Ever wonder why prices of bonds and bond funds do what they do when interest rates fluctuate? Here’s what you need to know about how bonds work — as well as what you may think you already know that’s wrong.
When you buy a bond, you are merely lending money to a government entity or corporation. Assuming there is no default, they will pay you interest for a period of time and then give you back your principal. Bonds have two main risks: default risk and interest-rate risk.
If you lend money to a company that then goes into bankruptcy, you generally get back either nothing or far less than your original investment, such as what happened with General Motors. Even large companies that were once financially secure can go bankrupt, and so can municipalities. The U.S. government can print money, so U.S. government debt has the lowest default risk.
Bond prices move in the opposite direction of interest rates. So when rates rise, the underlying value of your bond will fall — and that’s called interest-rate risk.
Let’s look at a simple example. Say you buy a $100 bond paying 4 percent for 10 years. The company is obligated to pay you $4 a year ($40 over 10 years) and then, on the 10th year, it must pay back your $100 principal. Now let’s say your timing was bad and, right after you bought the bond, rates shot up by 1 percentage point to 5 percent. You are still getting the $40 interest you bargained for, but the bond is no longer worth $100 since other investors now want $50 of interest over the next decade. Thus the value of your bond on the open market declines to a level where an investor would get a 5 percent return. Without getting into the math, the bond value would decline to $92.28. The $4 interest per year plus getting $100 principal in 10 years is the equivalent of a 5 percent annual return for someone who paid $92.28 for the bond. Since you paid $100 for the bond, you lost $7.72 (opportunity cost) whether you hold it to maturity or sell it now.
Now if instead your timing was good and rates went down from 4 percent to 3 percent, you are collecting $40 over the next decade when other investors expect only $30. Thus you are getting an extra $10 in interest and the value of your bond goes up to $108.53. You gained $8.53. This is why bond values move in the opposite direction of interest rates.
Common bond myths
I find most people believe in one or more of these three common myths about bonds.
- One is that the Federal Reserve controls bond interest rates. Last week, the Federal Reserve decided not to increase the Federal Funds rate, but that is essentially an ultra-short-term rate that banks pay to lend each other money. So an increase in Fed Funds rate, when it eventually does happen, doesn’t mean longer-term bond rates will rise or that prices on your bonds will decline. In fact, economists generally have a dismal track record of predicting intermediate and longer-term rates.
- Another myth is that an individual bond, compared with a bond fund, has no interest-rate risk since the investor knows he’ll get back his entire principal when the bond matures. This myth is busted by the example above where the value of the $100 bond declined by $7.72 when rates rose by 1 percentage point. Collecting that dollar less in interest than the market is currently paying over the next 10 years is the loss the investor experiences. True, you’ll get back the full amount of your principal when the bond matures, but the fact that you’ll be receiving less in interest over those years than what is currently available on new bonds represents an opportunity cost to you.
- Finally, there is the myth that stocks always outperform bonds in the long run. So far this century, bonds have trounced stocks, as can be seen in this post.
Bonds are an important part of a portfolio. You should bother with bonds. I generally recommend owning low-cost bond funds in order to build a diversified bond portfolio. I also recommend that the bonds be high-quality investment grade because I think bond funds should be boring. You need them to be the shock absorber when the stock portion of your portfolio plunges, which we know will happen, but don’t know when and by how much or whether the stocks will surge first.
One bond fund type I often recommend follows an index of all investment-grade U.S. fixed-interest bonds. It is offered by several providers, and three good ones are the iShares Core US Aggregate Bond ETF (AGG), the Schwab US Aggregate Bond ETF (SCHZ) and the Vanguard Total Bond ETF (BND). All have annual expenses of 0.08 percent or less. For many of my clients, I also recommend using direct bank CDs along with bond funds to greatly reduce interest-rate risk and eliminate default risk, thanks to FDIC insurance.
If you think you don’t need high-quality bonds in your portfolio, all I can say is try to think back to late 2008 and early 2009. I see people making the same mistake today that they made only seven years ago, which was to load up on stocks and own some low-quality bonds. Don’t you be one of them.
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