Bonds are a form of debt, issued by companies or governments, which pay investors a predetermined interest rate over a set period of time. Financial experts often tout bonds as a way to bring predictability to investors’ portfolios. But bonds are more complex than you might think. Below are common myths about bonds – debunked.
Myth 1: When interest rates rise, the value of bonds also rises. Interest rates and bond prices are inversely related; when interest rates go up, bond prices go down, and vice versa. If you plan to hold a bond until maturity, you’ll still receive the face value, regardless of interest rates. But if you decide to unload a bond when rates are on the rise, you may sell at a loss. Why? Imagine you hold a bond with a 6%* coupon rate, but the current market interest rate is 8%.* Why would investors want to buy your bond, which yields only 6%, when they could buy bonds yielding 8%? Your bond is less attractive to investors, so its price goes down.
Myth 2: Bonds are always safer than stocks. The most reliable bonds, such as Treasury bonds issued by the U.S. government, are guaranteed to be paid back unless the government fails. And corporate bonds are issued with the understanding that investors will receive payment at the end of the term and will receive funds first in the event of a company's failure. However, bonds do have risks. The major risk of bonds is that interest rates will rise, which means the value of your existing bonds will fall. This is not generally a problem if you hold them until maturity, but if you decide to sell them before maturity and rates are up, you won't receive the face value of your bond. For example, if you have a $1,000 bond that pays 3% interest, but new bonds pay 4% interest, a buyer will not want to give you $1,000 for your bond. Instead, the bond buyer will want to pay a discounted price to make up for the lower interest rate. By the same token, if your bond is downgraded a buyer will not want to pay you for the face value of the bond.
Another risk is that the issuer will default. Although investment-quality bonds are generally considered safer than stocks, the stock of a well-established, financially sound company might be safer than a risky bond.
Myth 3: There’s no risk with government bonds. Just because a bond is issued by a government does not mean it has no risk. For example, there is the risk that the issuer will default, or fail to pay back the bond principal. The debt problems of Greece, Portugal, Italy, Ireland and Spain have increased the possibility of payment defaults. State and local governments face a greater risk of defaulting on municipal bonds as communities face economic struggles. And there is inflation risk, the risk that the return on your bond will not keep pace with inflation. Although U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, they are still subject to inflation risk.**
Myth 4: Bonds tie up all money invested for the length of the term. Bonds can be sold prior to their maturity dates. However, as discussed above, interest rates affect the market value of bonds, so you may incur a gain or loss on the sale. If you choose to minimize the effects of interest rate fluctuations by holding your bonds to maturity, select bonds with maturity dates that align with your short- and long-term goals. Most individual investors do not purchase individual bonds, however. Instead, they purchase bond funds.
What about Bond Funds?
It's important to understand that, although bond mutual funds invest in bonds, they do not work in exactly the same way as individual bonds.
The biggest difference between an individual bond and a bond fund is that a fund has neither a fixed yield nor a contractual obligation to repay the principal amount at maturity. Because bond fund managers buy and sell bonds regularly, the net asset value (NAV) of the fund goes up and down based on the market. With an individual bond, you would not realize a capital gain or loss unless you sold the bond before its maturity date at a higher or lower price than you paid for it.
Generally, you can purchase bond mutual funds through your 403(b)(7) custodial account or 457 plan. Be sure to read the information about the fund so you fully understand its risks and potential rewards.
Click here to read more about the differences between bonds and bond funds.
* Rate of return is for illustration only and does not represent the return of any specific investment. Your returns will vary.
** Treasury Inflation-Protected Securities (TIPS) are an exception; they provide protection against inflation.