Stock market investors, especially those past the age of 40, should have bonds in their portfolios.
However, there is some confusion about owning bonds and whether they are safe investments.
Bonds are different (in many ways) from stocks. For one thing, most bonds have a maturity date, which means the bond issuer redeems the bond by paying the holder the face value of the bond.
For example, if you bought a ten-year bond when it was issued and held it to maturity, you would receive the face value of the bond from the issuer.
For most bonds, you would also receive two interest payments each year for the ten years you owned the bond.
The interest rate paid by the bond would not change (for most bonds) during the ten years.
However, you can buy and sell bonds in the secondary market.
In this case, you buy a bond after it was issued and sell it before it matures (if you desire).
When you buy and sell (trade) bonds, the price you pay for the bond depends on prevailing interest rates.
Since the bond pays the same interest rate regardless of market interest rates, the price you pay for a previously issued bond is adjusted.
For example, a bond with a stated interest rate of 5 percent will not sell at face value on the open market if interest rates are 6 percent.
Why would you buy an older bond paying 5 percent when you could buy a newly issued bond for 6 percent?
If you are the seller of the 5 percent bond, you adjust the price of the bond so that the buyer receives a yield equivalent to 6 percent.
If you own a bond paying 5 percent and the market rate is 6 percent, how much will you have to discount the face value ($10,000) so the fixed interest payment of $500 (5 percent of $10,000) is equal to the current market value of 6 percent?
The annual payment of $500 ($10,000 x 5%) must equal a 6% payment. Doing the math (5% divided by 6% = 0.8333), you discover that the face value of the bond must be discounted to $8,333 so that the $500 fixed payment equals a 6% yield on the buyer’s investment ($8,333 x 6% = $500).
If the situation were reversed and you owned a bond paying 6 percent while market rates were 5 percent, the bond would sell at a premium over the face value.
Buying and selling (trading) bonds is a huge market dominated by large institutional investors, mutual funds and other big players.
When you trade bonds, you expose yourself to market risk factors such as changing interest rates and supply and demand.
Bonds belong in every portfolio, but be wary of trading bonds if you aren’t comfortable with the bond market and are comfortable with the risks.
