Fearing a double-dip recession and another stock market fall, investors withdrew a whopping $33.1 billion from domestic stock mutual funds during the first seven months of 2010, according to the Investment Company Institute, the trade group for stock mutual funds. Many investors reacted by choosing an alternative that they deem safer: bonds.
While bonds are generally safer than stocks, it's still vital to understand the mechanics of an investment in bonds. So before we go further, let's do a quick review of what bonds are and why they're important.
When ordinary people borrow money, they ask the bank for a loan, mortgage or line of credit (aka credit cards). However, when extremely large borrowers, like corporations, municipal governments or the U.S. Department of Treasury want to borrow money, they don't run down to the local bank to fill out a loan application. Instead, they borrow money from the worldwide investment community via bonds. And by doing so, they make available a great opportunity for individual investors.
Large entities typically choose to borrow via bonds because they often pay a lower interest rate versus the rate on a bank loan. So when you buy a bond, you are essentially replacing the bank and becoming the lender to the entity issuing the bonds.
Because bonds are less risky than stocks, they're suitable for investors with more conservative goals. But regardless of whether you're conservative or aggressive, bonds are extremely important for diversification and should be a part of any well-diversified portfolio.
Keeping the basic structure of bonds in mind, let's delve into the three most common misconceptions of the notice bond investor.
Deadly Misconception #1: Bonds Aren't Risky
Many investors mistakenly think bonds are like a certificate of deposit. But this is absolutely not true.
Though bonds are less risky than stocks, that doesn't mean they aren't risky at all. Investors need to account for several different kinds of risk when they evaluate bonds, the most important being default risk and interest rate risk.
Default risk accounts for the chance that a company or government will simply stop paying their debts, meaning the bondholder won't get all the interest and/or principal he's entitled to.
Interest rate risk accounts for the chance that interest rates will increase in the future, making your bonds less valuable. We'll cover that concept in detail a little later.
Every almost all bonds come with a rating, which is an indication of the 'quality' of the issuer of that bond. After all, a bond is a promise to repay the investor both the interest and the principal at a stated future date. If the investor becomes insolvent, the investor loses out.
The highest-rated bonds -- AAA -- are issued by Uncle Sam, the largest issuer of bonds in the world. If the U.S. government itself goes belly-up, investors probably have bigger things to worry about than their bonds.
But why would an investor purchase a bond rated less than AAA? Because bonds with the highest ratings have the lowest yields, and bonds with the lower ratings have higher yields. Corporate bonds earn the pejorative term 'junk' if their rating is very low, and they pay the highest rates of all.
Deadly Misconception #2: The Coupon Rate Is Equal to the Rate of Return
To analyze a bond as an investment, you need to know five things: its par value (face value), maturity date, coupon rate, yield and price.
The bond's par value is the principal amount that the lender (investor) is lending to the borrower (issuer). Corporate bonds are typically issued in $1,000 increments. If a corporation wants to borrow $1 billion, it will issue 1 million bonds with a par value of $1,000 each.
The maturity date is the date on which the bond stops paying interest, and it's also the day the borrower repays the lender the par value of the bond. The maturity date is also sometimes referred to as the redemption date.
The majority of bonds are issued with an extended maturity date, sometimes as long as 30 years. But it's important to understand that regardless of the bond's maturity date, the investor can buy or sell it at any time. In fact, very few bonds are held all the way from issuance to maturity.
The coupon rate is the bond's expressed rate of interest. It determines the interest payment the bondholder will receive (usually annually or semi-annually). This rate is typically fixed for the life of the bond, although variable rate bonds are available.
Not all bonds have coupons. A zero-coupon bond does not make periodic coupon payments. Instead, investors purchase them at a discount to face value, and realize a return when the bonds are redeemed at face value at maturity. U.S. Savings bonds and U.S. Treasury bills are notable zero-coupon bonds.
If the bond's price stays equal to its face value, then the coupon rate will be equal to the bond's yield. Often called yield to maturity (YTM) the yield as the bond's annual rate of return. Investors tend to be confused by the difference between the yield and the coupon, so let's walk through an example.
Assume you purchase a 30 year bond for $1,000. The coupon rate is 6%. If you hold the bond for the full 30 years, you'll get $60 in interest payments each year (based on the coupon rate) and you'll get back your $1,000 in principal at the end of year 30. When you do the math, you'll see the bond yield is 6%, exactly the same as the coupon rate.
But if you buy a bond at a discount or a premium, the yield will be different from the coupon rate. If you purchase the same 30-year bond for $960 instead of $1,000, the yield jumps to 6.3%. It makes sense when you think about it -- you're getting the same annual payments for less money, so your return on investment (ROI) is higher.
[Use our Yield to Maturity (YTM) Calculator to measure your annual return if you plan to hold a particular bond until maturity.]
If you choose to sell your bond after five years instead of waiting the full 30 years, the issuer of the bond doesn't buy it back. Instead, you must find another investor willing to purchase the bond from you. Which brings us to…
Deadly Misconception #3: The Price of a Bond is Equal to Its Face Value
Now comes the tricky part. We're going to revisit the concept of interest rate risk that we introduced earlier.
Let's go back to the 30-year bond we bought in the first example. We've decided to sell it after five years, and we want to know what price we can sell it for. During the five years we held the bond, interest rates increased and new bonds pay coupon rates of 9% instead of the 6% coupon rate on our bond. We can still sell our bond, but the buyer will insist that he or she get the market rate of 9%.
Since you can't change the coupon rate on your bond, the only option is to sell it at a discount. In this example, for the buyer to get a 9% return on a 6% bond with 25 years left to maturity, he would pay you $705.32. That's a pretty substantial haircut from the $1,000 you paid.
The formula is complicated, but if you want to learn more, click here to walk through our InvestingAnswers definition.
Note that the price of the bond ($705.32) is very different from its par value ($1,000). The price fluctuates so that the yield on the bond always matches the going interest rates on bonds that are issued today.
As you can see, the value of bonds decreases when interest rates rise. Likewise, the value of bonds increases when interest rates fall. Today, with interest rates at or near historic lows, bond prices are at or near their all-time highs. For bond prices to increase, interest rates would have to drop even lower than they already have.
If you want to learn more about investing in a low-rate environment, click here for a must-read article from one of America's top income investors, Carla Pasternak: U.S. Treasury Bonds Offer Stable Returns in Difficult Markets.
For a primer on investing in a high-rate environment, see our Primer on Inflation-Linked Bonds.