Investing Basics: How Do Bonds Work?

Bonds and Interest Rates

The Relationship Between Bonds And Interest Rates

Most people have their 401K or other retirement plan invested somewhere so it can be working for them and earning a return over time. When it comes to investments we all hear the terms stocks and bonds used everywhere.

Both are complicated but more people understand the basics of stocks than bonds. Here is a basic look at the key bond concept of the relationship between bonds and interest rates.

bonds

A seesaw is a pretty good analogy for the way that bonds work, as interest rates and bond prices move in opposite directions. When rates go up, prices go down, and vice versa. This makes perfect sense when you think about it. Assume you buy a 10-year bond that pays, say, 2.5% annual interest, and interest rates rise soon afterwards so that new 10-year $1,000 bonds are paying 3%. Do you think anyone would buy your 2.5% bond for $1,000 when they can get a new bond paying 3% for the same price? Of course not. The price of your bond would have to fall to compensate the buyer for receiving smaller interest payments.

But many people don’t understand the inverse relationship between bond yields and prices. When more than 26,000 adults were asked as part of a 2012 financial literacy survey by the FINRA Investor Education Foundation what will happen to bond prices if interest rates rise, only 28% answered correctly that prices would fall

The U.S. government’s “full faith and credit” guarantee on Treasury securities ensures that you’ll receive all scheduled interest payments and repayment of principal. But if the price of a Treasury bond you own drops because interest rates have increased and you sell while the bond’s price is below what you paid for it, you will realize a loss.

Duration is a gauge of how sensitive a bond is to changes in interest rates. If a bond or bond fund has a duration of, say, seven years, its price will drop approximately 7% for each one-percentage-point increase in interest rates and rise by approximately 7% for each one-percentage point drop in rates. You can find the average duration of a bond fund by plugging the fund’s name or ticker symbol into the Quote box at the top of any Morningstar.com page. The figure will appear both on the Quote page and in the Portfolio tab. – Time Money

Individual Bonds Or Bond Mutual Funds – Which Is Better?

When buying stocks you can buy shares in individual stocks or mutual funds. There are pros and cons to each. The same is true when buying bonds. You can buy individual bonds or buy into a bond mutual fund. Here is a discussion of how these work and some pros and cons of each.

Unfortunately, while online stock brokers have made stock investing child’s play over the last 10 years, bond investing has been slow to catch up. In fact, on many online broker sites, online bond platforms don’t even exist. That’s made the world of individual bond investing pretty murky.

You know that a certain percentage of your portfolio should be allocated to bonds (say 40% if you’re in your 40s), but you’ve probably relied on bond mutual funds to do that. And that’s not a bad thing: Bond mutual funds let you own bonds from hundreds of companies with only a small investment. They also have professional managers who can do research into bond investments for you. But bond funds also have one, significant disadvantage to owning individual bonds.

When you buy a bond, you know:

exactly what your interest payments will be,
when you’ll get them, and
when you’ll get your initial investment back as long as the company doesn’t default.
The prices of bond funds, on the other hand, move up and down just like any other mutual fund. If you need your money on a specific date, you’ll have no idea what your mutual fund will be worth. That can make investing in individual bonds preferable for people who need a specific amount of money at a specific time.

For example, you might need to make a $40,000 tuition payment for your college-bound 16-year old in exactly two years. Invest $40,000 in two-year individual bonds, and you’ll have that money back when you need it (as long as the company doesn’t go bankrupt). But invest it in a bond mutual fund, and who knows what it’ll be worth when it’s time to withdraw? Although bond funds typically don’t go down by large percentages, 2008 taught us that that isn’t always the case.

If you are saving for a time-sensitive goal (or need a stream of retirement income) and think you might be a candidate for investing in individual bonds, here’s a primer on how they work…

…For investors just starting out or who have a small amount of their portfolios to devote to bonds (less than $100,000), the answer is, “Don’t!” Just stick with a no-load, low expense mutual fund until you’ve amassed more.

But investors who do meet that criteria can use bonds to create a predictable income stream — something that no bond fund can guarantee. – Get Rich Slowly

Do you have part of your portfolio invested in bonds?

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