When quarterly investment statements are sent out, they commonly include a listing of available investments and recent investment returns. Over the past year, the returns on bond investments on these reports have looked very good, especially compared to the losses experienced by most stock investments. I typically receive several phone calls from clients asking if transferring from stocks to bonds is a good idea. Answering this question, I've discovered that most folks don't understand how bonds work. Because you can lose money with bonds and because interest rates are so low today, understanding bonds is critical to creating an investment strategy.

Bond values and interest rates have an inverse relationship. Interest rates up, bond values down. This is because when interest rates go up, old bonds don't pay as high an interest rate as investors can get on newly issued bonds and so their market value drops.

This effect is more severe on bonds with longer maturities. For example, currently two-year government bonds pay about 1%, and 30-year bonds pay about 5%. Assuming that all rates go up 2% over the next year, the value of a two-year bond changes very little since it matures in the near future. The principal is returned at maturity and can then be reinvested at the higher rate. However, the 30-year bond will drop about 25% in value. In other words, if you originally invested $100,000, you will only get about $75,000 if you sold. Why? Since a new 7% bond pays 2% annually more interest than the old 5% bond ($2,000 on a $100k investment), the owner of the 7% bond will receive $58,000 more interest over the next 29 years. The investor buying a new bond doesn't care if she pays $100,000 for a 7% bond, or about $75,000 for the 5% bond. She will get a 7% return on her invested cash, either way. The 5% bond owner can get his $100,000 back, by the way - he just has to wait until for either: (1) rates for bonds with that maturity drop back down to 5%, or (2) the bond to mature in 29 years.

This inverse relationship works both ways. When interest rates go down, bonds with yields higher than current market rates go up in value. Because interest rates have been falling for the past 3 years, bond investors have benefited.

And this is why it is so important to understand bonds right now. With interest rates so low, do you think there is a higher probability that rates will go up, or go down, over the next year or two? I'm guessing "up." If you agree, avoid long-term bonds.

This doesn't mean you shouldn't buy any bonds, because bonds are an important component of many portfolios. They not only provide income, but they can also reduce overall volatility because of their low correlation to stocks. However, for those clients who do need bonds or bond funds, I am generally recommending short-term maturities. Do they have lower yields? Yes, of course. But they also have lower risk. With interest rates at such low levels, I believe this tradeoff is prudent for that portion of your portfolio invested in bonds, in order to protect your principal.

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