new bonds at lower rates. If a bond is called before its maturity, you may not get back the full value of the bond. Because of this risk, callable bonds often pay a higher interest rate.

In Summary

Bonds may be right for you if you are looking for a more predictable source of regular income and a specific return on your principal investment. Bonds can be particularly attractive to investors who want less financial risk than that associated with other investments.

On the other hand, while bonds typically provide more predictable income than stocks and pay higher returns than stable value investments, it’s important to focus more on diversifying your overall portfolio rather than responding to market swings by making big or sudden changes in your allocation strategy. Don’t let the risks scare you from investing altogether—be it investing in stocks, bonds or cash equivalent investments. Keep your eye on your long-term goals and your options in mind.

This Investment Corner includes links to tools and information provided by organizations that are not associated or affiliated with Northrop Grumman. The tools and information provided by these organizations are not the property of Northrop Grumman, and Northrop Grumman is not responsible for their accuracy, completeness, or continued availability. You are solely responsible for the investment and asset allocation decisions you make pertaining to your personal savings and investments, including investments in the Northrop Grumman Savings Plan, Financial Security and Savings Program, and any other savings plans sponsored by Northrop Grumman.