Bonds Explained (briefly)

The Fed Funds Rate is at historic lows and interest rates will eventually rise.  That will cause downward pressure on bond prices.  Bonds, though, are usually considered the safer, more stable part of a diversified portfolio.  So, professionals and individual investors alike have bonds on the brain these days…

Bonds Explained, briefly:

1.       Bond investors are essentially making loans to companies, governments, and municipalities

2.       In exchange for their temporary investment (a few months on up to 30 years or more; mostly 1-10 years), bond investors are paid interest (usually monthly, sometimes just yearly, and maybe at other times).

3.       The longer the bond, or the riskier the bond, the higher the interest rate paid.

4.       Bond investors get their money back at the end of the term, in addition to interest; sometimes there is no interest paid ongoing but instead it’s included with the principal repayment at the end.

5.       If the bond issuer has financial trouble, bond investors may not get some or any of their money back; that's rare, though, even in the case of "junk bonds".

6.       It is complicated for individual investors to build and manage their own bond portfolios.

7.       High-net worth individuals and institutional investors can get much better pricing.

8.       Bond funds have costs that eat away at income and total returns, but there are several bond funds that have excellent cost-justification track records (I am constantly searching for and evaluating such).

9.       Bond funds, however, do not offer the actual return of investment; instead, bond funds have a "net asset value" (like a share price) that fluctuates indefinitely.

10.   So, there are trade-offs, and my professional opinion is that bond funds with excellent track records and consistent management are very suitable for most investors

Interest Rate Risk Explained, briefly:

1.       In short, bond prices rise when interest rates drop, and they decline when rates rise.

2.       That is because bond interest rates move up and down as the prevailing interest rates (fed funds rate, treasury bonds, etc.) change.

3.       Different types of bonds will move more or less with prevailing rates for various reasons.

4.       Bond holders can wait for their bond to mature and get 100% of their money back after already getting the interest rates promised.

5.       Bond prices, meanwhile, fluctuate as bond rates move because of the secondary market for bonds:

a.       You buy a bond today that pays 3% interest, but, when rates rise, someone else looking to buy a bond next year can get something similar to yours that pays a higher rate.

b.      If you want your investment back before the bond comes due, someone might be willing to buy your bond instead of a new one.

c.       But since yours has a lower rate than what they can now get, they'd only pay you less for your bond than they would for a brand-new one offering a higher rate.

d.      So, bond prices decline when interest rates rise.  Likewise, though, bond prices rise when interest rates fall.

6.       You might have a very safe and sound bond portfolio, but its value may fluctuate between the time you buy the bonds and get your money back.

7.       But holders of individual bonds do get their money back (plus interest already paid or included with the principal repayment at the end) if they hold to the end; that is, of course, unless the bond issuer goes bankrupt or has major financial trouble.

8.       Bond fund holders would have to ride-out the interest rate fluctuations and/or the bond fund managers would have to successfully adjust the portfolio in order to keep the fund's NAV going up (or from going down) in a rising-rate environment.

9.       Even if rates rise and bond prices fall, you can still make money (and keep getting interest income) from bond funds.

10.   The better bond funds have methodology and strategy that work well, and track records to demonstrate that.

11.   There are no guarantees that a great bond fund manager will succeed all the time, of course.

Bottom line:

1.       Bonds are not as safe as they usually are because interest rates are likely to rise.

2.       But bonds remain one of the three most important parts of any diversified portfolio.

3.       Portfolios of individual bonds are difficult for most individual investors to assemble and manage; bond funds have drawbacks but are good choices for many.

4.       Bond index funds have been touted for their low-costs and benchmark-matching performance (or close to it), but they pose increased risks in this likely rising-rate environment.

5.       Actively-managed Bond mutual funds offer a lot of advantages to individual investors—diversification, potentially cost-justifying performance, and convenience.

6.       I work hard to find and use only the best bond funds that are likeliest to perform well going forward.

7.       PIMCO is an example of a "active" bond fund manager that has an outstanding track-record

a.       While I have no obligation to keep using PIMCO funds (or those of other managers I favor), I expect PIMCO and some others will remain a key part of the bond portion of my Flex and Strategic portfolios.