Bonds – Are They Good Investments?

 

Bonds are a security and are generally good investments for the older crowd who wants to earn higher interest rates for income. Bonds also belong in younger portfolios to enhance investment balance. But beware; the Big Bad Wolf may be knocking on the bond investing door.

In 2009 you couldn’t make 1% a year in the safest investments with easy access to your money. Examples include: money market bank accounts, short-term CDs, T-bills, savings accounts, and money market funds. But you could earn more than 6% in some bonds and over 4% in the safest ones in the world, the U.S. Treasury bond. Why not jump on these good investments?

The answer is that bond investing carries risk… more than the average new investor thinks. First, there is credit risk. The issuer of the security could get into financial trouble and fail to make timely payments of interest as promised. Even worse they could go broke. This risk can be greatly reduced by putting your money into a bond fund vs. an individual issue.

Interest rate risk is another animal altogether, and with interest rates at all-time lows the wolf is huffing and puffing at the door of bond investing. Unfortunately, the new investor is likely unaware of his presence and does not sense the danger. In a few minutes, you’ll get the picture.

When you buy a bond you are lending the issuer (like a corporation) money for a promise that reads something like this. “Lend me $1000 and in return I’ll pay you 5% a year in interest. In the year 2035 I’ll pay you back your $1000.” After the issue is originally sold to an investor, it then trades in the secondary market. The good news is that the bond can then be bought and/or sold any time between issue and 2035.

The scary news is that the price or value of the security changes as it trades in the market. When interest rates are falling these fixed-interest-rate investments go up in value. When interest rates go up, interest rate risk can bite you in the posterior… because bond prices (values) go down.

That’s how bond investing works. Picture owning the 5% security we used as an example. As long as the issuer remains financially strong and interest rates remain stable, your investment should be worth about $1000. What would happen if rates in the economy headed toward 10% for similar bonds being issued? Remember, your 5% rate is locked in until 2035.

Only a fool would offer you $1000 for a security that pays $50 a year when any investor could get closer to $100 in yearly income in the open market. There are plenty of fools out there, but no one is that dense. Your investment is headed toward a ½-off sale.

Bonds can be very good investments when interest rates are falling. They are not good investments when rates are on the rise. It doesn’t matter if you are rich or poor, young or old, new investor or experienced. The wolf is knocking on the bond investing door, and sooner or later interest rates will go up. Don’t let interest rate risk take a big bite out of your investment portfolio. Don’t chase bonds just to earn higher interest rates.

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