Skip to comments.Bonds Are Confusing
Posted on 12/13/2012 8:04:26 AM PST by Kaslin
Dear Carrie: I'm 37 and have been building up my IRA. So far, I've been focused on stocks, but I've read I should have some bonds, too. However, bonds seem really confusing and I've heard they can be risky. Can you help me get started? --A Reader
Dear Reader: You're right that bonds can be both confusing and risky -- and especially so in today's economic environment. That's because bond performance is directly related to interest rates, and today's rates are about as low as they go. But there's a lot more to understand about bonds, so let's take a look at some of the basics. Then we can get into whether or not you want to consider buying them.
What is a bond?
A bond is like an IOU. You lend a borrower money and, in return, the borrower promises to pay you interest, as well as return your money (principal) at a set date (maturity).
As an example, let's say that you purchase a bond with a face (or par) value of $1,000, interest of 5 percent, and a maturity of 10 years. Because most bonds pay interest on a semiannual basis, you can expect to receive two payments of $25 a year. Then in 10 years, when the bond matures, you will get your $1,000 back, assuming the borrower (bond issuer) can make good on its promise.
There are many different bonds, but in the United States, you can divide them into three primary types. Think of each type of bond as a different type of borrower.
-Corporate bonds are issued by corporations seeking to raise capital.
-Municipal bonds, also called "munis," are issued by state or local governments and government agencies. Oftentimes, the interest is exempt from federal and state taxes.
-U.S. Government bonds are issued by the U.S. Treasury. These are broken down into Treasury bonds (10- to 30-year maturity), Treasury notes (2- to 10-year maturity), and Treasury bills (90-day to 12-month maturity). In addition, TIPS, or Treasury Inflation-Protected Securities, offer a rate of return that is linked to inflation
Although bonds are generally less volatile than stocks, bonds carry their own set of risks. Bonds with longer maturities tend to pay higher rates -- as do bonds that are higher in risk. If you're thinking about buying bonds, two of the most important risks to understand are credit (or default) risk and interest-rate risk.
Credit risk is the likelihood that the borrower will be able to pay you back. It just makes sense that if a borrower is less likely to repay you, you'll require a higher rate of return to compensate.
Of the primary bond types, U.S. government bonds, which are backed by the full faith and credit of the U.S. government, are considered to be the safest and usually offer correspondingly lower interest rates (all else being equal); corporate bonds typically involve more credit risk with higher interest rates; munis generally fall somewhere in the middle.
Credit ratings issued by ratings agencies are one way to help evaluate a bond's credit risk. For instance, Standard AND Poor's rates what they consider to be "investment quality" bonds from AAA (highest quality) to BBB. Once again, lower-rated bonds generally offer higher returns as an incentive to buy them in spite of the higher credit risk.
When interest rates rise, bond prices fall, all else being equal. For instance, if interest rates rise, your 5 percent bond will be worth less than $1,000 in the open market (you would have to sell it at a discount). If interest rates go down, on the other hand, it will be worth more than $1,000 (you could sell it at a premium).
The potential for the bond's value to fall when interest rates rise is what is known as interest-rate risk. It may not be important to you if you plan to hold your bond to maturity (at which point you will expect to get your principal back), but can be significant if you want to sell early or if you invest in bond mutual funds. Note that in today's low-interest rate environment, there is the potential for considerable interest-rate risk.
Should you buy bonds now?
On the positive side, bonds are often considered a good way to help balance the volatility of stocks. Also, bonds are designed to produce income, which can be especially significant for older investors.
Because bonds have a stated maturity date when principal is expected to be returned, they can be useful for a known future expense, such as buying a home or paying for college tuition. But if you intend to use bonds for this purpose, only consider those that are thought to have very low credit risk, such as U.S. Treasury bonds.
However, a young investor who is comfortable with stock market risk may not have any bonds at all. Young investors with a more conservative investing style could reasonably have a small portion of their portfolio in bonds. It really gets down to individual feelings about risk, as well as your goals.
Bonds vs. bond funds
If you decide to invest in bonds, a bond mutual fund or exchange-traded fun (ETF) is one way to get started. It can be tough to purchase a diversified bond portfolio with less than $10,000. However, a bond fund or ETF can help provide that diversification with much less money.
The risk in a bond fund is that its value will go up and down with the market, which can be especially painful when interest rates rise. That's because unlike bonds, bond funds have no set maturity date, so you may have to sell at a loss when you need your money back. If you have a long time horizon, the income generated by the fund could balance that price fluctuation.
As a next step, I suggest you do more research. Go to a website that lets you compare bond funds. Look at types of funds, maturity and performance over time. Interest rates have more room to go up than down from here, so I'd suggest focusing on short- and medium-term funds.
In this low-interest-rate environment, I wouldn't feel pressured to buy bonds right now. Instead, you could take some time to think carefully about your goals and possibly talk to an advisor about how best to achieve them. That way, if and when you do decide to venture into the world of bonds, you'll feel more confident that you're making informed choices.
Investment return and principal value will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Fixed-income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Treasury-Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
Good investment advice.
Thank you for posting this
The funny remarks not withstanding many do not understand bonds
and this explanation was one of the best i’ve seen.
there will be Freepers who will benefit from this.
I would wager what you read said you should diversify, the carnal investment rule for the layman and the professional.
I was told to avoid all "paper instruments" at this time in our world history. Apparently, I need to have investments in "physical things"...land, buildings, gold/silver, antique cars, gun collections, bottles of whiskey, etc. Sounds reasonable, but what do I know....I'm certainly no financial wizard. Anyone care to expand?
Just don't get into any shorts or leveraged positions.
Bonds sure are confusing. Tell that to the GM bondholders who got screwed by Obama. They all thought they had rights until they got hosed.