Your Financial Future: Investing in bonds
For those interested in investing in bonds, it’s a good idea to understand the basics before you make any moves.
There are several types of bonds issued by different government or corporate entities. You are lending money to the issuer when you buy a bond. They promise to repay at a certain time and also pay you interest.
Once you lend your money, you usually have to wait until maturity to get your money back. Sometimes you can sell to another investor in a secondary market.
Some bonds are for short periods of time and some may last for decades. This length of time is known as duration. Since long duration bonds can last for 20 or 30 years, investors usually demand higher interest rates.
The credit quality of the issuer also is a major determinate of interest rates. If all financially strong companies are paying 3 percent interest, that is likely to be the rate companies with similar financials would probably have to pay to sell their bonds.
If a company is struggling and having financial issues, they will have to pay a much higher rate of interest to attract investors. These bonds are known as junk bonds because if the company goes bankrupt, you could lose all of your money.
Bond values are always affected by changes in overall interest rates. The longer the duration to maturity the greater the effect. Sometimes, the value of bonds goes up (when interest rates in general are going down) and sometimes the value of bonds goes down (when interest rates are going up). Remember, the interest rate that the actual bond is paying does not change.
What does change is the amount of money that you could receive in a secondary market if you need to redeem your investment before maturity.
A bond maturing in a short period of time does not react as much as one with many years. If you own bonds that have 20 years to maturity and you need to sell and get you money back for retirement or some other use, you will lose “principal” and suffer a loss when you sell. This could be substantial.
The reason that this happens is new investors will naturally want the highest yields available with the same amount of credit risk. If you want to sell your 3percent bond when overall rates have risen to 5 percent, you will have to sell at a discount to find a buyer. The buyer is only willing to pay a face amount that will net him the current interest rate. He will get full value from the issuer at maturity as long as they have not gone bankrupt.
The FED has clearly announced that interest rates will be going up. They are unwinding their balance that became bloated during quantitative easing. Both of these things will push interest rates higher. Rising interest rates will also have an effect on the stock market. Many people purchased stocks in the past because bond returns were so low since 2008. Also, many companies repurchased share of their own with cheap money which drove up stock prices.
We saw what happened in the stock market a few weeks ago when interest rates went up slightly. If inflation continues to pick up, the FED will likely raise interest rates quicker than anticipated. Make sure that your investments that you will need in the next few years are protected.
Your Financial Future is written by certified financial planner Gary W. Boatman, MBA and CFP, who also wrote the book, “Your Financial Compass: Safe Passage Through The Turbulent Waters of Taxes, Income Planning and Market Volatility.” If there is an area that you would like to see discussed in the column, send your suggestions to gary@BoatmanWealthManagement.com.