| When interest rates are low and stocks are falling, | | | | picture JKL Bond Fund. This mutual fund holds a |
| bonds in the form of bond funds look attractive | | | | portfolio of long-term bonds, on average maturing |
| to many investors looking for higher income. | | | | in 20+ years. The bonds are of high quality, and |
| Quality bond funds can offer dividend yields of | | | | the fund's dividend yield is 5%. Think early 2009. |
| 5% or more when bank CD's are paying about | | | | Now visualize a nightmare. You buy shares in JKL |
| 2%, and money market rates are even lower. | | | | Bond Fund, and then over the next couple of |
| Look twice before you leap into a bond fund in a | | | | years interest rates double. New investors can |
| low interest rate environment. Interest rate risk | | | | now buy JKL Bond Fund and get a dividend yield |
| looms, and could be a future nightmare for | | | | of 10%. What does this mean to you? |
| investors. | | | | Bond investors will bid down the price of the |
| There is a huge risk differential between investing | | | | bonds in JKL's portfolio as interest rates rise. |
| in bond funds vs. money market funds or CD's at | | | | When interest rates hit 10%, investors can pay |
| the bank. The latter are very safe investments. | | | | $1000 for a new bond that pays $100 a year in |
| When you invest in bond funds you are investing | | | | interest until it matures many years down the |
| in bonds. Interest rate risk applies. It could be | | | | road. Then they get their $1000 back. There is no |
| very risky to chase higher income by buying bond | | | | reason for anyone to accept less than a 10% |
| funds in a low interest rate environment. | | | | yield. |
| Interest rates in 1981-1982 went to historical | | | | The value of an older bond issued at a price of |
| highs, well into the double digits. In 2008 and early | | | | $1000 with a fixed coupon interest rate of 5% |
| 2009 rates hit historical lows. Many investors | | | | paying $50 a year in interest will fall like a rock. |
| looking for higher income with safety looked to | | | | Using simple math, in order to get 10% in yearly |
| bond funds for dividend yields of 5% vs. less than | | | | income from this bond, you might be willing to |
| 1% offered by safe money market funds. Let's | | | | pay a price of $500...interest of $50 a year |
| look at the big picture. | | | | divided by $500 equals 10%. |
| The problem with investing in bonds, bond funds, | | | | If interest rates double, the share price of a fund |
| when interest rates are real low is three-fold. | | | | like JKL will take a big hit. Bond fund prices or |
| First, new bonds being issued offer historically low | | | | values would not likely fall in half, but would head |
| coupon interest rates. Second, bonds are | | | | in that direction. This is the concept of interest |
| long-term in nature and their coupon rate of | | | | rate risk, and it is real. When interest rates go up, |
| interest paid is fixed for the life of the bond. | | | | bond prices fall. |
| Third, interest rates in the economy fluctuate. | | | | DURATION is a number that measures interest |
| Keep in mind the following. People invest in bonds | | | | rate risk for investors. The higher the duration of |
| and bond funds in order to get higher income. | | | | a bond or bond fund (average duration) the |
| Bonds trade much like stocks do, so their price | | | | greater the risk. A high duration figure means that |
| (or value) fluctuates. When you buy shares in a | | | | a bond or bond fund's price is very sensitive to |
| bond fund, you are invested in a portfolio of | | | | changes in interest rates. |
| bonds. | | | | If you want relative safety in a bond fund, look |
| Now, with interest rates near historical lows | | | | for one with a low AVERAGE DURATION. |