Bonds and safety go hand and hand in the minds of most investors. Unfortunately, there are great misunderstandings. I thought I would take the time to offer up an explanation to clear up the confusion.
Let's start off with bonds. When an investor purchases a bond, they are purchasing a contract. That contract is between the investor or bond holder and the bond issuer. The contract says that the bond issuer promises to pay stated interest for the life of the bond until a predetermined date where the bond issuer will pay back the principle (original money invested) to the bond holder. During that time period, the bond can fluctuate in value going up and down. The bond holder continues to collect their interest dividends. The bond holder only gains or loses if they choose to sell the bond. It would depend upon whether it was up or down in value. The whole idea is to hold it until the bond matures and get your principle back. The only downside would be if the bond issuer defaulted on the bond. In that case, the bond holder risks not receiving their principle back.
The bond has that safety net on it which is the date that the bond matures and the promise from the bond issuer to return the principle assuming no default occurs.
Bond Mutual Funds work the same way without the safety net. If you invest in a bond mutual fund, the value of your fund goes up and down with the collective value of the bonds in the bond mutual fund. A bond mutual fund is a portfolio of hundreds (most cases) of individual bonds. There is no collective safety net where a promise exists that you receive your money back. Thus you have principle risk in a bond mutual fund.
Why is this important today? Bond prices go up when interest rates go down and bond prices go down when interest rates go up. Unfortunately, we are in an environment where interest rates have the highest probability of going up. Thus bond prices have the highest probability of going down. Investors think they are getting an investment with a safety net. When in fact, that is far from the case.
So, if you are invested in bond mutual funds, don't make the mistake thinking you can't lose money. You most definitely can!
Bob Brooks is host of the Prudent Money Radio Show. If you have a question for him go to www.askbobbrooks.com. If you want to inquire about his financial advisement services, email him at firstname.lastname@example.org or call 972-386-0384 and ask for Judy.