If you own bonds, you had better understand bonds.
It seems like about once or twice a month I will get someone in my office that says they have invested in bonds, and only bonds, for forty years. And today of course, they would like to buy some bonds. Why bonds? Because, of course, bonds are what they have always bought.
Bonds can be a very serious part of any portfolio and can at times be a good fit for some folks. But if you own them, or have a fund that owns them, it might not be a bad idea to understand how they work. I find many clients understand one part of the bond very well, the interest payment, but pay little attention to the price of the bond.
There are two components to a bond: the interest payment and the selling price. The interest payment will come at some regular interval and will be a percentage of the bond. If a $10,000 bond pays 7%, then the interest would be $700 per year. The second component, the selling price of the bond, correlates to interest rates and can fluctuate a great deal. If sold this can add to or take away from that interest that is being earned.
Think of a see-saw when you were a kid. Imagine that on one side of the see-saw is interest rates and the other side is bond (selling) prices. As interest rates go down, bond prices go up. As interest rates go up, bond prices go down. This is called an inverse (see-saw) relationship. This inverse relationship is not true of every bond or every fund. There are many exceptions, but in general, this is the idea. “So what?”, you say. The “so what” is this: when a seventy-five year old client wants to purchase a bond that matures in thirty years (when they are 105 years old!) it is time to understand this inverse relationship! (Note that a 30-year bond could be far less than the par value or the face value if it is sold before 30 years.) I would finish this application, should he buy or not?
Now let’s look for a little application. Think of the economy today. Are interest rates generally high, low, or fairly average? If interest rates are very low, then bond selling prices will likely be adversely affected when interest rates rise. If interest rates are high right now then bonds will likely be selling at a discount. Not too tough right?
For those who elect not to watch so closely, there are blend funds which usually allow the fund managers to decide how many bonds to hold at any given time. If interest rates are historically low, look up a few blend funds, and you will probably see that the fund manager has bailed-out of his bonds and had a little profit taking which may indicate that he believes interest rates will soon rise. So if it is bonds that you seek, remember to look at BOTH components of the bond: the interest rate and the selling price.
PS. The longer the term of the bond (like thirty year) the more closely it will correspond to this see-saw guideline. And of course the shorter the bonding maturity, the less affected it will be by this guideline. And remember: bonds sell at the par or face value at maturity. Kevin Daniels is securities licensed through Investacorp, Inc. A registered broker/dealer Member NASD SIPC. For more information: 636-949-0999
