In this time of market turmoil, it is imperative that investors understand the risks that now exist in bonds. Bond price and bond yield move inversely to each other. That means, when bond prices go up, the yield goes down.
The yield is just a fancy word for the interest payment or the dividend payment as you might think of it in stocks. Unlike stock dividends, which can fluctuate according to the profitability of the company; bond yields are determined when the bond is written. Say you have a bond that pays $60 annually and sells for $1,000. That bond has a 6% yield, not bad.
Well, when that bond goes on sale, the price will fluctuate according to the interest rates available in the market at the time. If real interest rates, or market rates are 4.5%, then you'll most likely see this bond issue trade "above par". That means that the bond will trade north of $1,000 because it offers a higher than market rate interest rate or yield. If the bond trades all the way to the "market rate", the bond will be worth $1,244.33. That's a 24.4% increase in the price of the bond! This is how people make money in a deflationary period by owning bonds. This is what we have seen this year as $500 Billion has gone into bond mutual funds.
Owning bonds when rates are low is terrific, as they offer terrific safety and even a chance for a capital gain, on top of the interest you will earn. But what happens when interest rates are on the rise?
That's right, when interest rates rise, if you are holding a bond that offers a smaller interest rate than the market rate...the bond price has to decline in order to bring up the yield on the bond. So, take a bond with a 3% interest rate, when market rates are 4.5%. The same $1,000 bond will have to trade down to $754.38 just to have the 3% yield rise to the market rate of 4.5%. What happens if interest rates rise more than 1.5%? Let us just say that you do not want to have a large bond portfolio when interest rates or inflation sets in.
This is why Jim Cramer says holding a massive portfolio of bond mutual funds is just reckless. If you hold an individual bond, you always have the option of holding it 'till maturity, ensuring that you are given the principal back. You can also wait out a turbulent interest rate environment if your time until maturity is far enough out. But, if you have something with a shorter duration and a lower interest rate, you face significant risk to your principal. We are not saying that you shouldn't own bonds. In fact, based on your age, risk tolerance, and diversification needs you probably want to own some bonds. But, when things change, and you hold a mutual fund of bonds...what do you think that fund manager is going to do when rates change or inflation appears? The answer probably isn't hold the bond until maturity. All of that selling across that $500 Billion of bond funds will be like yelling fire in a crowded building...probably not the best thing for your principal.
So, before you buy bonds this year, think about what might happen in the future and choose carefully.