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Understanding bonds: price vs. yield

If you think good news is bad and bad news is good, you must own bonds.

Perhaps you're one of those people who listen to the "diversified portfolio" mantra intoned by financial planners. In that case, you're committed to always keeping a portion of your holdings in bonds to help provide balance for those days, months and years when the stock market is behaving badly.

Then there are the shell-shocked folks who have watched their stock-laden portfolios take a beating the last three years and are now loading up on bonds in hopes of stopping the bleeding.

If you own individual bonds and you plan to hold them to maturity, you won't see any loss of principal, assuming the issuer doesn't default. But if you plan on selling an individual bond before maturity or if you recently bought shares in a bond fund, you may find that fixed income isn't always fixed.

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Bewildering bonds
As the economy recovers, interest rates generally rise and when that happens, bond prices fall. It seems a simple concept, but it isn't.

Here's a question Vanguard, the gigantic mutual fund company, recently posed to 1,000 people in a financial literacy survey.

If interest rates decline, the price of an existing bond or bond fund generally will:

A. Increase
B. Decrease
C. Stay about the same
D. Don't know

Only 30 percent of the respondents got it right. The answer is A.

Yet bonds should be an important component of a personal portfolio, and it's good to understand how your investments work.

"Relative to stocks, people have less of an understanding about bonds in general. To get that kind of an answer isn't all that surprising, but it is a concern," says Vanguard's Catherine Gordon, principal of the investment counseling and research department.

"We get a lot of calls when the net asset values of bond funds decline. A lot of people are surprised. A lot of people think of bond funds the same way they think of money markets or certificates of deposit."

John Grundy, a financial planner with John E. Sestina and Co., in Columbus, Ohio, says he looks for signs that a client doesn't really understand bonds.

"The biggest problem is they don't share it with us. We have to get a feel for them; we have to use our intuition."

Just as when the stock market is hot and people scoop up the hot stocks at highly inflated prices, people too often buy bonds and bond funds when their prices are high, Grundy says.

"People have a tendency to follow the returns and unless you're in on it early, you're zigging when you should be zagging."

Bond basics
Generally, the economy dictates interest rates. Bonds are loans investors make to the bond issuer whether the issuer is a company, a city or state, or the federal government. Since bonds are loans, they're usually very sensitive to interest rate changes.

When times are good, interest rates are high and bond prices drop. When we talk about the price of a bond, we're referring to what an investor is willing to pay for an existing bond.

Let's look at the relationship between bond prices, interest rates and yield. The "coupon" is the interest rate offered during the life of the bond. Yield is the annual return a bond pays to an investor holding the bond, assuming interest is reinvested.

Suppose Joe bought a 10-year, $1,000 bond two years ago that has a 5.5 percent yield. He's been collecting $55 interest payments each year for the past two years. Now, his buddy Jeff decides to buy a 10-year $1,000 bond, but during the past two years the economy has tanked and interest rates have been slashed. Jeff is bummed to find a new 10-year $1,000 bond will only yield 4.5 percent, or $45 a year.

Joe knows if he holds on to his bond he'll continue collecting 5.5 percent a year, and he'll get $1,000 back at the end of 10 years. But Joe also knows that his bond is more valuable now because his old bond pays $10 more in interest each year than the new bonds pay. Since he's a little short of cash, he offers to sell his bond to Jeff.

Jeff likes that idea because he wants more than 4.5 percent for his investment. So, Jeff pays Joe a premium; he gives him more than $1,000 for the bond in exchange for being able to collect $55, or 5.5 percent, a year for the remaining eight years of the bond's life.

The catch here is Jeff won't really get 5.5 percent, since he's paying a premium for the bond. His "yield to maturity" will be less than the stated yield of the bond. Regardless, if the bond's credit quality is good and there's nothing else out there paying that yield to maturity, Jeff is still getting a good deal even though he's paying a premium.

Conversely, if interest rates rose in the three years since Joe bought the bond, his old $1,000 bond would be less valuable than new $1,000 bonds that are paying a higher interest rate. If Joe wants to sell his bond he'll have to drop the price to compensate for the fact that it pays less interest than new bonds. In that case, if Jeff bought the bond at a discount, in other words for less than $1,000, he'd actually earn a higher yield to maturity.

So, when interest rates rise, bond prices fall, and conversely, when interest rates fall, bond prices rise.

By the same token, when the price of a bond rises, usually because demand for the bond is high, the yield drops. When fewer people want to buy bonds, the price drops and the yield rises.

Many investors opt for bond funds instead of individual bonds. A fund provides an inexpensive way to buy a diversified bond portfolio, plus you benefit from professional management. While the correlation between interest rates and price, and price and yield, still apply, it's a little tricky because the 12-month yield is a rolling average.

"People will look at a Morningstar snapshot and see the 12-month yield. That's what the fund has averaged over the past 12 months. Rates may have come down over the past year. Maybe down to 8 percent, 5 percent and 4 percent. You just bought in when interest rates are low; you'll receive lower income," says Grundy.

Grundy says investors should look for the 30-day yield because it's much more relevant as a current barometer for how the fund is doing.

A big difference between individual bonds and bond funds is you don't really have a maturity date with a bond fund. The fund manager decides when to sell the individual bonds held in the fund. If you sell a bond fund when yields are high, there's a good chance the price -- the money you would get per share -- is low. Even if you reinvest the dividends, you may not come out ahead.

"I've seen people in bond funds for quite some time and they haven't made any money even though they consistently reinvested the dividends," Grundy says.

Invest in maturities that coincide with your investment horizon. Long-term bonds are sensitive to interest rate changes, so make sure you have a long-term outlook before buying. Short-term bonds are less sensitive to interest rate changes and, therefore, better suited to someone who may need the money in two or three years.

Your best bet when investing in a bond fund is to plan on holding it long term. Reinvest dividends and hold the fund in a tax-deferred or tax-free plan, such as a Roth IRA. The long-term investment horizon will allow you to wait out economic upturns and downturns and sell your fund when its price is high.

The same goes for individual bonds. Plan to hold until maturity so you're sure to get back the principal, again barring default. If during the interim the economy goes south, you may be able to sell the bond at a premium.

But, as always, unless you're planning on cashing a bond and spending the money, be sure to consider your options for reinvestment before selling an individual bond or fund.

-- Posted: Dec. 16, 2002

See Also
International bond funds
U.S. bonds get new rates
Savings glossary
More savings stories

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