Investing in bonds by owning a bond fund is easy compared to selecting individual bonds. Few average investors can analyze bonds, so the vast majority investing in bonds buy a mutual fund called a bond fund, and let professional money managers make the selections for them. Hence, when you own a bond fund you own part of a professionally managed portfolio of bonds, often called an income fund.
Don't get confused. Investing in bonds or an income fund has little in common with buying U.S. Savings Bonds. The government guarantees that you will not lose money in savings bonds. There is no market risk in these savings products. When investors speak of bonds they are not referring to savings bonds.
A bond fund is sometimes labeled as an income fund, because the primary objective is to provide higher income vs. other investments. These funds pay dividends from the interest earned on the bonds in the fund portfolio. Along with this higher income, investing in bonds involves risk. Bond prices or values fluctuate because bonds are marketable securities that trade in the open market, much like stocks do.
In order to understand investing in bond funds, you first need to learn some bond basics. Let us turn our attention now to a simplified bond example, a new issue of a very basic corporate bond.
ABC Corporation decides to raise a large sum of money to expand their operations. Instead of selling stock to the public, they decide to sell bonds. In other words, they will borrow money from investors. Each bond has a face value or initial bond price of $1000. The coupon rate will be 6%. These are high quality bonds and mature in 2039. Once all of the bonds are sold ABC gets their money, and these bonds begin to trade in the bond market.
If you buy an ABC bond for $1000, ABC promises to pay you $60 per year, or 6%, for as long as you own it until 2039 when the bond matures. At that time the bond owner gets the $1000 back, and the bond no longer exits. Up until that time the deal never changes. ABC promises to pay the bond owner $60 per year, period.
You as a bond holder are not required to hold the bond until 2039. You can sell it at will on the bond market, or buy more bonds at market price if you wish. But beware that bond prices fluctuate, as do stock prices. Bond prices or values can go up and they can go down. In other word, a $1000 bond is not necessarily worth $1000 after it is issued. Hence,there is market risk involved when investing in bonds.
Now picture an income fund invested in a portfolio of bonds similar to ABC bonds. Because this bond fund holds a wide variety of different bonds, investors need not worry about a company like ABC going broke and not making interest payments or not paying investors back upon maturity. The fund is broadly diversified.
The real risk you should be aware of when investing in bonds and bond funds is of a different nature, and this risk is called interest rate risk. Interest rates in the economy fluctuate, but a bond's coupon rate does not. ABC bonds, for example, pay $60 per year, period.
What happens when long term interest rates in the economy go up? Simply this: the value of existing bonds, in other words bond prices, go down.
Look at it this way. If interest rates double and go from 6% to 12%, new bonds will be paying investors $120 per year in interest vs. $60. What do you think investors in the bond market would be willing to pay for a 6% bond under these circumstances? Since investors buy bonds for the higher interest they offer, the price of our 6% bond will fall like a rock. The bond price will not likely fall in half, but it will be heading in that direction.
Interest rates peaked in 1981-82, and have generally been falling since. Contrary to our above example, falling interest rates send bond prices higher. Investors in bonds and bond funds get income from interest or dividends when interest rates fall, plus the value of their investment increases.
But interest rates can not fall forever. When they do head north again many folks invested in bond funds or income funds will be caught standing flat footed. Invest informed and understand this: When interest rates go up significantly, the value of your bond investments will fall.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.
Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com
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