Should I Invest in Bonds?

James Bonds
Photo by LuckyN / Shutterstock.com

Welcome to “Ask Stacy,” a short video feature answering money questions submitted by readers and viewers.

Today’s question is about investing in bonds; specifically, what is the best time to buy bonds and why. If you’re not knowledgeable when it comes to these potentially important investments, watch the following video and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said. You also can learn how to send in a question of your own below.

For more information on this topic, check out “Ask Stacy: Why Is My Bond Fund Losing Money?” and “11 Pointers to Investing in Your 60s and Beyond.” You can also go to the search at the top of this page, put in the words “bonds” or “investing” and find plenty of information on just about everything relating to this topic.

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Got a question of your own to ask? Scroll down past the transcript.

Don’t want to watch? Here’s what I said in the video

Hello, everyone, and welcome to your money Q&A question of the day. I’m your host, Stacy Johnson, and this question is brought to you by MoneyTalksNews.com, serving up the best in personal finance news and advice since 1991.

Today’s question comes to us from Cindy:

“I hear that when interest rates go up, bond prices go down. However, I truly don’t understand when the best time to buy into bonds would be. For instance, if interest rates go up, are bonds cheaper to buy? I also don’t understand how to buy bonds or what type of bonds would be the right purchase for various situations.”

Let’s begin by going over bond basics.

Bonds are a “loaner” investment. Stocks, on the other hand, are “owner” investments. When you own stocks, you own a part of a company. When you own bonds, you’ve lent money.

There are two reasons you buy bonds. One is because bonds pay interest. You might need the income. In fact, people searching for income often buy bonds. The other reason to buy bonds is because you don’t want to have all your money in stocks. Bonds are typically safer, as being a loaner carries less risk than being an owner.

Bonds can be short- or long-term. They could be coming due in three months, five years or even 30 years. Longer-term bonds pay the most interest, but they’re also most affected by market rate changes. More on that in a minute.

Another factor for bond buyers is quality. Triple-A-rated bonds, the highest corporate bond rating, are safer than lower-quality bonds. U.S. government bonds are even safer, because the government prints money, so it literally can’t default. Because they have less risk, safer bonds pay less interest.

You can buy bonds in two basic ways: either individually, or in a bond mutual fund.

If you’re not familiar with mutual funds, they really represent a bunch of people getting together, pooling their money and hiring an expert to buy bonds for them. A mutual fund allows you to own a slice of a bunch of bonds, instead of just one or two.

Now, let’s talk about how bonds are priced. If you buy a bond and hold it to maturity, you’ll normally get back what you put in, plus interest. But what if you decide to sell your bond before it comes due? You can. Like stocks, there’s an open auction market in bonds. But also like stocks, if you sell your bond on the open market, you might get more, or less, than you paid for it.

What determines how much you’ll get if you sell early? Picture a seesaw. On one end is bond prices. On the other is interest rates. When market interest rates are going up, bond prices are going down. When interest rates are dropping, bond prices are rising.

In short, bond prices move inversely to market interest rates. If you hold your bonds to maturity, you get out what you put in. But their value in the interim fluctuates based on market interest rates.

Why do bonds, especially long-term bonds, fluctuate with interest rates?

Imagine that a few years ago, you bought a bond for $1,000 that pays 5 percent interest, or $50 a year, and it’s coming due in 10 more years. Now, something’s come up and you need to sell your bond on the open market. If similar-quality bonds issued today are still paying 5 percent, no problem. Your bond is as good as anyone else’s, and it’s worth the $1,000 you paid for it.

But what if interest rates have gone up since you bought your bond? What if I can buy a newly issued 10-year, $1,000 bond that pays 10 percent, or $100 per year? In that case, I’m not going to give you $1,000 for your 5 percent bond. If you want me to buy your bond, you’ll have to discount the price. In order for your bond to match the current market rate of 10 percent, you’ll have to sell it to me for $500. Then, the $50 it pays will match the market rate of 10 percent.

So, rather than your bond being worth the $1,000 you paid, it’s now worth $500. You’ve just lost half your investment. On the other hand, if interest rates have dropped since you bought your bond, your 5 percent bond is worth more than you paid for it.

See how that works? That’s why market interest rates affect bond prices.

Today, interest rates are slowly rising. So, what’s happening to bond prices? They’re slowly dropping. Hold them to maturity, no problem: You’ll get your money back. But when you look at your monthly statements, you’ll probably see the market value of your bonds falling.

Going back to what Cindy asked: When do you want to buy bonds? As you now know, the best time to buy bonds, especially long-term bonds, is when interest rates are high. The worst time to buy bonds is when interest rates are bottoming.

When I became an investment broker for EF Hutton back in 1981, interest rates were super high. At that time, you could easily buy a triple-A-rated bond that paid 15 percent interest. As interest rates fell, those bondholders were richly rewarded.

As I mentioned, however, some investors need to buy bonds now — despite the fact that rates are rising — because they need income and/or safety. What should they do? They have a couple of choices.

If they’re convinced interest rates have nowhere to go but up, they could stick to short-term bonds, since they won’t drop as much as interest rates rise.

But since nobody knows for sure where interest rates are headed, a safer bet would be to buy some long-term, some medium-term and some short-term bonds or funds. That way, if rates go up, your short-term funds won’t get hurt as much. If rates go down, your long-term funds will benefit. In other words, spread the risk.

I hope that makes sense, Cindy. If it doesn’t, do a little reading. We’ve got plenty of information at MoneyTalksNews.com. Just do a search for “bonds,” and you’ll be reading until the cows come home.

Let’s finish with our quote of the day. This comes from author Frank Clark:

“The more you learn, the more you earn.”

Appropriate advice for Cindy. Have a super-profitable day and meet me right here next time!

Got a question you’d like answered?

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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.

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Got more money questions? Browse lots more Ask Stacy answers here.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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