5 Things You Really Need to Know About Bonds Right Now

United States Savings Bonds
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Most investors believe that the stock market is the riskiest way to invest. But as many investors have learned the hard way lately, even supposedly safe investments like bonds can create losses in your portfolio.

For years, the Federal Reserve has done everything it could to keep interest rates low. But now that the Fed has started thinking about plans to cut back on some of the methods it has used to reduce rates, the bond market has suffered big declines, with losses of 10 percent or more for some types of bonds.

Here are five things you need to understand about bonds in order to make sure rising rates don't cause you any further nasty surprises.

1. Rising Interest Rates Hurt Bond Prices

Many bond investors make the mistake of thinking that rising yields on bonds are a good thing. That's true for new investors, as newly issued bonds will carry higher interest rates than older bonds.

But if you already own bonds, rising yields cause your bonds' value to fall. That's because as new bonds with higher rates come out, your lower-rate bond looks less attractive by comparison, and so buyers aren't willing to pay as much for your bonds, causing their prices to drop.

2. Longer-Term Bonds Move More When Rates Change

Typically, investors can get higher rates by buying long-term bonds. For instance, 30-year Treasury bonds pay almost 4 percent right now, compared to about 0.5 percent for two-year Treasuries.

The tradeoff, though, is that yield increases hurt the value of long-term bonds a lot more than short-term bonds. The reason: The longer you're locked into a relatively low rate, the more interest you lose from being stuck with that bond.

By contrast, even if rates rise substantially on a bond that matures within a few months, you won't lose much value because you'll soon be able to take your money at maturity and reinvest it in a higher-rate bond. That's one reason why so many analysts have advised bond investors to focus on shorter-term bonds lately.

3. Individual Bonds Have One Big Edge Over Bond Funds

Most investors buy bond funds for diversification rather than individual bonds. With bond funds, you can get exposure to dozens or even hundreds of different bonds even if you only have a modest amount to invest. To buy that many individual bonds, it would cost you tens or even hundreds of thousands of dollars.

However, one attractive feature of individual bonds is that even if their market value declines due to interest-rate rises, individual bonds eventually recover to their full par value at maturity. For bond funds, on the other hand, capital losses can be permanent because most bond-fund managers typically buy and sell bonds rather than holding them to maturity.

4. Municipal Bonds: Attractive Yields with Tax Benefits

Within the bond market, different niches have had varying results. Municipal bonds have seen an especially large run-up in yields, and right now, 30-year municipal bonds have yields that are almost a full percentage point above comparable Treasury yields.

What's particularly unusual about the current muni-bond environment is that munis usually have lower yields than Treasuries. That's because muni interest is exempt from federal tax, providing even greater after-tax returns than taxable Treasuries and other bonds. The recent Detroit bankruptcy has highlighted the risks of muni-bond investing, but high yields make that risk worth it for many investors, especially if you're in a high tax bracket.

5. Inflation-Protected Bonds Can Still Lose Value

Most bonds are vulnerable to inflation. That's one reason why inflation-protected bonds like Treasury Inflation-Protected Securities, aka TIPS, have become popular.

Yet the rise in bond yields lately hasn't come from inflation fears but rather from the Fed's anticipated policy changes. As a result, TIPS yields have also risen, causing big price declines in them as well.

Be Careful With Bonds

Having bonds in your portfolio still makes sense for most investors who can't afford to take on the full risk of the stock market and other riskier assets with their entire portfolio. By keeping these five things in mind, you can do your best to minimize any losses and take advantage of opportunities as they arise.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

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This is just one set of options people can pursue for investing. Learn more about bonds in general at http://www.mutualfundstore.com/bonds. These investments tend to have fewer risks than others, but all investments do have some risks involved, especially if you sell or cash out early on these. Learn all you can before taking any steps when it comes to investments.

April 24 2014 at 12:32 AM Report abuse rate up rate down Reply

Individual bonds do not 'recover' to their par at maturity. They remain at
par through the life of the bond. The writer confuses market price of a
bond with its inherent value. I would advise purchasing a bond for the
periodic interest payments and not as a trading tool. There are a good number
of 6%+ corporate bonds available. It will be some time and some disaster
when a higher rate is offered by A or A- issues.

September 16 2013 at 6:57 PM Report abuse rate up rate down Reply

Misleading photo of Savings bond?

Although, with something that is backed by "the full faith and credit of the US Government", you might be better off with something else.

September 15 2013 at 12:43 AM Report abuse rate up rate down Reply

The picture os US Savings Bonds is misleading. This article does not relate to Savings Bonds.

September 15 2013 at 12:10 AM Report abuse rate up rate down Reply


September 14 2013 at 8:52 PM Report abuse rate up rate down Reply
hi chet

The GREATEST con game in history. I bought them for YEARS after all double your money IN TEN YEARS. THAT'S WHAT THEY SAID AND THAT WAS HOW THEY WERE SOLD. If you paid $100 for a $200 band you got that amount IN TEN YEARS. OTHERWISE WHY DID THEY MARKET THEM THAT WAY? Now you'll get that $200 in thirty or fourty years. Then feds VERY QUIETLY changed the rules to make them virtualy WORTHLESS. I never heard about it till I went to cash them in.

It gave me such a warm fuzzy feeling knowing the U. S. Government CONNED ME OUT OF THOUSANDS.

September 14 2013 at 8:32 PM Report abuse -2 rate up rate down Reply

I know someone who has a bond from WW2 filled with 25cent stamps but never cashed in. There is no name on the bond. According to this person , the bond is worthless , who knows ?

September 14 2013 at 8:22 PM Report abuse rate up rate down Reply

Terrible illustration for this story. While the facts in the story are correct about bonds generally, the photo is of US Savings Bonds, which never lose face value even if interest rates rise.

September 14 2013 at 5:18 PM Report abuse +1 rate up rate down Reply

Things Bernake never told you.

September 13 2013 at 5:21 PM Report abuse +2 rate up rate down Reply