Bonds Investing FAQs
Bond investing can occasionally be perplexing. Often when a specific bond or income investment question comes to mind, no obvious source for an answer is apparent.
Here is a list of practical answers to frequently asked bond investing questions. This quick reference guide is designed to be a "go to source" for answers to your bond and income investing needs.
AAII's bond area is your key to successful investing.
Bond Investing: Purchasing the Bonds
Bond Investing: The Basics
What causes a bond's price to rise?
If you have invested in a bond and interest rates fall, your bond will rise in value. If interest rates rise, your bond will fall in value. Why? When interest rates change, the price of an existing bond with a fixed interest payment (coupon rate), one that doesn't float (adjustable rate) with market interest rates, or a bond with a zero-coupon interest rate, must adjust in price to provide the same return as an equivalent, newly issued bond that has a higher or lower coupon interest rate. The risk that a bond's price will vary as interest rates change is usually termed interest rate risk.
Paper gains or losses on your bond investments caused by market interest changes will go unrealized if you hold your bonds to maturity, often an intention rather than an accomplishment. Sounds fine for unrealized losses, but why not cash in on any gain? Cashing in, paying taxes on the gain, and using the funds for other purposes makes sense. But if you just intend to reinvest in a new bond at what are now lower interest rates, your gain will be generally offset by the lower interest payments received on the new bond with the same remaining years to maturity as the bond sold. And don't underestimate the impact of the capital gains tax.
Of course, you could minimize capital losses if you invested in longer maturity bonds only near interest rate peaks, locking in high rates; and by investing in shorter-term bonds near interest troughs, so that you are not locked into low interest rate bonds that will be exposed to capital losses as rates inevitably climb. Peaks and troughs, however, are usually observable only from a distant vantage point.
What type of bonds carry higher interest rate risk?
Longer-term bond prices are more volatile than shorter-term bond prices. While the price changes increase at a diminishing rate, long-term bonds are riskier and should promise higher returns, which they usually do. Longer-term bond investments are more susceptible to interest rate risk because they have a long future stream of interest payments that don't match the current rates, and so the bond price must adjust more to compensate for the change in interest rates.
If you don't like bond interest rate risk, you would be best served by investing in the shorter maturities, or by closing your eyes and holding everything to maturity. How short does "shorter" mean? Probably no more than five-year maturities. Stay away from the 10- and 20-year maturities and don't even think about 30 years. Besides, you are much more likely to hold a five-year maturity bond to maturity than a 30-year bond.
How does a bond's coupon interest rate affect its price?
The higher the coupon interest rate on the bond, the lower the bond price change when interest rates change. If you are worried about interest rates rising and the value of your bond investments declining, then stay away from low-coupon bonds, especially zero-coupon bonds, which are obviously the lowest coupons possible.
In particular, avoid buying a long-term zero-coupon bond. Zero-coupon bonds are sold at a discount from face value and mature at face value, paying no interest along the way. The only cash flow is the maturity value. Because there are no intervening interest payments, changes in interest rates hit a distant maturity value very hard; long-term zeros soar on interest rate declines and plummet on rate increases.
If you want to avoid a roller coaster ride on your bond investments, then stay shorter term and seek out bonds with coupon rates near current levels or bonds with coupon rates above current levels. These latter bonds would sell at a premium above the face value of the bond. But if substantially above current rates, they are more likely to be called-paid off before maturity-unless they are U.S. government bonds, which are virtually call-free.
Will my yield-to-maturity be affected by interest rate changes?
Yes. If you bought a bond at face value and held it to maturity, you would expect your realized return to be about equal to the coupon. But this is not necessarily true. Your actual return will depend on the rate at which you can reinvest your coupon interest payments. Of course, for a zero-coupon bond with nothing to reinvest, the yield-to-maturity that you bought the bond at, if held to maturity, is your realized return. All bonds with coupon interest-everything but zeros-have reinvestment risk, but lower coupon bonds have less reinvestment risk than higher coupon bonds.
Higher coupon bonds either penalize you more than lower coupon bonds when you reinvest at lower rates or reward you more when you reinvest at higher rates.
So if rates fall and your bond price rises but you still intend to hold to maturity, don't rejoice. Your interest payments will be reinvested at lower interest rates and your realized yield will be lower than you may have anticipated. But if interest rates rise and your bond falls in price, don't be disheartened: You can reinvest those interest payments at higher yields, raising your realized yield-to-maturity.
How do I know what return I'm getting on my bond investment?
In order to understand what you actually earn from bonds, you need to understand two different concepts: yield and total return.
