Think you should invest money in bonds or bond funds now? The best bond funds might pay three times the interest income you can get at the bank. Even the safest bonds in the world, the U.S. Treasury bond, pay twice as much as a longer-term bank CD. But before you invest in bonds to simply increase interest income, read this.
When you buy bonds you are lending money to the issuer, like a corporation or the federal government. They are borrowing from you and promise to pay a fixed rate of interest; and to pay back the amount borrowed on a fixed date in the future.
What isn’t fixed is the price or value of your investment as you hold it. Bonds trade in the open market much like stocks do. Hence, their price fluctuates.
For the above reason you can lose money in even the safest bonds in the world, the Treasury bond. And you can also take a loss in even the best bond funds available, because when you invest money with them you own a small part of a large bond portfolio.
The bond market works like any other market. Buying pressure sends prices up; and selling sends them down.
The federal government borrows money by issuing government securities like the Treasury bond. Trillions of dollars worth of these safest bonds in the world are owned by foreign countries. Both China and Japan own a ton of U.S. government securities.
The U.S. national debt is going through the ceiling and everyone, including foreign governments, is aware of it. What would happen if and when the rest of the world loses faith in America’s ability to keep its financial promises in regard to all of this debt?
When doubt or fear looms, investors sell. If foreign investors start to seriously sell the Treasury bond, bond prices will fall. When bond prices fall this has the effect of increasing interest rates. Example: if a $1000 bond that has a fixed interest rate of 5% falls to a price of $500, someone buying it for $500 earns $50 (5% of $1000) a year in interest … 10%. If, that is, the issuer doesn’t default.
Even the best bond funds can’t make money for investors when bond prices are falling and interest rates zoom upward. If investors can invest money in a Treasury bond and get 10% a year, what kind of interest would they demand from other bonds?
Fear is the greatest threat to any market since it generates selling. The point of this article is not to predict doom and gloom for America’s future. The point is this: bonds and bond funds pay higher interest because they involve risk. Interest rates are at historical lows and the temptation for investors to load up on bonds is high.
History shows that interest rates fluctuate. In the early 1980’s you could make 15% interest and some experts predicted rates would only continue to go up. They were dead wrong; and if you think rates at this point in time can only continue to fall its time to think again.
The above scenario is my greatest financial nightmare for this country. Whether it occurs or not … in the not too distant future interest rates will rise and bond prices will fall. If you own bonds when this happens you will lose money, even if you hold the safest bonds in the world or one of the best bond funds.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.