Bonds have long been the backbone of the safer, or more conservative, portion of an investment portfolio, and bond-owning mutual funds have been stellar performers this year.
But now bonds are looking riskier. Interest rates are so low that they’re more likely to go up than down, and that could undermine bond prices.
There is a way to minimize this risk: Buy individual bonds rather than bond funds, and plan to hold them to maturity.
Bonds are loans from the bond buyer to the bond’s issuer, such as a government agency or corporation. Buying a 10-year bond with a $10,000 face value and 4% yield means you are lending that amount to the issuer. For the next decade, you will receive $400 a year in interest, and then the issuer will return your $10,000 “principal.”
But if you want to sell the bond before the 10 years are up, its price will be determined by supply and demand in the market, and that’s largely governed by changes in prevailing interest rates. Rising rates drive bond values down, falling ones push them up.
Just imagine that new bonds paid 8%, so that an investor paying $10,000 would earn $800 a year, twice what your older bond pays. Your bond’s price would fall to $5,000, because that’s the point where its $400 payment would match the prevailing rate of 8% of the invested sum.
In real life, other factors like the bond’s time to maturity and the issuer’s potential for default make the price calculation much more complicated. But it’s not uncommon for a one percentage point rise in rates to drive a bond’s price down by 5% to 10%.
It also works the other way, with falling rates making older, more generous bonds, more desirable, driving their prices up. That’s what caused the big bond gains this year, with long-term U.S. bond funds returning nearly 24% since Jan. 1, according to Lipper, the market data firm.
Price fluctuations are greater for bonds with more time to maturity, since the benefits or damage from rate changes last longer.
To avoid the hazards accompanying rising rates, the investor can keep the bond until it matures, getting the $10,000 face value regardless of how much the price has fluctuated over the years. But you cannot do that if you invest in bonds through mutual funds, since funds constantly change their holdings to maintain an average maturity promised to investors. A fund has no maturity date.
Fortunately, it has become easier over the years for individual investors to buy individual bonds. In the past, investors had to pay hefty commissions to full-service brokers. Now many discount brokers, such as Charles Schwab (Stock Quote: SCHW), E*Trade (Stock Quote: ETFC) and TD Ameritrade (Stock Quote: AMTD) sell individual bonds.
Keep in mind that a hold-to-maturity strategy does not eliminate all risk. If rates rise substantially, you can be stuck with an unpleasant choice between sticking with your stingy older bond until it matures, or selling it at a loss to invest in a new bond that’s more generous. With some bonds, especially corporate bonds, there’s a risk the issuer will default, or fail to pay interest and return principal.
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