Keith Schwanz

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This article was written on 05 Mar 2012, and is filed under Personal Finance.

An Impromptu Education — Bonds

My friend asked a question many folks have wondered about given the economic mayhem in the past few years. He said, “I’ve heard that bonds are safer than stocks. Is this a good time to move my investments from stocks to bonds?”

Oh, my! This was a challenging question to answer. I wondered how to respond, but finally said, “This isn’t a good time to make that move.” The stare looking back at me clearly beckoned for the long answer. I took a deep breath and began.

Interest Rate Risk

“You’re right. Over the long haul, bonds have tended to be less volatile than stocks, but there are different kinds of risk. There’s market risk—the influence of economic and political factors. We’ve seen a lot of that in the past couple of years. Then there is purchasing power risk—the possibility an investment will return less than inflation and cause you to lose purchasing power. The issue right now is interest rate risk—the effect a change in interest rates has on the value of a bond. When interest rates go up, the current value of the bond goes down.”

I paused to assess whether my description brought clarity or confusion. After a moment, my friend just nodded. I assumed this meant to continue, so I traipsed on.

“Okay, let me try to put this in a story. Suppose you wanted to buy a bond. Would you rather receive $50 or $60 in return for your investment?” My friend just rolled his eyes. “I thought so,” I said. “Say you buy a bond at par, and…”

“What is par?” my friend interrupted. “Are you saying we have to go golfing to purchase a bond, and then get to do so only after getting par?” I skipped his question.

“Okay, so bonds are issued with a $1,000 face value, also called ‘par.’ A bond with a five percent coupon rate will pay $50 in one year. A bond at six percent will pay $60. Are we still tracking?” My friend smiled at how hard I worked to explain this. “Suppose the owner of the bond at five percent wants to sell it. Why would you want to buy a bond that pays $50 when you could buy one that pays $60?”

“I don’t know. You’ve got the nimble brain cells. Why would I do that?”

I ignored his cleverness and kept talking. “To make the bond at five percent marketable—to get you $60 at the end of the year—the bond market will discount the bond. Instead of selling at par of $1,000—it will sell for $990. At the end of the year when the bond matures, you will get the par value of $1,000 which is $10 more than you paid for it, plus the $50 in interest for the year. There’s your $60. The calculation is more complicated than this and takes other factors into consideration, but you get the picture. Anyway, the main point is that when interest rates go up, the current value of bonds goes down. The higher the interest rates go, the lower the current value of bonds. The longer it is until maturity, the more the volatility. It’s like a teeter totter.”

Timing

“So why is this not a good time to buy bonds?” he asked (finally, a serious tone to his voice).

“Interest rates have been trending downward for three decades. They can’t go much lower and many think interest rates will begin rising soon. When interest rates start up …”

“I know, the teeter totter,” my friend said. “When interest rates start up the current value of a bond will go down.”

“You’ve got it. Now if you know you’re going to need $10,000 in five years, you might buy 10 bonds to mature right when you need the cash. You’ll know what your income will be each year and you’ll know when your cash will be available. Then don’t worry when your monthly statement shows the bond decreasing in value when the interest rates rise. You’re going to hold the bonds until maturity and you’ll get the full par value on that day.”

Bond Mutual Funds

“But I was thinking of buying a bond mutual fund,” my friend said, “not individual bonds. What do I do then?”

I sighed deeply. It was getting more complicated with each question.

“Mutual funds have the advantage of professional management and diversification of investments,” I told him. “That’s good. But bond funds don’t have a maturity date. Individual bonds within the fund do, but not the fund itself. As a result, bond funds tend to be more sensitive to interest rate risk than holding individual bonds until maturity.”

My friend took stock of the situation, then reminded me I had not answered his question.

“Well, you should always research any investment before you commit money to it. With a bond fund, check how long the fund manager has done the job. The more experience, the better. You can find that information on a website that has information on the mutual fund you are considering. Then, scroll down to find the duration number. The duration will tell you the calculated number of years until maturity for the composite of all the bonds in the fund. The longer the duration, the more the net asset value will drop with the rise in interest rates. With interest rates expected to rise, you’ll want to own funds with a lesser duration.”

In the weeks since this conversation, I’ve been pondering the need for financial education. Some nuggets of financial wisdom are widely circulated, such as the safety of bonds in comparison with stocks. But a more nuanced understanding is needed to prevent mistakes. The particulars of investing have their own vocabulary and strategies, but it isn’t rocket science. I hope I helped my friend become more serious about managing his resources today for a more secure financial future.

Originally published by Pensions & Benefits USA.

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