Bonds are debt securities usually issued by corporations or government institutions. An investor who buys a bond is lending money to the issuer in return for interest payments and future repayment of the principal. A bond fund is a mutual fund invested in several bonds. An investor could buy a single, secure government bond if only concerned about safety of principal. However, bond funds offer more options. Bond funds put your principal at some risk, but they also give you more liquidity and diversification than you would get with a single bond.
Bonds can be classified as either high yield or high quality. High yield bonds, also called junk bonds, usually pay a higher interest rate because they carry more risk. High quality bonds, also called investment grade bonds, can usually pay a lower interest rate because they are more secure. Investment grade bond funds are better for more conservative investors because they have lower credit risk. The Securities and Exchange Commission (SEC) says, "Credit risk is the risk that the issuers of the bonds owned by a fund may default (fail to pay the debt that they owe on the bonds that they have issued). This risk may be minimal for funds that invest in insured or U.S. Government bonds."
Bonds can also be classified as long-term, interm-term, or short-term. The term length of bonds in a bond fund will affect the interest rates they pay. Probably the biggest risk of principal in bond funds is the interest rate risk. The SEC says, "Interest rate risk is the risk that the market value of the bonds owned by a fund will fluctuate as interest rates go up and down. Nearly all bond funds are subject to this type of risk, but funds holding bonds with longer maturities are more subject to this risk than funds holding bonds with shorter maturities. Because of this type of risk, you can lose money in a bond fund, including those that invest only in insured bonds or government bonds."
Bond fund prices tend to move inversely with interest rates. When interest rates go up, new bonds are issued at higher prices. Investors prefer to buy the new higher interest rate bonds opposed to older lower interest rate bonds because newer bonds are paying more interest. This causes already issued bonds to go down in price. When interest rates go down, the prices of already issued bonds go up. Investors prefer to buy the older bonds because they are paying a higher interest rate than newly issued bonds. This depends on the assumption that bonds held in the bond fund are issued with fixed interest rates. That means the issuers have to pay the interest rate set at the issue date rather than fluctuating rate they pay to reflect market changes.
Here is an example of how you could loose money in a bond fund. There is a bond fund priced at $10.00 per share right now. If you invested $5,000 in that bond fund, you would buy 500 shares ($5,000 / $10 per share). When interest rates increase, the bond fund price per share could drop to $9.50 per share. If you wanted to liquidate your bond fund at that time, your would receive $4,750 (500 shares X $9.50 per share). On the other hand, if interest rates decreased after you purchased your shares, the bond fund price could increase to $10.50 per share. Liquidating your shares at that time would give you $5,250 (500 shares X $10.50 per share).
The previous example does not consider interest payments you would receive from the bond fund while you own the shares. Let's say the bond fund above is paying 4.8% interest (yield). Divided by 12 months, would be 0.4% per month, times $10 per share, would be $0.04 per share per month. Owning 500 shares would give you $20 of monthly interest. Assuming a constant 4.8% rate and ignoring compounding of interest, that would be $240 of interest for the year. Remember in the above example where the principal investment dropped $250 ($5,000 - $4,750)? The $240 of interest earned would almost negate the principal loss. While the interest income will never be negative, the total return could be negative because of losses of the principal investment.
You might find this information interesting when comparing the historical investment performance of stocks and bonds, also stock funds versus bond funds. This data was collected from Financeware.
Evaluating historical returns from 1925 through 2007...
In every 5-year holding period, stocks outperformed bonds 76% of the time (78 observations).
In every 10-year holding period, stocks outperformed bonds 85% of the time (73 observations).
In every 15-year holding period, stocks outperformed bonds 94% of the time (68 observations).
In every 20-year holding period, stocks outperformed bonds 98% of the time (63 observations).
In every 25-year holding period, stocks outperformed bonds 100% of the time (58 observations).
To summarize, the longer you plan to be invested, the more likely stocks will preform better than bonds. This information would not be as important to you if your primary concern is safety of principal. In that case, you would sacrifice potentially higher returns in preference for the lower risk investment. The appropriateness of stocks versus bonds depends on the financial goals of the individual investor. Consult a financial advisor if you need help deciding what investment mix is right for you.
