Invest in Bonds at Your Own Risk

You can invest in bonds to earn more interest, but if you do invest in bonds beware: it's at your own risk. Some of the safest and best bond funds are insured for credit risk and pay interest that is free from income taxes. None insure you against investor losses. And losses are virtually guaranteed when interest rates go up.

Some of the best bond funds today are municipal bond funds that are tax-exempt in terms of federal income tax on the interest earned from the securities in the portfolio. That's the good news. It gets even better. Some of these funds insure the investor against default of the bond issues held in the portfolio. And then there's the bad news called interest rate risk. It applies to municipal, corporate, government bonds and all of the mutual funds that invest in them.

The FDIC might insure you against loss in your bank savings account and the federal government will tell you on their web site that savings bonds are safe investments. But that's not the same as when you invest in bonds, even the U.S. Treasury issue which is the safest long-term debt security in the world. Marketable securities called BONDS all have risk associated with their ownership.

Even the best bond funds in the land do not claim to protect investors against a rising interest rate environment. In fact, every bond fund in America warns potential investors of the potential losses. Every one of them put it in writing for all to see in the prospectus and other investor material.

The truth of the matter is that after 35 years of investing and as many years communicating with the average investor I've learned one thing above all else. People don't understand the risks associated with bond investing. So let me save you thousands of dollars or so in the future by laying it out for you in simple terms.

Investors large and small have an intense interest in bond investing today because interest rates are at historical lows. People want to make more interest and that's the primary attraction of bonds of all kinds. Visualize a piece of paper that promises to pay you 5% a year for the next 20 years or so. For a $1000 investment you get $50 a year in interest and then you get your $1000 back upon maturity in 20 years or whatever. That's a bond, and the $50 figure never changes.

Now visualize the value of that same piece of paper as it continues to exist, if interest rates offered by new bond issues went up to 10% and paid $100 a year. And consider how unhappy you would be earning ½ the interest you could be earning with a new bond issue. With interest rates near all-time lows, the direction of future rates seems obvious to even the most casual observer.

The math need not be sophisticated or complex. Somebody will be willing to buy your piece of paper, but you won't get anywhere near $1000 for it unless you hold on until it matures. Meanwhile, whoever holds it is making a lousy interest rate for as long as rates are higher than what your paper promises.

It doesn't matter whether you own an individual issue or a bond fund. When interest rates go up these debt securities lose value because they become less attractive as income-producing investments. Long-term issues and bond funds that invest in them get hit the hardest. When interest rates are high and start coming down it's a great time to invest in bonds. You earn an attractive income while the value of your investment goes up.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.

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