A lot of people in the last couple years have rushed to bonds as the safe place to be. But that’s not necessarily the way it is. Too often, bonds are bought without fully understanding what’s involved.
Bonds can be a really good way for people to make their portfolios less risky. With bonds, you are like the bank lending money to a government or to a business or to whatever it is that your bond owns. But there could be danger here.
A classic example of the danger is what’s going on with Charles Schwab. Schwab was selling a bond fund called Yield Plus, which was supposedly safe like a money market fund…until it no longer was. Investors got hit with huge losses. Now there’s an investigation of the people involved and the brokerage has reached yet another settlement to pay a big fine over the false promises of safety it used to market Yield Plus.
Since that news broke, many other sellers of bonds are no longer making claims about safety. But old habits die hard and people still try to run to bonds for safety.
Here’s the problem: If you buy a bond fund and interest rates go up, the value of your bonds go down. Depending on what kind of bond you have, the value could go way down. Let’s say you buy a bond at 3%, and then interest rates rise and new bonds are issued at 4%. If you needed to sell your bond, you’d be forced to discount your bond to the point that the new buyer would effectively make the entire 4% interest on their money.
So, as interest rates go up, the value of bonds go down. As interest rates go down, the value of bonds go up. Remember that and you won’t get burned.