The skinny on bonds
(MoneyWatch) Legendary investors such as Peter Lynch and Warren Buffett have warned investors not to make purchases of assets that they don't understand, but it's doubtful that either of them meant that you should not educate yourself about one of the main asset classes available to investors.
A recent report from the SEC and the Library of Congress found that "low levels of investor literacy have serious implications for the ability of broad segments of the population to retire comfortably, particularly in an age dominated by defined-contribution retirement plans." In other words, if you don't understand investment basics, you are going to have a rough go of it when it comes time to planning for retirement. So for all of the bond-phobes out there, here's what you need to know.
When you buy a bond, you are actually lending money to an entity, whether it's the US government, a state, a municipality or a company. The bond covers a set period of time -- from 30 days to 30 years -- at a fixed rate of interest. (The term "fixed income" is often used to describe the asset class of bonds.) At the end of the term, the borrower repays the obligation in full.
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Bond prices fluctuate based on the general direction of interest rates. Here's how it works: if you own a 10-year US government bond that is paying 5 percent, it will be worth more now, when new bonds issued by Uncle Sam are only paying 1.6 percent. Conversely, if your bond is paying 1.6 percent and your friend can purchase a new bond paying 5 percent, nobody will be interested in your bond and the price will fall. That's why bond prices move in the opposite direction of prevailing rates, regardless of the bond type. So, if you hear that interest rates are on the rise, you can count on your individual bond or bond mutual fund dropping in value.
Although often hailed as "safe," bonds present investors with a number of risks, in addition to the interest rate risk described above. One is credit risk, which is the risk of default or that the entity does not pay you back. That is a pretty low risk if the entity is the US government, but can be a high one if it's a company or town that is in trouble. Another risk is inflation. Even if the bonds are paid in full, the promised rate of interest can turn out to be worth less over time due to inflation, which eats into the fixed stream of payments.
Many investors prefer owning a bond mutual fund versus an individual bond because funds offer broad diversification at a low cost; and they offer the convenience of being able to buy or sell shares at any time and at any quantity. Additionally, there is no easy way to reinvest interest payments into individual bonds. However, individual bonds offer the certainty of a defined maturity date, which provides an investor with more control over the investment.
Because bonds deliver a consistent stream of income, many investors view them as the perfect retirement vehicle. But as mentioned above, bond prices can fluctuate. The worst calendar year for the broad bond market was 1994, when it returned -2.9 percent due to an unexpected upward shift in interest rates (prices dropped more, but the interest from bonds helped defray some of those losses). Just this summer, the 10-year treasury market saw big price drops. In the three weeks from the July 25 peak to August 16, prices tumbled about 8.5 percent and yields went to 1.82 percent from an all-time low of 1.38 percent. So yes Virginia, you can lose money in the bond market, though the magnitude of the fluctuations tends to be smaller than those in stocks and other riskier asset classes.
Bonds are an important type of investment that can have a stabilizing effect on a diversified portfolio over time, but it's imperative that to understand how they work so you can prepare you for their ups and downs.
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