Shifting from Stocks to Bonds May Be Risky

When the stock market is too risky (as it was in 2008), investors often flee to safer shores.

In many cases, U.S. Treasury Bonds are those safer shores. And why not, the U.S. government guarantees it will redeem the bonds at their face value if held to maturity.

In other words, if you buy $10,000 worth of U.S. Treasury Bonds you will receive that $10,000 back when the bonds mature. In the interim, you will receive interest payments twice per year.

If your goal is to buy and hold the bonds until maturity, this is all you really need to know.

Stocks and Bonds

However, many investors hold the bonds during difficult times in the stock market and then sell them on the open market when the investor wants cash to get back into the stock market.

This is a common strategy and one that works because there is a secondary market for buying and selling U.S. Treasury Bonds.

There is a risk however in this strategy. The U.S. Government guarantees to redeem the bonds at face value when held to maturity.

It does not guarantee that you will receive face value if you want to sell (as many do) before the bond's maturity.

There are three numbers that you need to know when assessing a bond:

• Coupon or stated interest rate � This is the interest rate that is used to compute interest payments to bond holders. In most cases, it does not change during the life of the bond.
• Face value � This is the value of the bond and what you will pay if you buy a newly issued bond from the U.S. Government. It is the amount you will receive when the bond matures. Yield � This is a computed interest rate for bonds sold on the secondary market. It changes based on the price of the bond in the secondary market. There are more complicated numbers (yield to maturity for example), but for purposes of this article, I'll keep it simple.

When you buy or sell a bond in the secondary market you are not dealing with the bond issuer, but another investor.

Price of Bond

This is important to know because the price of the bond may not be its face value.

Here's how it works. If a bond is issued with a stated interest rate of 6 percent it will pay the holder that interest rate for the life of the bond.

However, suppose the bondholder decides to sell the bond before the maturity date.

What the bondholder will receive for the bond is based on current interest rates and how they differ from the stated interest rate on the bond.

For example, a U.S. Treasury Bond is issued for $10,000 with a stated interest rate of 6 percent and a maturity in 10 years.

The bondholder wants to sell after just three years. In the three years that have passed, interest rates have climbed to 8 percent.

Who would want a bond paying 6 percent when they could buy a bond paying 8 percent?

Bond Rule

A rule about bonds: when interest rates rise, the price of existing bonds falls.

To entice a buyer, the bondholder must lower the price of the bond so that the interest rate (remember it is fixed at 6 percent) of the bond equals what an investor could receive from a new bond.

The math makes sense. If you are paying the same interest rate on a smaller principal the effective interest rate or yield is more than the original bond.

You can't change the interest rate on the bond. That's fixed at 6 percent. You can, however change the price you will take for the bond.

The annual payment of $600 ($10,000 x 6%) must equal an 8 percent payment. Doing the math, you discover that the face value of the bond must be discounted to $7,500 ($600/8% = 7,500) so that the $600 fixed payment equals an 8% yield on the buyer's investment ($7,500 x 8% = $600).

If interest rates went down instead of up, you could then sell your bond at a premium over face value because the fixed interest rate would be higher than the market rate.

Illustration

PLEASE NOTE: This is just an example to illustrate the relationship between interest rates and bond prices. It does not represent an actual computation. To do this calculation correctly would require a more complicated process and the answer would be different. However, the seller would still have to discount the face value of the bond to compensate for the interest rate difference.

This illustrates the risk investors face when holding bonds. If interest rates rise and they want to sell before maturity, the investor will have to take a discounted price for the bond.