Aaron Katsman 58.
(photo credit: Courtesy)
As the wild ride in financial markets continues, investors are looking for ways
to stabilize their portfolios.
What are bonds?
One way of accomplishing this is through
the use of bonds. The only problem is that with bond rates at historic low
levels, the next few years could provide a rude awakening to some bond investors
if interest rates were to start rising.
A bond is
essentially a loan or an IOU issued by a corporation, government or government
agency. When a person buys a bond, he is basically loaning money to the issuer
in return for interest payments and the return of principal.How does it
For example, let’s say Microsoft issues a bond that matures in four years
at a fixed interest rate of 5 percent. If a person invests $10,000, he will
receive $500 annually. Additionally, Microsoft repays the original $10,000 to
the investor after four years. If Microsoft is unable to meet its obligations,
the bond would default and the bondholder might lose some or all of his
Bonds are liquid investments, meaning they can be sold anytime.
Keep in mind that if you sell before the maturity date, there is no guarantee of
principal and the bond will be sold at the market price, which may be higher or
lower than the purchase price.Bond prices
Two main issues affect the
prices of a bond. Bonds move in response to changes in the credit quality and
financial stability of the issuer, as well as shifts in interest rates. Let’s
focus on what happens if historically low interest rates begin to
When interest rates climb, bond prices usually fall. The reason for
this can be explained using the example of the 5% Microsoft bond. If interest
rates fall, the 5% received on this bond becomes more attractive, and as the
demand for the bond increases, so does the price. Conversely, if interest rates
move up, suddenly the 5% isn’t as attractive as it was when rates were lower, so
the price of the bond drops.A new rate environment
While pundits have
been calling for higher interest rates for some time, logic would indicate that
at some point in the next year or two rates will almost certainly have to rise
to fight off inflation caused by the US government’s 24/7 printing of money. If
you are a bondholder, this can have huge ramifications. If you own individual
bonds, as long as you hold them to maturity you will be okay, but if you need to
sell prematurely, you could suffer a loss of principal.
don’t hold individual bonds and instead own bond mutual funds. According to
MarketWatch: “While deflation may be an immediate threat, in the coming years
the US is likely to see rising inflation and interest rates.
If that does
happen, investors who’ve been fleeing to bond funds recently may see losses.
Floating-rate funds won’t face that problem. That’s because their rates reset,
between every 30 and 90 days depending on the security, usually in line with the
London Interbank Offering Rate, or LIBOR. This means their rates will climb
along with the market.”Floaters
While many well-known corporations such
as General Electric and Goldman Sachs are big issuers of floating-rate bonds,
investors need to do some homework if they plan on investing via mutual funds.
Many floating-rate funds invest in senior bank loans.
According to The
Wall Street Journal: “Floating-rate funds mostly invest in bank loans made to,
or bonds issued by, companies with low credit quality, and these portfolios
usually sport average credit ratings well below the definition of ‘junk.’ A
review of the funds that investment researcher Morningstar Inc. includes
in its bank-loan category, and for which it has credit-quality data, shows none
rated over double-B – near the top of the junk-rating spectrum but junk
nonetheless. The credit risk is a red flag for conservative investors who may
find floating-rate funds appealing as a way to stay in bonds even as interest
Floating-rate bond-fund managers argue that these funds’
holdings are superior to junk bonds because bank loans are higher up the credit
structure and investors have a bit more protection.
Now more than ever
floating-rate bonds may be a very useful tool in a bond portfolio.
make sure you understand what it is that you are buying, so that you don’t end
up with something much more aggressive than you
email@example.com Aaron Katsman is a licensed financial
adviser in Israel and the United States who helps people open investment
accounts in the US.