Bonds For Smarties
Even sophisticated investors can be put off by "bondspeak." Let's decode it
(MONEY Magazine) – Bonds are based on a simple idea: When you buy one, you've essentially lent money to a company or a government, and they pay you back with interest. Yet following what's happening in the bond market can be baffling. First, there's the arcane terminology, such as "duration." Then there's the counterintuitive notion that bonds (and bond funds) can actually lose money. Yes, you're assured of getting your principal back if you hold a bond to maturity. But a bond's value in the market—that is, what you would get if you sold it to another investor today—fluctuates every day, just like stock prices do.
What drives those ups and downs? Changes in interest rates. Once you understand the basic interplay between rates and the market value of bonds, you'll have what it takes to make smart bond investments. Just remember these four simple rules.
1 Rates Up, Prices Down
And vice versa. Here's why. Let's say you buy a $1,000 bond paying a 4% yield, or $40 a year. The next day, bond traders get spooked by fears of rising inflation, and the going rate for a bond of the same maturity jumps to 5%, or $50 a year. Would you be able to sell your bond for $1,000? Of course not. Investors would want a bond paying $50 for their thousand bucks, which means the price of your 4% bond would have to drop to make its lower interest payments worth as much as those of a 5% bond.
As interest rate go up or down...
...bond price move in the opposite direction.
NOTE: Rates are yield to maturity for Lehman's long-term Treasury index. SOURCE: Lehman Brothers.
A bond's sensitivity to rate changes depends on its maturity date, how much interest it pays and other factors. "Duration" wraps all this into one number. If a bond has a duration of five years, its price would rise roughly 5% if rates dropped by one percentage point—and fall about 5% if rates rose a point. Any broker selling you a bond should be able to tell you its duration; you can look up a fund's duration at Morningstar.com.
Price change for durations of...
SOURCE: Ryan Labs.
3 With Funds, Buy and Hold
While rising rates hurt bonds short term, they can actually boost the long-term return of bond funds. That's because funds get to reinvest interest payments and proceeds from maturing bonds in new bonds paying higher yields. "People get hung up about bond prices getting hit," says Fran Kinniry of Vanguard's Investment Counseling and Research Group. "But bond fund owners with a long time horizon can actually be better off with rising rates."
Annualized bond fund return if rates...
NOTE: Based on intermediate-term fund with initial yield to maturity of 4% and duration of 5.8 years. SOURCE: Vanguard.
4 Don't Go Long
There are no guarantees, but history shows that intermediate-term bonds (those with durations of three to seven years) typically deliver 80% or more of the gains of longer-term bonds while subjecting investors to roughly 50% less risk. To put it another way, you give up a little return for a much smoother ride.
Intermediate-term bonds return almost as much a year on average as long-term bonds...
...but with about half the fluctuation in returns.
NOTES: Annualized returns for January 1980 through September 2004. Volatility is standard deviation of returns. SOURCE: Ibbotson Associates.