The vast majority of investors are looking to enhance their income through the purchase of bonds, but are unaware of the pitfalls when investing into these securities. Given the recent moves by the Federal Reserve regarding interest rates as well as the action in the U.S. dollar, we thought that it would be an appropriate time to discuss the pros and cons of fixed income investing. Always keep in mind that, like stocks, investors do lose money in bonds!
The first fact that any investor in bonds should recognize is that the price of a bond responds inversely to interest rates. As an example, let us assume that you purchased a thirty year U.S. Treasury Bond (both principal and interest payments backed by the full faith and credit of the U.S. Government; widely accepted as the most secure fixed income investment in the world) for $10,000 and that bond pays a yield or interest rate of 4.00% semi-annually. Therefore, you would receive $400 per year or $200 every six months with your principal guaranteed upon maturity in thirty years. Now let us assume that after purchasing the bond, interest rates on thirty year U.S. Treasury Bonds rise to 6.00%. Therefore, should you purchase a bond at this time, you would receive interest payments of $600 per year or $300 every six months. However, in response to the rise in interest rates, what has happened to the interest rate and the value of the 4.00% bond that you purchased initially? Very succinctly, the interest payments of $200 semi-annually will remain the same for the balance of the life of the bond or until its maturity. However,the principal value of the bond, should you wish to sell it prior to its maturity, has declined! After all, who would give you $10,000 for a bond yielding 4.00% when they can go out today and buy their own bond that pays 6.00%? The answer, nobody in their right mind! You are stuck getting $400 per year for let us assume the remaining twenty-eight years until the maturity of the bond rather than the $600 that you would receive if you had waited until interest rates rose a bit. The loss to you is $200 per year over twenty-eight years or $5,600 in interest!
What conclusion should an investor draw from the above paragraph and slew of examples? Simply, of course that your bond or bond fund can decline in price or net asset value! Once again (for the benefit of both of us) bond prices respond inversely to interest rates! As interest rates go up, the value of bonds go down and as interest rates go down, the value of bonds go up! As interest rates have edged up slightly over the past year, the value of bonds has gone down. However, this does not affect the interest payments!
What should you now do? Be patient. Two of our principal tenets of investing are that asset allocation works best over the long haul and invest in bonds for income and stocks for growth. Asset allocation is defined as the percentage of your total financial assets that you allocate to equity, fixed income and cash investments. For the purpose of this column, investment real estate should fall under the fixed income heading. Invest in bonds for income. We referred to the yield curve above. Try to stick with the intermediate part of the yield curve. That would be bonds maturing between three and eight years. By so doing, you will receive nearly all of the interest of a thirty year bond with less than fifty percent of the principal risk should you wish to sell your bonds prior to their maturity.
One final comment, generally speaking, bonds react inversely to one to two year historical performance. This means that the more meager the returns during the past, the more lucrative the future may be. One more final thought, when measuring performance, always compare your bond or bond funds to similar investments. Do not compare your bond or bond fund to the stock market. Remember, asset allocation provides predictable returns and quantifies your risk. Give us a call should this column require any further clarification or generate any questions.