With Bond Investing, It’s About Income, Not Price

FireAlarmEveryone hates to lose money.  It’s not fun to look at your portfolio value and see that it has gone down.  Yet if you are investing in bonds for income, portfolio value really isn’t all that important.  What is important is income.

Before going further, let’s talk about what a bond is.  When a company (or government) needs money, they can get a loan from investors.  Unlike a consumer loan, where you are lent some amount of money and then pay it off over a number of years, companies issue bonds.  With a bond, the investor will be paid a fixed amount of money for a period of several years.  At the end of the period, the company then pays back the loan.

Normally corporate bonds are issued in $1,000 increments and have a period of ten to twenty years before maturation – when the loan is repaid.  The first investors pay $1,000 per bond, but then they are able to sell these bonds to other people for more or less than $1,000.  The price they are able to get depends on interest rates and how safe people think the bonds are.  If interest rates go up after the bond it issued, the price will decrease, and vice-versa.  In really low interest rate environments like today, bonds may actually sell for more than the maturation price ($1,000) because people are willing to lose money when the bond matures because the interest they will receive in the mean time is worth the loss at the end.  They might buy a bond for $11,000 that they know will be repaid at $1,000 in a few years.

If the company has great finances and is almost sure to repay the loan at the end, the price fo the bond will tend to also stay around $1,000.  If things get dicey, where the company may default on the bond, the price will decline.  People want to make sure the interest rate they receive is worth the risk of a default.  Because bonds pay a fixed amount of money each year, the effective interest rate you get for your investment goes up if the price you pay goes down.

So right now, interest rates ae very low and the Federal reserve is indicating that they may raise interest rates soon.  If that happens, the price of bonds is sure to go down, so the value of your bond portfolio may decline.  If you are speculating, planning to sell your portfolio in a year or two, you should be concerned.  If you are planning to hold on for a long time, such that the bonds in that portfolio will have time to mature, price fluctuations between now and maturity date won’t really matter – you’ll get $1,000 per bond when the bonds mature regardless of what happens to the price between now and then.

So if you’re investing in bonds, don’t worry about what happens to the value of the portfolio.  It will go up and down with interest rates.  In fact, if the value declines and you have some cash sitting around, you can buy more bonds at a discount.  You’ll then get a better interest rate plus a little gain at the end when the bonds mature.  Instead, just focus ont he income you are receiving.  So long as the income stream remains in place, the rest is just noise.

To ask a question, email vtsioriginal@yahoo.com or leave the question in a comment.

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  1. Thanks for the informative post SI. I’ve just introduced a small allocation of bonds to my retirement portfolio, and consider them a good alternative to term deposits/fixed interest. As you mention, over the long term these short-term gyrations won’t matter too much, the bond sector my retirement account invested in is up 60% over the past 6-7 years.

    • Definitely better to be in bonds than CDs and other bank assets for money you’ll have more than a few years. You actually lose to inflation in bank CDs most of the time. Just the cost of having them hold on to your money for you, I suppose.

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