Purchasing bonds by owning a relationship fund is straightforward in comparison to selecting individual bonds. Few average investors can analyze bonds, so a large proportion buying bonds buy a mutual fund called a relationship fund, and let professional money managers make the selections for them. Hence, when you own a relationship fund you possess section of a professionally managed portfolio of bonds, often called an income fund.
Don't get confused. Purchasing bonds or an income fund has little in common with buying U.S. Savings Bonds. The federal government guarantees that you will not lose money in savings bonds. There's no market risk in these savings products. When investors speak of bonds they are not discussing savings bonds.
An attachment fund might be labeled as an income fund, because the primary objective is to supply higher income vs. other investments. bonds to invest in These funds pay dividends from the interest earned on the bonds in the fund portfolio. Along with this particular higher income, buying bonds involves risk. Bond prices or values fluctuate because bonds are marketable securities that trade in the open market, much like stocks do.
In order to understand buying bond funds, you first should find out some bond basics. Let's turn our attention now to a simplified bond example, a fresh dilemma of a really basic corporate bond.
ABC Corporation decides to boost a big amount of money to expand their operations. As opposed to selling stock to people, they decide to market bonds. In other words, they will borrow money from investors. Each bond has an experience value or initial bond price of $1000. The coupon rate will soon be 6%. They are top quality bonds and mature in 2039. Once every one of the bonds can be bought ABC gets their money, and these bonds begin to trade in the bond market.
If you get an ABC bond for $1000, ABC promises to pay you $60 per year, or 6%, for provided that you possess it until 2039 once the bond matures. During those times the bond owner gets the $1000 back, and the bond no more exits. Up until the period the deal never changes. ABC promises to pay the bond owner $60 per year, period.
You as a relationship holder are not required to put up the bond until 2039. You are able to sell it at will on the bond market, or buy more bonds at selling price if you wish. But beware that bond prices fluctuate, as do stock prices. Bond prices or values can go up and they are able to go down. In other word, a $1000 bond is not necessarily worth $1000 after it is issued. Hence,there's market risk involved when buying bonds.
Now picture an income fund invested in a portfolio of bonds similar to ABC bonds. Because this bond fund holds a wide variety of different bonds, investors will not need to worry about an organization like ABC going broke and not making interest payments or not paying investors back upon maturity. The fund is broadly diversified.
The real risk you need to be alert to when buying bonds and bond funds is of a different nature, and this risk is called interest rate risk. Interest rates in the economy fluctuate, but a bond's coupon rate does not. ABC bonds, for instance, pay $60 per year, period.
What are the results when long term interest rates in the economy go up? Simply this: the value of existing bonds, in other words bond prices, go down.
View it this way. If interest rates double and go from 6% to 12%, new bonds will soon be paying investors $120 per year in interest vs. $60. What you think investors in the bond market would be willing to pay for a 6% bond under these circumstances? Since investors buy bonds for the higher interest they give, the price tag on our 6% bond will fall just like a rock. The bond price will not likely fall in half, but it will soon be heading because direction.
Interest rates peaked in 1981-82, and have generally been falling since. Unlike our above example, falling interest rates send bond prices higher. Investors in bonds and bond funds get income from interest or dividends when interest rates fall, plus the value of the investment increases.
But interest rates can not fall forever. Once they do head north again many folks invested in bond funds or income funds will soon be caught standing flat footed. Invest informed and appreciate this: When interest rates go up significantly, the value of your bond investments will fall.
A retired financial planner, James Leitz posseses an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly using them helping them to attain their financial goals.
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