Many people are under the impression that bonds are usually safer investments than stocks because you don't lose your principal. However, that is not always the case, especially if you buy bonds in a bond fund. Bonds can be just as risky, and even more risky, than stocks, if not researched thoroughly. Recently, I wrote about creating a Diversified Bond Portfolio to avoid this, and I got a lot of feedback about how now is not a good time to buy bonds because interest rates are so low (thus prices are very high), and so you could lose money. And that is the case, if you buy a bond fund.
Buying Individual Bonds
A bond is debt issued by someone, usually a company or government. It is essentially an IOU with interest. By buying a bond, you are lending that institution money for a specified period of time.
For example, this week, GE is offering a series of bonds with the following statistics:
Maturity: 7/15/2020
Coupon: 4.050
Price: $1,000
Coupon Frequency: Semi-Annually
Callable: No
What this means is that you would lend GE $1,000 until 7/15/2020. In exchange, GE would pay you interest of 4.050% semi-annually. If a bond is callable, it means that GE could redeem the bond early, which in this case it cannot. At maturity, you will receive your entire principal back.
You can sell bonds prior to maturity, but you could gain or lose based on current market conditions for that bond (just like a stock). However, the bond market is predictable in that people want the following: safety, coupon amount, price. So, since GE is highly rated, if the coupon it offered on future bonds went down, this bond above would go up in price since it would be more valuable to investors. If you hold a bond to maturity, none of this applies.
This is what bond traders do. And this relates directly to bond funds.
Buying a Bond Fund
A bond fund is simply a fund that invests in many different bonds. Many funds target bond sectors (just like stocks), so would focus on US Treasuries, or municipal bonds. And since bond funds are always buying and selling bonds, you can lose value. Very rarely do bond funds hold bonds all the way until maturity. That would lock up capital for a long period of time, and most funds simply can't do that.
In fact, many bond funds actually have much higher turnover than stock funds. Turnover is the percentage of the portfolio sold during the period (usually annually). As a result, bond funds also have higher expense ratios than stock funds.
So, why would you lose money on your bond fund if interest rates rose? Because the basket of bonds would drop in price, and the fund would actually sell those bonds and buy into new bonds with higher interest rates. Unlike owning a bond by itself, which you would get your principal back at maturity, a bond fund will continue to sell to find the best coupon at the time.
So, if you invest in a bond fund, make sure you fully understand the bond fund's performance over time.
The Balance
It is tough because most investors don't have the capital to build a diversified bond portfolio outside of a bond fund. Most bonds require an initial investment of $1,000 each to start. And this gets you one bond. A bond fund may be the best way to go. However, make sure that you read the prospectus and understand what the fund managers are doing with the portfolio. And, finally, understand that bond prices go down when interest rates go up, and so you could lose money in the near term since interest rates are at all time lows.
What are your thoughts on buying individual bonds vs. bond funds?
Interesting how that perception persists. Bonds can be just as, or more risky than equities. Bonds can also be wiped out entirely if the issuer defaults, as has been the case in the past with sovereign debt. Good post.
Yes, I think a lot of people forget about bonds being defaulted on – yet it is in the news everyday with the crises in Europe and the debt ceiling crisis at home.
One of the best intro on bonds and bond fund Robert. Very well done!
Tweeting it!
My husband has always been a fan of index funds and I would have to agree. Allowing your money to be diversified is the safest place to go. I would think the same would be true for bond funds.
It’s funny how you always hear people talk about the “safety” of bonds when they are,a s you pointed out, just as risky as stocks. These days, it’s hard to find an invest opportunity without legitimate risk. I guess that’s the main reason it’s so important to maintain a diverse portfolio. Thanks for breaking this down in plain terms!
You’re absolutely right on the bond funds, they are as risky as stocks. As you mentioned, bond funds may lose value because of excessive transactions (buy and sell) and these are common to any mutual funds as well.
I really don’t think most investors really understand how interest rates will affect their bond positions
I don’t believe they do. Otherwise, they would realize that they are buying into a high right now.
I really enjoy your posts related to investing. I am in search of Investing 101 information that is well written and easy to understand. I think I found my source. Great post!
Nice post. I think most folks are looking at the volatility of stock prices when they say that stocks are more risky than bonds.
Of course that volatility differs among stocks, but in my experience, stock prices (particularly on things such as metals) have roller coasted by 50 -60 dollars a share in as little as a month, while bond fund share prices tend to stay within a few dollars range.