Critical To Investing In Bonds: Understanding Them

- Alan Lavine and Gail Liberman

In fact, in a bond quiz by American Century Investments, Kansas City, the average score was less than four correct answers out of 10. The quiz went to 400 investors.

David MacEwen, chief investment officer at American Century, says the results of the study are disturbing. The reason: Many experts believe bond prices could decline this year. Bond prices and interest rates move in opposite directions, and interest rates are expected to rise as the economy picks up steam. This means bonds could suffer.

It is critical that you understand this relationship before investing in bonds. Because of economic predictions, it could be best to keep your powder dry when it comes to bonds. When rates rise, then invest. Or, you might buy bonds that mature at different dates. Then you will have money to roll over at higher rates.

"Even in years when the potential for higher interest rates dominates the news, investors still are in the dark on some basic financial principles," he says. "If it is true that we are headed into a higher rate environment, now more than ever, it important for investors to understand the concepts."

What you need to know:

- Bond prices move in opposite directions to interest rates. If you need to sell a bond prior to maturity, expect these factors to influence its value: If rates rise, bond prices fall. The longer the maturity of the bond, the greater the price decline. For example, if interest rates rise 1 percent, the price of a five-year Treasury bond will decline about -4 percent if you go to sell it. But a 20-year bond's price will drop -10 percent.

- Individual bonds mature. So even though the price of an individual bond can rise or fall based upon interest rates or news about business, this shouldn't affect you provided you hold the bond to maturity. You should get your full principal back. To profit or lose money with an individual bond, you must sell it prior to maturity.

- Bond funds do not mature. Bond funds own a large number of bonds and have no maturity date. Thus, you can lose money with a bond fund. Even if your bond funds hold the safest U.S. Treasury bonds, there is no guarantee you will get your principal back.

- U.S Treasury bonds are guaranteed against default by the U.S. government. But corporate bonds are only as safe as the financial strength of the issuing company. The financially strongest rated corporate bonds carry triple A ratings by Standard & Poor's and Moody's. The riskiest corporate bonds carry ratings below triple B.

- The higher the bond yield, the greater the risk of default.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).