Basics of Investing in Bonds

This article has been updated January 2014

Bonds are one of the cornerstones of the investment industry.  They are an integral part of institutional money management and have an important place in retail investing.

What is a bond?

Technically a bond is just a loan where you lend the money and someone is willing to pay you back plus interest.  The entity doing the borrowing might be the government in which we call it a government bond.  The entity might also be a company which we call a corporate bond.  You get a set rate of return for lending that money.  This is often called the bond coupon.

Bonds have a maturity date which sets the term of the bond.  At maturity, the original amount of the loan gets paid back.

Bonds can be bought and sold before the maturity date which means the price of the bond can fluctuate making them a little more risky than a Guaranteed Interest Certificate at the bank.

Are bonds safe?

As you can see from the risk return chart below, bonds are considered less risky than stock, Bonds, however are still not guaranteed.  Bonds are interest rate sensitive so the performance will vary as interest rates change.  When interest rates go up, bond values drop.

bond_vs_stock_ris_return_chart_2013_001

As you can see form the data below, bonds can fluctuate but not nearly as much as stocks.

Bond Returns vs. Stocks 1988 – 2014

YearBondsStocks
20148.8%10.6%
2013-1.513.0
20123.67.2
20119.7-8.7
20106.717.6
20095.435.1
20086.4-33.0
20073.79.8
20064.117.3
20056.524.1
20047.114.5
20036.726.7
20028.7-12.4
20018.1-12.6
200010.27.4
1999-1.131.7
19989.2-1.6
19979.615.0
199612.328.3
199520.714.5
1994-4.3-0.2
199318.132.5
19929.8-1.4
199122.112.0
19907.5-14.8
198912.821.4
19889.811.1

Here are some other observations from the data:

  • The biggest loss in bonds over the past 23 years has been −4.3% compared to −33% in the stock market
  • Bonds don’t lose money nearly as often as the stock market (only 3 times compared to 8 times in the stock market)
  • Bonds do not go up and down at the same time as stocks.  They are what we call “not correlated.”

Two elements to bond returns

  1. Interest return.  This is quite easy to understand.  Bonds provide a fixed amount of interest for a certain period of time (known as the term of the bond).  For example, if you have a 10-year bond that pays 5.0%, then the interest return is 5.0%.  This interest could be paid monthly, quarterly, semi-annually or yearly.
  2. Price return.  The more complicated part of the return is the fluctuation of the bond price.  Bonds can be traded and sold at any time.  As a result, the price of the bond can change.  The main determinant of the bond price is interest rate movements. For example, if interest rates fall, bond prices will go up.  If interest rates go up, then bond prices will fall.  However, if you hold the bond to maturity, price return does not matter as much.

So, if you have an interest return of 5.0%, what could cause you to lose money?  If interest rates start to rise, then the price of the bond will start to fall.  If the price of the bond falls by more than 5.0%, then you will start to lose money.  As you can see in the chart on the next page, the interest return plus the price return gives you the total return on the bonds.  In the last 15 years, the price return on the bonds was negative four times and the total return on the bonds was negative only twice.

Bond returns 1988 – 2013 (Source:Morningstar,Paltrak)

YearInterest ReturnPrice ReturnTotal Return
20141.96.98.8
20131.6-3.1-1.5
20121.62.03.6
20111.97.89.7
20102.04.76.7
20091.93.55.4
20083.03.46.4
20073.30.43.7
20063.20.94.1
20052.73.86.5
20042.94.27.1
20033.13.66.7
20023.94.88.7
20014.04.18.1
20005.34.910.2
19994.8-5.9-1.1
19984.44.89.2
19974.74.99.6
19965.66.712.3
19957.113.620.7
19947.4-11.7-4.3
19936.411.718.1
19927.82.09.8
19919.312.822.1
199011.2-3.77.5
198910.32.512.8
198810.1-0.39.8

Long term bonds have greater price fluctuation

Generally speaking, the longer the term of the bond, the greater the interest rate you will get.  However, it is also important to know that the longer the term of the bond, the greater the potential for fluctuation in price return based on interest rate movements.

In today’s economic climate, there is some concern that interest rates are more likely to rise than continue to fall.  If this is the case, it may not be the best time to invest in bonds.  Basically, the interest portion of the bond is low and does not give investors much of a cushion if interest rates start to trend up.

Regardless of timing, I’m not sure you should sell out of all your bonds because bonds will be an integral part of most people’s portfolios so it’s important to understand the basics of how they work.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

11 Responses to Basics of Investing in Bonds

  1. Bonds are one of the most misunderstood asset classes. I’m glad you have done an excellent job of explaining how they work.

    Investors analyzing risk should realize that Bonds have been in a 30+ year bull market where bond yields have fallen and bond prices have risen. The data above is from this period, meaning, it may not be representative of future returns or volatility.

    It’s possible that Bonds are the most over valued asset class today. The public continues to be heavy bond buyers even though the risk/reward ratio is the poorest in decades.

  2. The data set provided has a correlation of 0.098 which means there is no correlation, not a negative correlation. Granted, the data set is only 24 years.

    As Ken pointed out, bonds have been on a long bull run. Not that I necessarily agree with them, but many analysts are recommending investors shy away from bonds because if interest rates rise, prices will fall.

      • Suppose you own a $10,000 bond that pays 4% interest. If the bond is one year away from maturity, that means you will get $10,400 in one year (your principal + interest). Suppose interest rates rise to 5% and you need to sell your 4% bond. No investors would pay $10,000 to get $10,400 in one year when they could buy a 5% bond and get $10,500. They would want to get the same 5% interest, so they would be willing to pay $9,904.76 ($10,400 / 1.05). At that price, they earn the same 5% interest as they would buying a bond that paid 5%.

        • Does this only apply if you sell before the term is out? why do i ‘need to sell the 4% bond’? Can’t I just wait for the term to expire and get the 10400?

          • Yes, if you wait until the bond matures you would get the $10,400. The capital loss (or gain if interest rates go down) exists only if you sell the bond.

            What it’s really saying is that instead of having a bond worth $10,000 today, it’s only worth $9,904.76 because if you had to sell it, that’s what someone would pay you for it.

  3. I’m not such a big fan of bonds. I just don’t think the returns are as good as you can get from mutual funds. But for people looking for lower risk investments, bonds might be a good choice!

    What would you say is a good mix of bonds and mutual funds? 50/50? 25/75?

  4. You’re right, John–the returns from bonds aren’t as good as you can get from mutual funds. But then, the returns from mutual funds aren’t as good as those you can get from investing venture capital. Problem is, as you’re potential for higher returns increases, so does your risk. Bond holdings help to offset risk in equities investments.
    As for the “good mix” of bonds to mutual funds (I presume here you mean equities funds–bond mutual funds are out there, too), standard wisdom of bonds-to-equities in a mutual fund mix says your age should be the percentage of your portfolio you hold in bonds–increasing bond holdings as you approach retirement in order to minimize risk. The best mix for an individual investor is going to depend on that investor’s risk tolerance, which can be a factor of a bunch of variables (age and years to retirement included).

  5. Thank you for your excellent overview on bonds!

    Could you possibly give us a primer on how the laddered bond ETF offerings work. I’m especially interested in which way the total return would go in changing interest environments.

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