The Winds of Change Are Affecting Bonds

Physician's Money Digest, March31 2004, Volume 11, Issue 6

You've certainly heard the expression, "What goes up must come down." We know this is true because when we toss a ball into the air, gravity pulls it back to earth. But that truism is often forgotten when it comes to investing, and in particular with bond funds.

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According to an article in magazine, total investments in bond funds have increased from $37 billion in 1983 to $1.2 trillion today. That's not necessarily a bad thing, because advisors recommend that a diversified portfolio should always contain bond investments of some sort. But investors who sought shelter from the recent roller coaster ride of the stock market had a rude awakening this past summer when rising interest rates resulted in a drop in bond fund value.

That's not to imply that bonds or bond funds are poor investment vehicles. But it's important to understand exactly what they are, how they work, and what impact they can have on your overall investment portfolio.

Ins and Outs of Bonds

A bond is a loan that the investor makes to a company or government body with the promise that the loan will be paid back with interest. A bond fund is an investment company whose portfolio is made up mostly of these individual bonds. The attraction of bond funds is that while they have historically provided lower returns than stocks, they have also proven less risky. According to Lipper Inc, the average bond fund declined in only 5 of the past 40 years, with an average loss of 5.2%. Stock funds, on the other hand, have declined in 12 of the past 40 years by an average of just under 9%.

However, there are risks with bonds and bond funds. The two main culprits are default, where the entity borrowing your money is unable to repay the loan, and interest rate risk. Of the two, interest rate risk poses a much greater threat.

The rule of thumb with bonds and bond funds is that bond prices move in the opposite direction of interest rates. Bond funds might seem attractive with interest rates so low, but as rates begin to inch up, their value will decline as will their attractiveness.

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Of course, not all bonds are impacted as severely by rising interest rates. According to the article, long-term bonds, those with maturity dates of 10 years or greater, are more sensitive to a change in interest rates. The safest bonds are usually the ones with the shortest maturity dates (2 years or less) that are backed by the federal government. However, with the risk reduction comes a reduced yield.

Deciding Which to Own

Is it better to own individual bonds rather than bond funds? There are advantages to each. Individual bonds make set interest payments on a fixed schedule. Bond funds do not make specific payments to investors, and they do not have a set maturity date since the fund is made up of many different bonds. But because bond funds spread your investment over dozens, and sometimes hundreds, of different types of bonds, your risk level is reduced.

In addition, the Schwab Center for Investment Research suggests that the decision to invest in individual bonds or bond funds should in part be driven by the amount you have to invest. The Schwab Center recommends that investors avoid purchasing individual bonds if they have less than $25,000 for US Treasury investments, $50,000 for corporate bond investments, and $100,000 for municipal bond investments. Part of the rationale stems from the higher commissions and dealer markups that accompany both corporate and municipal bond purchases. It is recommended that your portfolio contain a minimum of 10 individual bonds to help lessen the pain from any potential defaults.

Bonds are an important element in a well-diversified investment portfolio. But as with any investing strategy, it's important to understand the trade-offs of risk vs reward before you take the plunge.