Bonds: Know When to Hold Them, Know When to Walk Away

A client and recent widow sent the following note looking for some financial advice:

My husband passed away two years ago.  I am now ready to invest the insurance money for income.  I was going to buy bonds, but my friends say this is a bad time to buy bonds.

Her friends have a legitimate concern. It is important to understand what a bond is along with some basic bond behavior rules.  Essentially, a bond is a loan.  Typically, the US government, a state, city or corporation will borrow money from the general public so that they have money to pay for their various activities and projects.

Here is a simple example to demonstrate bond behavior:  In 2008, XYZ Corp wanted to borrow $1,000,000.  It issued 100 bonds for $10,000 each.  It agreed to pay 5% interest or $500 each year.  In addition, it promised to pay back all the money borrowed in ten years.  It is now 2013 and XYZ Corp has more projects to complete and needs to raise another $1,000,000.  However, given the fact that interest rates have gone down since 2008, it issues 100 bonds for $10,000 each, but only offers 2% interest or $200 each year.

Now, which would be preferable to an investor, spending $10,000 to buy the old 5% XYZ bond from 2008 or the new 2013 XYZ bond at 2%?  Most investors would, of course, choose the old bond.  And, here is where the concept of “Supply and Demand” comes into play.  Not only are the old bonds more desirable, but the price of the old, more desirable 5% bonds goes up because of greater demand and less supply.  The price of the new 2% bonds will inevitably go down due to lack of demand.  Again, this is a simplified example to emphasize the challenges of understanding bond behavior and investing strategies.

Here are some very general guidelines about bond behavior:

Rule # 1 -When interest rates go down, the values of older, existing bonds generally go up.
Rule # 2 – When interest rates go up, older, existing bond values generally go down.
Rule # 3 – Today’s guiding principle, given the current investment climate, is that when interest rates are low, investors should consider buying short-term bonds.  As the bonds come due, investors will then generally have the opportunity to reinvest at higher interest rates.

It can get very complicated when making decisions about bond sales and purchases, because in addition to these general guidelines, there are many other variables and options that should be considered as part of a bond investment strategy.  Some of the options are listed below:

• Hold existing bonds to maturity or sell prior to maturity.
• Consider higher risk Floating Rate bonds.
• Consider a “bond barbell” strategy that combines short and longer-term bonds.
• Consider diversifying among all bond types including government, municipal, corporate, international and emerging market debt.

The bottom line: It is a precarious time for bond investors.  Consider taking the time to meet with a professional investment advisor who understands your various options for dealing with these risks.  Then take the appropriate action.

Learn about the Wealth Preservation Solutions Investment Planning Process.