Helpful hints for bond investors — Part 1

As the S&P 500 has lost more than 10 percent annually, bond investments have produced returns of more than 7 percent.

Marvin Appel, MD., PhD & Brian Hufford, CPA, CFP

As the S&P 500 has lost more than 10 percent annually, bond investments have produced returns of more than 7 percent. This performance gap between stocks and bonds has encouraged investors to pour their assets into bonds, driving interest rates to the lowest levels in decades. Investors should consider the following issues before investing in bonds.

Bonds 1-2-3

A bond represents a loan made to a company or government from which the lender — the investor — receives interest payments. Bond investors rely upon the ability of the borrower to make the payments and return the principal at the end of the loan.

The main source of return on bonds is their interest. For example, a $1,000 bond that pays $50 per year and matures in 10 years will pay $50 during each of the next 10 years. When the bond matures, the investor recoups the original $1,000 investment.

The interest rate is the $50 annual payment (called the coupon, which is paid in half-year installments) divided by the price paid for the bond. In the previous example, the coupon represents a yield of 5 percent per year. This $1,000 bond held until its maturity will return 5 percent per year.

Investors who buy bonds and hold them until maturity know what the investment return will be over the entire life of the bond. The risks include the borrower's credit and the fact that inflation may increase enough to outstrip the interest income from the bond.

What happens if you decide to sell a bond before it matures? The investment return will depend not only on the interest income received during the time you held the bond, but on interest rate fluctuations. If interest rates go down, existing bondholders profit. If interest rates rise, existing bondholders lose.

Let's return to the example of the $1,000 bond that pays $50. Note that for a regular bond, the dollar amount of the coupon is fixed for the life of the bond. Suppose that interest rates fall to 4 percent. A new borrower now needs to pay only $40 per year on a $1,000 bond. A pre-existing bond that pays $50 should be worth more than $1,000 in this scenario. Likewise, if interest rates rise so that investors can now get $60 per year from interest on a newly issued, $1,000 bond, nobody would offer the same $1,000 for a pre-existing bond that pays only $50 per year. Interest rate risk is highest for long-term bonds, and lowest for short-term bonds (money markets).

The reason bond investors have done so well since 1999 is that interest rates have dropped substantially, producing large capital gains in addition to interest income. Interest rates cannot continue to fall indefinitely, so, at some point, bond returns will have to decrease. At current interest rates, it is unwise to assume that the past three years' returns on bond investments will continue over the long term.

Implications

Most analysts do not expect our country to suffer a prolonged recession like Japan. However, should something similar happen with our economy, bonds could be among the best investments, even at current low interest rates. On the other hand, if the economy starts growing briskly and the demand for corporate borrowing picks up, interest rates could rise and bond investors could suffer.

The bottom line is that bonds, especially long-term bonds, expose investors to economic risks that they should take into account before committing a large portion of their capital. Consider keeping a reserve in the money market, even though their yields are now paltry. Investors also should consider using Treasury inflation-protected securities for part of their bond investments (see the "Practical Investor," September 2001 Dental Economics.).

Next month, we'll discuss buying individual bonds from a broker and how to select bond mutual funds.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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