(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)Many investors consider bonds the "safe" investment. But in considering a bond "safe" you may be failing to manage some very real risks that bond investing presents. These risks are why bonds, like equities, require ongoing oversight and active management.
For starters, there is a difference between a bond fund and a bond.
An individual bond is a promise to pay ongoing interest over the life of the bond and your principal at maturity. You have three risks with an individual bond. The first is the risk of default. The second is the risk that you will need your principal prior to maturity and be forced to sell a bond at a loss. The third risk is that when your bond matures, you will be unable to replace it with another bond paying comparable interest.
The value of a bond over its lifetime is directly related to (1) the perceived risk of default and (2) current interest rates. If you purchase a bond during a period when 6% interest rates are the norm, and interest rates subsequently fall, your bond could be worth more than its face value. If interest rates were to go up, the value of your bond, if sold prior to maturity, would fall because an investor could purchase other bonds offering higher returns.
A bond fund is a collection of bonds with differing maturities and interest rates. The manager buys and sells bonds with the goal of increasing the value of the fund. The investor receives diversification across multiple bond issues, professional selection of bonds with an eye toward reducing the risk of default, and laddering of bonds of different maturities and returns typically with the goal of creating a stable flow of income (but no guarantee).
Unless the bond fund is a Unit Investment Trust (UIT,) it has no maturity and thus no obligation to return your principal. If a bond fund falls in value, there is no option of simply holding it until maturity to recapture your principal. The value of your investment in a bond fund will change in response market conditions and interest rates. On the other hand, you gain liquidity through the ability to sell virtually all bond funds at the current fund value (NAV).
The problem with bond funds, and with bonds you might want to sell before maturity, is the future direction of interest rates. The chart below shows the change in interest rates over the last 10 years. With every drop in rate, the value of a good bond increases if sold today. It's a good ride and one you want to stay on as long as it lasts.
The catch is that we don't know how long interest rates will remain at their current lows. The Federal Reserve has indicated that it sees no need for increases in the Fed Funds rate in the near future. The economy still struggles to recover and low rates are a good thing for the greatest debtor in our country - the U.S. Government. What we do know is that when rates begin to rise, they will affect the value of a bond portfolio. That's when risk management needs to be a part of the portfolio.
Feel free to email me with any questions or comments at Paul@investfortomorrow.com.
Until next time…
Paul Schatz
Heritage Capital LLC
Follow us on Facebook at www.facebook.com/heritagecapital and on Twitter @Paul_Schatz
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