Turn on CNBC, and you hear a bunch of analysts screaming at each other, and also screaming at you. You’re getting headaches, and you’re getting angry because you don’t fully understand Bonds, interest rates, or the Federal Reserve; so you turn on SpongeBob.
Kevin to the rescue. Here’s a brief overview explaining what is going on with Bonds.
Think of Bonds as loaning your money to a company. They agree to pay you back in a certain amount of time, and also pay you regular interest payments. Bored yet?
How does the Federal Reserve impact bonds you ask? Without getting to technical, the Fed has been using monetary policyto keep interest rates low. They did this to encourage people and businesses to take on loans, in hopes of getting money flowing through the economy.
So now let’s talk interest rates. Think of interest rates, or bond yields, as the return you will receive from the bond. Bond Prices and Yields are inversely related. Let’s say you have a Bond yielding 10%, and interest rates (returns) decline so bonds are now only yielding 5%; A plethora (had to) of people will want your 10% yielding Bond and you can charge a higher price for it. The opposite would be true if interest rates rose, nobody would want to buy your crappy Bond only yielding 10%.
OK we’re almost there. Since I am going into Financial Planning, long term horizons are most common. Day trading is too dangerous because I am, after all, supposed to make you enough money to buy a Ferrari and also that Yacht to retire on. Can’t risk not getting those gems on making false market timing bets.
So the Bond scenario above is only relevant if you sell your Bond before it matures. If you hold your bond to maturity, you will not actually lose money. Granted you may be missing out on higher yielding bonds, but you’re still receiving the locked in interest payments and principal when it matures.
Stay with me friends. If you want to learn more, this page from 2013 on ZeroHedge has just that http://www.zerohedge.com/news/2013-04-25/bonds-101-yields-prices-and-inflation. If you’re irritated because you already knew this about Bonds, here’s another thing to think about.
Here’s a pretty chart from Morningstar:
As the title suggests, Inflation is definitely the biggest Bond enemy. This is because Bond payments are fixed, and Inflation erodes the real value of money you’re receiving. Inflation isn’t as big of an enemy for stocks, because company earnings will usually increase and price in Inflation.
Sources: Morningstar: Investing in a Rising Interest Rate Environment PPT, Slide 15