Buying bonds by owning a bond fund is straightforward compared to selecting individual bonds. Few average investors can analyze bonds, so a large proportion investing in bonds purchase a mutual fund called a bond fund, and let professional money managers make the selections for them. Hence, whenever you own a bond fund you own section of a professionally managed portfolio of bonds, often called an income fund.
Don't get confused. Buying bonds or an income fund has little in keeping with buying U.S. Savings Bonds. The us government guarantees you will not lose money in savings bonds. There's no market risk in these savings products. When investors speak of bonds they are not discussing savings bonds.
A connection fund might be defined as an income fund, because the principal objective is to offer higher income vs. other investments. These funds pay dividends from the interest earned on the bonds in the fund portfolio. Along with this particular higher income, investing in bonds involves risk. Bond prices or values fluctuate because bonds are marketable securities that trade in the open market, similar to stocks do.invest in bonds
In order to understand investing in bond funds, you first should find out some bond basics. Let's turn our attention now to a simplified bond example, a new issue of a really basic corporate bond.
ABC Corporation decides to boost a big amount of money to expand their operations. Rather than selling stock to people, they decide to offer bonds. In other words, they'll borrow money from investors. Each bond has an experience value or initial bond price of $1000. The coupon rate will be 6%. They are top quality bonds and mature in 2039. Once all the bonds can be bought ABC gets their money, and these bonds begin to trade in the bond market.
If you get an ABC bond for $1000, ABC promises to pay you $60 annually, or 6%, for provided that you own it until 2039 when the bond matures. At that time the bond owner gets the $1000 back, and the bond no more exits. Until the period the offer never changes. ABC promises to pay the bond owner $60 annually, period.
You as a bond holder are not required to carry the bond until 2039. You can sell it at will on the bond market, or buy more bonds at market price in the event that you wish. But beware that bond prices fluctuate, as do stock prices. Bond prices or values can rise and they are able to go down. In other word, a $1000 bond is definitely not worth $1000 after it is issued. Hence,there is market risk involved when investing in bonds.
Now picture an income fund committed to a portfolio of bonds similar to ABC bonds. Because this bond fund holds a wide variety of different bonds, investors do not need to concern yourself with an organization like ABC going broke and not making interest payments or not paying investors back upon maturity. The fund is broadly diversified.
The actual risk you should be aware of when investing in bonds and bond funds is of an alternative nature, and this risk is named interest rate risk. Interest rates in the economy fluctuate, but a bond's coupon rate does not. ABC bonds, for example, pay $60 annually, period.
What are the results when long haul interest rates in the economy rise? Simply this: the value of existing bonds, put simply bond prices, go down.
Look at it this way. If interest rates double and go from 6% to 12%, new bonds will be paying investors $120 annually in interest vs. $60. What you think investors in the bond market will be willing to pay for a 6% bond under these circumstances? Since investors buy bonds for the larger interest they give, the buying price of our 6% bond will fall just like a rock. The bond price will not likely fall in half, nonetheless it will be heading because direction.
Interest rates peaked in 1981-82, and have generally been falling since. Contrary to our above example, falling interest rates send bond prices higher. Investors in bonds and bond funds get income from interest or dividends when interest rates fall, plus the value of these investment increases.
But interest rates can not fall forever. Once they do head north again many folks committed to bond funds or income funds will be caught standing flat footed. Invest informed and appreciate this: When interest rates rise significantly, the value of your bond investments will fall.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly together helping them to reach their financial goals.
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