The 3 Most Deadly Misconceptions About Bonds
Fearing aand another fall, investors withdrew a whopping $33.1 billion from domestic mutual during the first seven months of 2010, according to the Company Institute, the trade group for . Many investors reacted by choosing an alternative that they deem safer: .
Whileare generally safer than , it's still vital to understand the mechanics of an in . So before we go further, let's do a quick review of what are and why they're important.
When ordinary people borrow loan, or line of (aka cards). However, when extremely large borrowers, like corporations, municipal governments or the U.S. Department of Treasury want to borrow , they don't run down to the local bank to fill out a loan application. Instead, they borrow from the worldwide community via bonds. And by doing so, they make available a great opportunity for individual investors., they ask the bank for a
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 lender to the entity issuing the bonds., you are essentially replacing the bank and becoming the
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 noticeinvestor.
Deadly Misconception #1: Bonds Aren't Risky
Many investors mistakenly think bonds are like a certificate of. But this is absolutely not true.
Though bonds are less risky than stocks, that doesn't default risk and interest rate risk.they aren't risky at all. Investors need to account for several different kinds of risk when they evaluate bonds, the most important being
Interest rate risk accounts for the chance that interest ratesincrease 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, which is an indication of the "quality" of the of that . After all, a 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 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.
Deadly Misconception #2: The Rate of Return
The's par value is the principal amount that the lender (investor) is lending to the borrower ( ). Corporate bonds are typically issued in $1,000 increments. If a wants to borrow $1 billion, it 1 million bonds with a par value of $1,000 each.
The maturity date is the date on which thestops paying interest, and it's also the day the borrower repays the lender the par value of the . 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 maturity.'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
The coupon rate is the bondholder receive (usually annually or semi-annually). This rate is typically fixed for the life of the , although variable rate bonds are available.'s expressed rate of interest. It determines the interest payment the
#-ad_banner_2-#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 yield to maturity (YTM) the yield as the '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.'s price stays equal to its face value, then the coupon rate be equal to the 's yield. Often called
Assume you purchase a 30 year for $1,000. The coupon rate is 6%. If you hold the 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 yield is 6%, exactly the same as the coupon rate.
But if you buy aat a discount or a premium, the yield be different from the coupon rate. If you purchase the same 30-year 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 , so your is higher.
If you choose to sell yourafter five years instead of waiting the full 30 years, the of the doesn't buy it back. Instead, you must find another investor willing to purchase the from you. Which brings us to…
Deadly Misconception #3: The Price of a
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-yearwe 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 , interest rates increased and new bonds pay coupon rates of 9% instead of the 6% coupon rate on our . We can still sell our , but the buyer insist that he or she get the rate of 9%.
Since you can't change the coupon rate on your haircut from the $1,000 you paid., the only is to sell it at a discount. In this example, for the buyer to get a 9% return on a 6% with 25 years left to maturity, he would pay you $705.32. That's a pretty substantial
The formula is complicated, but if you want to learn more, click here to walk through our InvestingAnswers definition.
that the price of the ($705.32) is very different from its par value ($1,000). The price fluctuates so that the yield on the 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,prices are at or near their all-time highs. For prices to increase, interest rates would have to drop even lower than they already have.
If you want to learn more about 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.in a low-rate environment,
For a primer on Primer on Inflation-Linked Bonds.in a high-rate environment, see our