Why Bonds? #3 – Bonds Can Be Safe, Low Risk Investments (video)

– Posted in: Asset Allocation

Asset allocation is your most important investment decision: How much to own in stocks? How much in bonds?Why Bother With Bonds? Bonds are safe bet is the third of four short videos that address why CDs, Bonds, and Bond Funds are critical to building an all-weather portfolio—even during low interest rates.

Video Transcript: Bonds Are Safe, Low Risk Investments

The value bonds goes down when interest rates go up, so how’s that a safe bet? That’s coming up.

So, Why Bother With Bonds? The third reason is that Bonds can be a safe bet. And by that I mean “no surprises”. With any bond or CD, you loan your money for a specific period of time in exchange for periodic interest payments on specific dates of fixed amounts. And then at the end of the term you get your full investment back. In some cases, this is all guaranteed by the government—that’s pretty safe.

What can go wrong? Well, you can get into trouble by chasing after high-yield bonds from companies with low credit ratings. These are called “junk bonds” and they tend to get in trouble at the same times the stock market does—the very time you most want some stability. You can also have a problem if you lock your money up for a long term and then need it before the bonds mature.

The strategy I like, is to choose a fund of high-quality bonds that add stability to your investment portfolio when the stock market plummets. The thinking behind this strategy is that you’ll get better overall return by taking your investment risk on the stock side of your portfolio.

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.

Here’s the first one: If you hold a bond (or a CD) to maturity, you still have interest rate risk.

Next: US Treasury Bonds, or FDIC-insured CDs, are risk-free investments.

This one is false. These do have impeccable credit risk, meaning they will pay you exactly as agreed (all the interest payments and then you’ll get 100% of your invested principle), but they still have interest rate risk. Interest rate risk means the value of your bond changes when interest rates change. All bonds, including all CDs, have interest rate risk, which is why this first fact is true.

YES! This is true. But it confounds a lot of people how you can have any risk from changing interest rates if you get all your interest payments and then 100% of your invested principle on the dates promised.

Let’s look at a simple example to help you see this. Suppose you purchase two bonds. The first bond you purchase yields 5%. The next day, bad luck, interest rates rise 1% and you buy a second bond. At 6%, it’s worth $10 more at maturity. That makes Bond 1 instantly worth $9.43 less than what you paid and that grows to the $10 difference at maturity. (1)

Another way to look at it is: you would need to invest $9.43 at the new interest rate to be equal to the $10 additional that the second bond pays.

Yes, ALL bonds have interest rate risk. So how can that be a safe bet? Because there were no surprises. You got exactly what you expected, and what was promised, when you purchased each of these!

Later, we will show how to choose bonds that will protect yourself from both interest rate changes, and from inflation. But next we’re going to see the important bonus you get because bonds often YING when stocks YANG.
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Footnotes And Video Production Credits for Bonds Are Safe, Low Risk Investments

(1) This particular example was originally presented by Allan Roth in his article for CBSNEWS.com “Bonds vs. Bond Funds? An Easy Choice!”, December 14, 2009.

This video may be freely shared under the terms of this Creative Commons License .

Video copyright 2009-2014 Rick Van Ness. Some rights reserved.

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  • Ben January 29, 2015, 6:17 am

    In your example: a bond at 5% (1000$ bond) is held in a market when rates jump to 6%, the value decreased to 990.57$. If you hold the bond to maturity, does the corporation or gvt only pay 990.57$ +5% or does it pay the entire 1050$? (1000$ plus 5%)

    Thank you, Ben

    • Rick Van Ness January 29, 2015, 7:49 am

      Thanks for your question. The obligation of the corporation or gvt doesn’t change so they still give you the same interest payments and full value at maturity. However, just because you still get $50 + $1000 at maturity doesn’t mean that you were not affected by the rise in interest rates. You easily see this if you consider all those that received the higher interest payments from the bonds issued a little later at the higher interest rates.

      A practical side of this comes from understanding the concept of “duration”. Hold your bonds longer than the “duration” after a rise in interest rates and you’ll come out ahead (because of reinvesting your interest payments at the new higher rate). Hold for the duration and you would be indifferent. Hold them for shorter than the duration, then you get less than you originally expected from that bond investment. —Rick