Bonds and bond funds are the way to go if you want to earn higher interest rates according to your neighbor who knows everything. Bond investing is simple if you invest money in bond funds because they do the investment management for you, he points out. Since interest rates are pathetically low at the bank, why not take his advice?
People invest money in bonds and bond funds to earn a higher income in the form of interest or dividends (bond funds). That’s the advantage of bond investing. On the other hand, your not-real-savvy neighbor neglected to tell you the other half of the story. Bond investing always involves risks. Even the safest bond investment in the world, U.S. Treasury bonds, is subject to interest rate risk.
Interest rates are at or near historical lows, which makes it tempting to chase higher interest income. A bond investment pays a higher rate of interest than you can get at the bank. But here’s the problem, the risk factor most folks know little about: a bond has a fixed coupon rate (interest rate) that never changes for the life of the security.
All bonds have a maturity date … they mature. At that time the owner is paid back his or her principal, usually $1000. Example: You buy a $1000 bond with a 6% coupon rate that matures in the year 2020. This investment pays you $60 per year in interest for as long as you own it. In the year 2020 the issuer (a government entity or corporation) pays you back the $1000. It’s a done deal, the bond no longer exists.
The interest rate of 6% is fixed. But the price or value of your investment is not. Bonds trade just like stocks do. What happens if interest rates go up across the board? Well, banks will raise the rates they pay their customers. And new bonds will be issued by the government and corporations WITH HIGHER AND HIGHER COUPON RATES as interest rates continue to rise.
Interest rate risk: what happens to the value or price of your 6% bond when new issues are paying 7%, then 8%, then 10% and so on? Your bond’s price (value) will fall. Who’s going to pay you $1000 for this investment that only pays $60 a year in interest when they can go out and buy a new issue that pays $70, $80, $100 a year?
In the above scenario bond investing is a losing proposition. If you own bonds when interest rates are moving up significantly your interest earned will pale compared to the loss of value your investment suffers. If this trend continues for several years, your brokerage or mutual fund statements will show losses for several years.
IF you had invested in an individual bond issue in the above scenario (like our 6% example) you could always look forward to your investment maturing and to getting out with $1000 at maturity.�But what if you took your neighbor’s advice and you did invest money in a bond fund that held a large and diversified portfolio of securities similar to our 6% issue maturing in 10 years or so?� Bond funds don’t mature.
What would happen to your bond fund investment as interest rates continued upward? Well, many investors, like your neighbor and his friends, would cash in their bond fund shares to cut their losses. This means the fund must then sell bonds in their portfolio (likely at a loss) to raise the cash to pay them. As this trend continues bond prices continue to fall, along with the value of bond funds in general.
If and when interest rates eventually stabilize at higher levels, there won’t be many happy campers who took your neighbor’s advice. Those who cashed in took a loss. Those who held on are hoping for a miracle.
The bond market will then heal only when savvy investors seize the day and bet that interest rates are done going up. At that point they buy bonds and send prices up. That’s how smart investors really make money bond investing.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.
Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com
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