When the stock market is going through rough times, many investors "rediscover" bonds. After all, the thinking goes, bonds are fixed-rate investments, so they must be more secure than stocks. And even if a bond's rate isn't particularly high right now, at least it's predictable. But are bonds really that solid and stable? Yes -- and no.
Let's look at the "yes" side first. When you invest in bonds, you will receive a regular stream of interest payments. And, if you hold the bond until it matures, you will get the full value of your principal back, provided the issuer doesn't default. And there's not even much chance of that, as long as you purchase a government bond or a high-quality, "investment-grade'' bond.
So far, it looks like bonds do indeed offer the stability you seek. But now, let's look at what happens if you don't hold your bonds until maturity. To begin with, keep in mind that bond prices rise and fall all the time. For example, if you have a bond that pays 5 percent interest, and market rates rise to 6 percent, then no one will want to buy your bond at full value, so, if you want to sell it, you'll have to offer it at a lower price. Conversely, if market rates fall to 4 percent, then your 5 percent bond will look pretty good to other investors, so they'll pay you a premium over and above the face value.
Consequently, if you buy a bond with the intention of selling it before it matures, you need to be prepared for the ups and downs of the bond market. In that case, as a true investment, rather than just a source of income, bonds may not be quite as "stable'' and "solid'' as you might expect.
The only way you can be sure that you won't lose any principal on your bond is to hold it until maturity. One way to do that is to match a bond's maturity with your needs. If you think you'll need proceeds from a bond in five years to help pay for a child's college education, you won't want to buy a 10-year bond. In five years, interest rates could have risen higher than what your 10-year bond is paying -- so, if you want to sell it, you'd have to take a loss. But if you bought a five-year government bond, or a high-quality corporate or municipal bond, you can be reasonably certain of having the money you need in time for college.
It's also important to be aware of a couple of the characteristics of bonds. First, bonds with longer maturities usually -- but not always -- pay higher interest rates than shorter-term bonds. And second, long-term bonds carry a higher degree of interest-rate risk. In other words, the longer you hold your bonds, the more susceptible you are to interest rate fluctuations and their impact on bond prices.
You'll also need to be cognizant of the fact that your bond may be "called'' at any time. Bond issuers may pay off principal early -- or "call'' their bonds -- when interest rates have fallen. They can then re-issue bonds at a lower rate. Some bonds, however, can't be paid off early, so, before buying a bond, find out if it offers this type of "call protection.''
Since you usually don't know exactly when you might need to sell a bond, a good long-term strategy would be to build a "bond ladder" containing bonds of varying maturities. Bond ladders also offer a degree of income protection: When market rates are low, you'll always have some higher-rate long bonds, and when market rates are high, you'll have short-term bonds coming due to reinvest.
Bonds may not be the perfect safe and sound haven you seek from the stormy stock market, but they still offer good diversification benefits. In addition, if you take a long-term perspective and ladder bond maturities, bonds can offer you smoother sailing.
Ross Hage is a licensed financial adviser with the firm of Edward Jones.