The Federal Reserve's monetary policy has forced investors of all stripes into riskier investments. Thanks to vanishingly low rates on certificates of deposit, savers now look to bonds and structured products while bond investors may have moved toward dividend-paying stocks as a way of earning income.
The problem with moving toward riskier asset classes is that they are, well, riskier. Though bonds are very similar to CDs with a stated interest rate and maturity, they do carry credit risk from the issuer or in other words, the risk of default. Plus, bonds with longer maturities also can prove hazardous if interest rates rise. Finally, bond funds can be even be more perilous for investors as there's no definitive maturity.
Rising interest rates will decrease the value of existing bonds. That's not too much of a problem for most types of bonds that will be held to maturity. But in bond funds, there are many different bonds, typically with varying maturities. Many will not be held to maturity. Fund managers may feel they need to buy different bonds and sell some in order to meet the funds objective. Plus, in order to fulfill shareholder sell orders, some bonds may need to be sold early.
CDs do have some interest rate risk. A saver could buy a long maturity and then find himself stuck with a low-yielding CD as CD rates rise for years. To break the CD early, the bank will charge an early withdrawal penalty. That is a subject tackled by Paul Solman on PBS' website earlier this month in a column titled, "CDs vs. bond funds: Which is better?"
How to compare the interest rate risk of a CD with that of a bond fund? It all depends on the average "maturity" of the bonds in the fund. Again, how long are you tying up your money? In the case of a fund, there's no penalty for early withdrawal. Instead, the value of your share in the fund drops if interest rates rise before the bonds come due.
The logic is counterintuitive, but essential if you're going to invest in bonds, so understand what you're doing.
Buying a bond fund today in order to get a generous yield could put a dent in your principal once rates do increase. For that reason, many experts recommend sticking to funds that specialize in short maturities over longer ones, they'll be less affected by an interest rate increase.
How risky do you perceive bond funds to be? If the Fed sticks to the promise of delaying a rate increase until 2015, savers have plenty of time to learn about bonds.
What do you think of CDs versus bonds? Are low CD rates pushing you toward other investments?