When you show your displeasure, the teller suggests that you talk to their investment guy, Jeff. A real nice fellow, Jeff can get you 6% in a bond investment. He explains that these investments are not insured like a CD is, but basically bonds are safe investments designed for folks who want to earn a higher interest rate.
Earning a safe 6% sounds good to you, but is this offer too good to be true? In truth, Jeff didn't give you the rest of the story. Or, if he did you only heard what you wanted to hear.
Are bonds safe investments? The answer is that they are safer than stocks, but no where near as safe as money in the bank. That's exactly why Jeff can offer you 6% vs. about 3%.
Millions of investors these days are facing the same problem. If you want your money to be safe, you can't get a decent interest rate. Simply put, money isn't worth much at the moment. Interest rates are simply a reflection of what other people are willing to pay you for the temporary use of your money.
So, why can Jeff and his bond investment offer you 6%?
Jeff was referring to bond mutual funds with a dividend yield of 6%. If interest rates in the economy remained unchanged after you made your bond investment, you could expect to earn about 6% in interest in the form of dividends. The value of your investment would likely be stable. In other words, the price of your bond fund shares would change little.
However, in the real world interest rates in the economy change on an ongoing basis. Bonds are normally long term investments with fixed interest rates that do not change for the life of the bond. Since they trade in the open market much like stocks do, their price or value fluctuates.
Hence, any bond investment has risk. Our concern here is with INTEREST RATE RISK. If interest rates go up after you make a bond investment, what happens to the value of your investment? Bond prices fall when interest rates go up.
If you invest with Jeff when rates are at 6%, you will not be a happy camper if rates later zoom to 8%, 10% or more. The value of bonds and bond funds will take a significant hit, because bond prices will be bid down in the market.
Look at it this way. If you pay $1000 for a bond with a coupon interest rate of 6% you earn $60 a year in interest. If rates go up to 10% after you buy it, new bonds of similar quality can be had for $1000, and would pay the investor $100 a year in interest.
Investors in the marketplace will still buy your 6% bond at the prevailing market price, but this price will be well below $1000.
Interest rate risk is very real and applies to virtually all bond investments. Every bond has a maturity date when the life of the bond ends and the owner is paid back the face value, which is usually $1000.
Bonds due to mature in a few months or years are referred to as short-term, and their price (value) is not greatly affected by changing interest rates. Long-term bonds might not mature for 20, 25 or more years. These get hammered when rates go up significantly.
Now you know the rest of the story. Be careful in your search for higher interest rates. If you need safety, stay away from longer term bonds and bond funds in a low interest rate environment.
James_Leitz
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