bonds chalkboard

September 2014: Back to the Basics

In Back to the Basics, Investment Management, September 2014 by Adam Cufr

Back to the Basics – Bonds 101

If you have an IRA, 401(k), 403(b), 457, SEP, Simple IRA, or any other type of investment account, you have the option to place money into bonds. In fact, I would be shocked if you do not own any bonds right now. You are a bond investor, but do you really know how they even work?

As a study in contrast, let’s start by noting that owning a stock means you own a piece of the company who issued the stock. A bond, on the other hand, is a debt instrument. That means bond owners are actually lending money to the company (or municipality) who issued the bond. In other words, bond owners do not own a part of the company like stockholders do. You’re simply loaning them money for a predetermined period of time. Once that time is up, the bond matures and that company gives you your money back. While they had use of your money, they paid you a predetermined amount of interest.

Now that we have an understanding of what bonds are, let’s have a very practical discussion about what bonds do for their owners. Bonds have typically been the “safe” place to invest in your retirement accounts. That is, when you want to avoid taking too much risk with your savings, having bonds in your portfolio means you’ll see smaller losses when the stock market experiences its inevitable drops. Why is that? Well, because bonds have a set interest rate and a set maturity date, the guesswork is largely removed. Bonds just do what they’re supposed to do.

What about risks? Bonds are a unique investment with specific risks that we need to watch out for. Because bonds generally do what they’re supposed to do, a rise in interest rates out in the world means a new bond being issued for sale will have a higher interest rate payable to its owner than the bond you bought when interest rates were lower. That means rising interest rates generally reduce the value of the bond you currently own. Since interest rates are already near zero, what direction do you think they’ll move in the future?

Simply put, bonds are riskier now than they have been in the past. Bond mutual funds inside your retirement accounts may protect you when stocks drop, but they’re likely to lose value relative to rising interest rates.

What should you do next? Consider professional management for your personal IRA accounts. Our money managers are very skilled in choosing bonds that will respond better to rising interest rates. In your retirement accounts at work, consider sending us a recent statement to allow us to analyze the bond risks you’re facing. A second set of eyes may help you avoid the slow bleed in your bond funds due to rising interest rates.

It’s a crazy world where what was once safe now feels risky and what was risky now feels safe. Let us help guide you.