Understanding Bonds

The blog has been talking about making and losing money on bonds. Perhaps some questions need to be answered. How is it possible to lose money on bonds? Which bonds should a person buy? Should a person buy junk bonds?

How is it possible to lose money on bonds?

This is the main subject of the next blog. A few points of interest:

1. Bond prices move inverse to interest rates. What this means is if the interest rate drops it will cost more money to sell and buy a bond. To illustrate this point the value to sell and buy a $1,000 30 year bond that has no coupon, makes no semi-annual payments, is $141 at a 7$ interest rate and $424 at a 5% interest rate.
2. If a bond is sold early, not held to maturity, price come into play and if sold for less than purchases is a capital loss and if sold for more is a capital gain.

Which bond should a person buy?

A bond is an obligation for an entity to pay you back on the money you are allowing them to use. A key is when do you want your money back? Realizing that the longer the time that this entity has your money the higher the return to compensate you for the additional risk. This is not always 100% true as yield curves on occasion do inverse with longer term bonds having a lower interest rates than shorter term bonds.

My guidance is to buy a series of bonds to ladder your maturity dates, have bonds mature at different times, instead of a single bond. Another alternative that is much easier is to buy a bond mutual fund. This gives a greater amount of flexibility for an average investor.

Should a person buy a junk bond?

The first thing to do is define a junk bond. The simplest definition is a bond that is assigned a speculative rating by a rating agency. To put it simpler, they have a higher chance of not paying you your money meaning a higher degree of risk. Why would anyone buy junk bonds because with greater risk should come the potential for a greater return.

Do I recommend an average investor buy a junk bond. No!!!

Do I recommend an average investor buy a mutual fund that includes a grouping of junk bonds. Yes!!! Why? In the book a Random Walk Down Wall Street, on average a mutual fund of junk bonds yields about 7.5% while a mutual fund with in investment grade bonds yields about 5.5%. This means to me that you can achieve about a 30% higher return at a low amount of risk of default. Things would have to be really bad if one of these funds had a 30% default rate.

Bottom Line: You need to understand your time horizon, needs, and risk level before buying bonds or bond mutual funds.