When you buy an individual bond, you can expect to receive coupon payments (usually every six months) for most bonds. When you buy a bond fund, you can expect a monthly payout of the income earned by the bond fund. That stream of income is variously described as the bond's "yield." But you also have to bear in mind that when you sell or redeem your bond (or bond fund), you may sell at a higher or at a lower price than the price you paid. That difference can be an additional source of earnings, or it may result in a loss. That change in price is one of the main factors that determines a bond's total return.
What may be confusing, however, is that the term yield has a number of different meanings. Even more confusing is the fact that these meanings are not directly comparable for individual bonds and for bond funds. Moreover, individual bonds are usually sold to investors and are discussed primarily in terms of yield, not returns. But discussions of bond funds often focus on total return.
To gain a better of understanding of yield and total return for bonds, see the Investing in Bonds Classroom called "The Ins and Outs of Bond Yield."
What does bond duration indicate?
The effective duration for a bond portfolio is the best indicator of interest rate risk. Duration is a sophisticated measure of a bond's "average" life, considering its time to maturity, stream of interest payments, and price. It's essentially a weighted average time to recovery of all payments to the bondholder. For instance, the duration of a 20-year zero-coupon bond is its time to maturity-20 years-since all payments are received at that time; the duration of a 20-year, 10% coupon bond would be less than 20 years, since income payments are received prior to maturity. The duration of a bond mutual fund is found by averaging the durations of its bonds.
The shorter the duration, the less risky the bond investment.
For bond mutual funds, the telephone reps at major fund companies can provide up-to-date duration information; it can also be obtained from Morningstar.com. Typical maturity-group duration ranges are one to three years for short-term funds, four to six years for intermediate-term and seven to 10 years for long-term portfolios. Conversely, money funds have readings near zero. The higher the number, the more net asset value fluctuates in response to interest rate changes. For example, if interest rates increase by one percentage point, a long-term fund with a duration of 12 could be expected to fall about 12% in value. The longest durations are found among the long-term target maturity bond funds.
Be aware that duration gauges only the interest rate risk of a bond fund, not its credit risk, currency risk, or any other potential perils.
Bond Investing: Purchasing Bonds
How do I go about investing in bonds?
Individuals may purchase bonds from a number of sources, such as full-service brokerage firms, banks or firms that specialize in debt instruments, and discount brokers. U.S. Treasuries may also be bought directly from the Federal Reserve Bank. (See How do I buy Treasury securities? FAQ below.)
However, bonds trade quite differently from stocks. First, the availability of bonds varies from dealer to dealer. If you want to buy a specific type of bond (say, an intermediate municipal bond with a rating of A or better), you cannot just assume that you can buy that bond from any dealer. Instead, you may have to approach several dealers before you find one who has what you want.
Discount brokers generally do not maintain inventories for bond investors. If you want to buy a certain type of bond, their traders have to buy it from another dealer; if you want to sell the bond, their traders ask for bids from other dealers.
The best sources for individual bonds tend to be larger broker-dealer firms or firms that specialize in selling bonds to individual investors. These firms typically maintain inventories of bonds. They may also be able to obtain desirable new issues, whereas smaller firms may not.
For more information on bond pricing, commission costs, and other factors you need to know before purchasing individual bonds, see the Investing in Bonds Classroom called "Getting a Handle on the Bond Market."
What's the best way to buy Treasury securities?
The simplest and most economical way for individuals to purchase Treasuries is to buy them directly at auction, through the Treasury Direct program. Individual investors can buy securities for as little as $1,000, with additional increments of $1,000. This is attractive for a number of reasons. First of all, all commission costs are eliminated. Also, individual investors are able to consolidate all of their Treasury securities in one account. And finally, individual investors receive the same yields as institutional investors.
When you open an account through Treasury Direct, you are banking directly with the Federal Reserve Bank, colloquially known as the Fed. The advent of the Internet has enabled the Fed to make this process extremely simple. Information and any necessary forms can all be downloaded directly from the Treasury Direct Internet site. However, if you do not have access to the Internet, forms necessary to open an account can be obtained from any of the 12 Federal Reserve Banks or from any of their branches. (The phone numbers of these banks can be obtained from your local bank; or from the reference desk of your local public library. Forms can also be obtained by telephoning the Treasury Direct Office in Washington: 800/722-2678).
Treasury Direct is a highly efficient operation:
- Interest payments are automatically wired to the account that you designate, as is matured principal.
- You can choose to automatically reinvest, or to withdraw cash periodically.
- No matter how many different securities are in your account, in whatever combination of maturities you desire, all are held in one central account with one account number.
- You may access information about your account via the Internet, or by phone.
A Treasury Direct account enables you to purchase any Treasury security, including inflation-linked bonds, in any maturity you desire, from three months to 10 years, and to put together a portfolio that is totally tailored to your needs.