A bond, as some people are likely aware, is a loan from the investor to the issuer of the bond. Issuers may include corporations, local municipalities, and the Federal Government (to name a few examples). U.S. government bonds, known as treasuries, are considered to be secure bonds a certain extent, because the interest and principal payments are guaranteed by what’s known as the “full faith and credit” of the U.S. Government. The current deficit of the U.S. Government is rather large; however, due to lack of historical default risk, these treasuries carry low yields (interest paid to the lender). Corporate and municipal bonds, by contrast, carry varying degrees of risk; thus, the reward for owning them is a potentially higher yield. In these cases, the interest and principal payments are guaranteed by what’s known as the “full faith and credit” of the issuing corporation or municipality.
A bigger question for those who currently own bonds is this: how do interest rates affect the value of bonds? The answer partially depends on what the owner of the bond plans to do with it. If a bond is held to maturity, interest rates have little or no effect on that particular bond (unless the issuer defaults). If there has been no default or any other issues, the principal is returned to the bond holder at maturity. However, if the bond holder decides to sell that bond before it matures; its value is determined by the current interest rate environment, supply and demand, remaining term, and the credit quality of the issuer.
A bond’s current value is inversely related to current interest rates. For example, a $10,000 bond that’s paying 3% annually is worth less on the secondary market if interest rates are at 4%. Similarly, that same bond would be worth more if current interest rates were at 2%. So if interest rates rise, the value of the existing bonds falls; if they decline, the value of the existing bond goes up. In order to sell a 3% bond in a 4% interest rate world, the seller must discount the price of that bond to something lower than its $10,000 face value. (Example is for illustrative purposes only and is not meant to represent performance of any particular investment.)
Many other factors must also be taken into consideration when owning, buying, and selling bonds, including the yield to maturity, the credit quality of the issuer, the duration of the bond, etc.
Should bonds play a role in your overall portfolio? Call the advisors at Lucia Capital Group at 800-644-1150, or find them online at wealthed.com, to find out whether owning bonds is a potentially good fit for your investment strategy.
Please note: It is important to keep in mind that investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Interest may be subject to the alternative minimum tax. Treasury securities are backed by full faith and credit of the U. S. Government but are subject to inflation risk.
Information presented should not be considered specific tax, legal, or investment advice. You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal.
Investment advisor representatives of Lucia Wealth Services, a registered investment advisor, are also registered representatives of, and offer securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Lucia Wealth Services and Lucia Securities, LLC are wholly owned subsidiaries of Lucia Capital Group.