A Very Short Primer On Bond Investing
The two main investment vehicles available to most investors are stocks and bonds. Bonds are thought to be “safer” and less “risky” than bonds. There is one reason why: bonds are thought to be better protectors of principal. This means that the money you put into them has a larger certainty of being returned (or not lost) than stocks. The biggest fear that investors have is losing their principal.
Bonds are more complicated than this though, and in some ways are much more like stocks than people realize. If your goal is to protect principal, you need to know which kind of bonds to buy. Otherwise, you can both make and lose money on bonds just like stocks.
Bonds Than Protect Principal
If you want to keep your principal at all costs, you will want to buy these type of instruments. All of these investments are designed to keep their value at a fixed, or par value.
- U.S. Savings Bonds, I-Savings Bonds (inflation protected bonds). The key word here is “Savings”. U.S Debt that is a “Note” or “Bond” does not guarantee principal.
- Money Market Funds, available at banks and credit unions.
- In your retirement accounts (IRAs, 401K, 403b), bond funds that use the term “Stable Value”. These funds are designed to maintain par value.
Bonds That Don’t Protect Principal
Bonds that do not protect principal can be bought and sold for a capital gain or loss (high or lower price than what you bought them). The key here is that this gain or loss can occur if you sell before the bond matures. If you buy a bond and no default occurs, you hold it to maturity, then you get all your principal back. This is why even these type of bonds protect principal better than stocks do.
- Municipal Bonds (local/state government general obligation/capital bonds).
- U.S. Treasury Bonds/Notes.
- Corporate Bonds.
There are many risks to investing in bonds, here are the main risks that you should be aware of. Check out this complete article for a more extensive list.
- Interest rate risk, which is the chance that bond prices overall will decline because of rising interest rates.
- Inflation risk, Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal.
- Credit risk, which is the chance that a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
How You Lose Money With Bonds
For the typical investor, they don’t buy individual bonds, they invest in bond funds which work just like stock mutual funds: they own many different bonds which together form the fund. Just like stock funds, the bond manager can trade bonds over time which can cause both gains/losses in the fund overall. Even if they don’t trade, the mechanics of bond maturity, bonds being called affect returns. Managers can try to mitigate these affects so you need to understand their strategy.
If you have owned bond funds in the recent past you have made money because bond prices have risen as interest rates have decreased. This may or may not continue. The key concept to understand here is that bond funds don’t protect principal.