| Bonds and bond funds are the way to go if you | | | | Interest rate risk: what happens to the value or |
| want to earn higher interest rates according to | | | | price of your 6% bond when new issues are |
| your neighbor who knows everything. Bond | | | | paying 7%, then 8%, then 10% and so on? Your |
| investing is simple if you invest money in bond | | | | bond's price (value) will fall. Who's going to pay |
| funds because they do the investment | | | | you $1000 for this investment that only pays $60 |
| management for you, he points out. Since interest | | | | a year in interest when they can go out and buy |
| rates are pathetically low at the bank, why not | | | | a new issue that pays $70, $80, $100 a year? |
| take his advice? | | | | In the above scenario bond investing is a losing |
| People invest money in bonds and bond funds to | | | | proposition. If you own bonds when interest rates |
| earn a higher income in the form of interest or | | | | are moving up significantly your interest earned |
| dividends (bond funds). That's the advantage of | | | | will pale compared to the loss of value your |
| bond investing. On the other hand, your | | | | investment suffers. If this trend continues for |
| not-real-savvy neighbor neglected to tell you the | | | | several years, your brokerage or mutual fund |
| other half of the story. Bond investing always | | | | statements will show losses for several years. |
| involves risks. Even the safest bond investment in | | | | IF you had invested in an individual bond issue in |
| the world, U.S. Treasury bonds, is subject to | | | | the above scenario (like our 6% example) you |
| interest rate risk. | | | | could always look forward to your investment |
| Interest rates are at or near historical lows, which | | | | maturing and to getting out with $1000 at |
| makes it tempting to chase higher interest | | | | maturity. But what if you took your neighbor's |
| income. A bond investment pays a higher rate of | | | | advice and you did invest money in a bond fund |
| interest than you can get at the bank. But here's | | | | that held a large and diversified portfolio of |
| the problem, the risk factor most folks know little | | | | securities similar to our 6% issue maturing in 10 |
| about: a bond has a fixed coupon rate (interest | | | | years or so? Bond funds don't mature. |
| rate) that never changes for the life of the | | | | What would happen to your bond fund |
| security. | | | | investment as interest rates continued upward? |
| All bonds have a maturity date ... they mature. At | | | | Well, many investors, like your neighbor and his |
| that time the owner is paid back his or her | | | | friends, would cash in their bond fund shares to |
| principal, usually $1000. Example: You buy a $1000 | | | | cut their losses. This means the fund must then |
| bond with a 6% coupon rate that matures in the | | | | sell bonds in their portfolio (likely at a loss) to raise |
| year 2020. This investment pays you $60 per | | | | the cash to pay them. As this trend continues |
| year in interest for as long as you own it. In the | | | | bond prices continue to fall, along with the value |
| year 2020 the issuer (a government entity or | | | | of bond funds in general. |
| corporation) pays you back the $1000. It's a done | | | | If and when interest rates eventually stabilize at |
| deal, the bond no longer exists. | | | | higher levels, there won't be many happy |
| The interest rate of 6% is fixed. But the price or | | | | campers who took your neighbor's advice. Those |
| value of your investment is not. Bonds trade just | | | | who cashed in took a loss. Those who held on are |
| like stocks do. What happens if interest rates go | | | | hoping for a miracle. |
| up across the board? Well, banks will raise the | | | | The bond market will then heal only when savvy |
| rates they pay their customers. And new bonds | | | | investors seize the day and bet that interest |
| will be issued by the government and corporations | | | | rates are done going up. At that point they buy |
| WITH HIGHER AND HIGHER COUPON RATES as | | | | bonds and send prices up. That's how smart |
| interest rates continue to rise. | | | | investors really make money bond investing. |