Conventional thinking says that bonds are a buffer and offer diversification from the stock market, and many people don’t realize that bonds can lose value, too. A bond is a debt instrument. When you buy a bond you are loaning your money to the government or a municipality or a corporation. In return for the loan, the issuer of the bond promises to pay a fixed interest rate for a specific period of time. Then at the end of the term, the issuer is to return your money in full. This is a simple description of a bond. There are complicated hybrids, but this is a bond in a nutshell.
It is important to remember that the promise to pay is only as good as the credit worthiness of the issuer. The U. S. government is considered to be very safe, as close to risk free as there is, because U. S. government bonds are backed by the full faith and credit of the U. S. government. The U. S. government has never defaulted in its history because it can tax its citizenry to raise the capital it needs.
The credit worthiness of each state and the many cities and counties across the country varies greatly and it is important to know from whom you are buying when you buy municipal bonds.
Corporate bonds are rated as to the creditworthiness of each corporation. The higher the credit rating, the lower the interest the issuer pays. A high yield bond is a bond issued by a corporation with a low credit rating and it pays a higher than market rate of interest because of the risk the purchaser is taking.
Investors can hold the actual bond or buy shares of a mutual fund which invests in bonds. When you buy a bond directly, you receive your interest payments for the term of the bond and then at the end you receive back the money which you invested. If the issuer defaults then it is possible for the interest to stop and for you to lose part or all of your original investment. This is the worst case and it is not supposed to happen, but it does sometimes.
Generally a bond mutual fund doesn’t mature. The manager trades bonds inside the fund and it pays shareholders interest based on the interest received from the bonds in the portfolio. The share price of the fund fluctuates with the bond market and with an open-ended bond fund there is not a point in time when the fund matures. Your value is whatever the market price is at any given time. This is the type of bond investment in most 401k plans. There are closed end funds which are designed to mature, but that is outside the scope and purpose of this article.
The price of a bond and shares of a bond fund fluctuate with moves in interest rates. When interest rates go up, the price of the bond goes down. And the reverse is true. With interest rates at historic lows right now, the only way for rates to move is up, so we can expect the value of bonds and bond funds to decline when this happens. It is important for investors holding bonds and bond funds to realize they need to keep an eye on interest rates because an increase in rates will be reflected in lower bond values.
If you think your bonds are safe and you cannot lose money in bonds, think again. In 2008 when the stock market declined, bonds declined too so this attempt to diversify did not protect investors from that decline. Cash was the only safe place to be in 2008. Before the next downturn comes, have a risk management plan for your bonds just as you do for your stocks and remember, diversification is not risk management. The steeper the decline in stocks the more correlated other asset classes become and everything can go down.
If you would like to discuss this topic further or you would like an analysis of the risk in your portfolio, call us at 540-772-4545.
Written by Connie C. Guelich, CFP, AEP, CLU, ChFC. This represents our views at the time of this writing, and it is subject to change. It is not intended to be personal investment advice. If you would like to discuss your own account, please don’t hesitate to call us. We are here to help and welcome your call.